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Fifth Circuit Affirms Bright Line Test on Use of Completed Contract Method by Developers.

(Parker Tax Publishing November 16, 2015)

The Fifth Circuit affirmed a Tax Court decision holding that a developer's contracts were not home construction contracts and, thus, gain or loss from such contracts could not be reported using the completed contract method. The court relied on the fact that the taxpayer did not build homes on the land it sold, and qualifying dwelling units did not exist at the time of the sales. Howard Hughes Company, LLC v. Comm'r, 2015 PTC 387 (5th Cir. 2015).

Background

In 2007 and 2008, The Howard Hughes Company, LLC (HHC) and its subsidiaries were in the residential land development business. They generated revenue primarily by selling property to builders who would then construct and sell homes. The land HHC sold was part of a large master-planned community known as Summerlin. Summerlin is divided into three geographic regions, each of which was further divided into villages averaging about 500 acres. Those villages were further divided into parcels, or neighborhoods, which contained the individual lots.

Sales by HHC generally fell into one of four categories: (1) pad sales; (2) finished lot sales; (3) custom lot sales; and (4) bulk sales. In a pad sale, HHC, after dividing the village into parcels, constructed the entire infrastructure in the village up to a parcel boundary. HHC then sold the parcel to a buyer, usually a homebuilder, who was responsible for the entire infrastructure (such as streets and utilities) within the parcel and subdividing the parcel into lots. In a finished lot sale, HHC also divided the village into parcels, constructed any additional needed parcel infrastructure, divided the parcels into lots, and sold the neighborhoods to a buyer, usually a homebuilder. In both the pad sales and the finished lot sales, HHC contracted with homebuilders through building development agreements (BDA).

Custom lot sales were essentially the same as finished lot sales, except that HHC sold the individual lots. The buyers of these individual lots were individuals who were contractually bound to build a residential dwelling unit. Finally, in a bulk sale, HHC sold entire villages to purchasers, who would then be responsible for subdividing the village into parcels and lots and for constructing all of the infrastructure improvements within the village.

The BDAs, loan agreements, governmental laws, and other legal obligations required HHC to build infrastructure and common improvements in Summerlin, such as parks, roadways, and water and sewer systems. Some of these improvements were necessary for construction of the dwelling units. In addition, HHC monitored and maintained approval control over all construction in Summerlin, including construction of the dwelling units. HHC did not build homes, perform any home construction work, or make improvements within the boundaries of any lots in Summerlin.

In 2007 and 2008, HHC used the "completed contract method" of accounting in computing gain or loss from their long-term contracts for the sale of residential real property in Summerlin. By using this method, HHC deferred reporting income on a contract for the sale of land until the contract was "complete," i.e., until the year in which HHC's incurred costs reached 95 percent of their estimated contract costs.

OBSERVATION: HHC's method of accounting was in contrast to the general method of reporting income under long-term contracts, the "percentage of completion" method. The percentage of completion method requires a taxpayer to recognize gain or loss annually in proportion to the progress the taxpayer has made during the year toward completing the contract.

The IRS disagreed with HHC's method of accounting and issued notices of deficiency for the 2007 and 2008 tax years, changing the method of accounting and increasing taxable income.

Tax Court Opinion

Code Sec. 460 requires taxpayers to account for long-term contracts under the percentage of completion method and generally prohibits the use of the completed contract method, subject to certain exceptions. One such exception is for "home construction contracts." Under Code Sec. 460(e)(6)(A), a contract is a home construction contract if it satisfies a two-prong test. Under that test, 80 percent of its costs must come from building, construction, reconstruction, rehabilitation, or integral component installation with respect to (1) dwelling units, and (2) improvements to real property directly related to and located on the site of such dwelling units.

The Tax Court held that HHC's contracts were long-term contracts within Code Sec. 460 but were not "home construction contracts" that would permit the use of the completed contract method. The lack of any home construction activity on the part of HHC was particularly important to the Tax Court.

The court found HHC's costs did not come within the first prong of Code Sec. 460(e)(6)(A), because HHC did not engage in any activities attributable to the construction of the dwelling units. The court determined HHC's contract costs also did not come within the second prong of Code Sec. 460(e)(6)(A) because the costs were not incurred for improvements "on the site of such dwelling units," a phrase which the court interpreted to mean "the individual lot."

The Tax Court concluded its opinion by drawing a bright line, under which a contract could qualify as a home construction contract only if the taxpayer builds, constructs, reconstructs, rehabilitates, or installs integral components to dwelling units or real property improvements directly related to, and located on, the site of such dwelling units.

Fifth Circuit Affirms Tax Court

On appeal, the Fifth Circuit affirmed the Tax Court, holding that HHC's contracts were not "home construction contracts", thereby making HHC ineligible to use the completed contract method of accounting.

As the Tax Court recognized, the Circuit Court said, Code Sec. 460(e)(6)(A) creates an 80 percent test that allows a contract to qualify as a home construction contract if 80 percent of its costs come from construction activities directed toward the two prongs of the statute.

The Circuit Court noted the Tax Court held that the first prong applies only if the taxpayer builds, constructs, reconstructs, rehabilitates, or installs integral components to dwelling units, and found that a plain reading of the statute supported that holding. Because the first prong refers to activities with respect to dwelling units, and since a dwelling unit is "a house or apartment used to provide living accommodations" (as defined in Code Sec. 168(e)(2)(A)(ii)(I)), the court stated that necessarily means that a taxpayer seeking to use the completed contract method must be engaged in construction, reconstruction, rehabilitation, or installation of an integral component of a home or apartment. Because the costs HHC incurred were not the actual homes' structural, physical construction costs, or were not related to work on dwelling units, the court determined HHC did not come within the first prong.

The Circuit Court found the Tax Court correctly rejected HHC's argument that it fell within the second prong, because HHC's construction activities for common improvements were not located on the site of such dwelling units. The court agreed with the Tax Court's holding that the word "site" in the statute meant a single site of a building otherwise described as a "lot." Because HHC never made improvements on the lots where homes were built, the Circuit Court concluded that HHC's construction activities did not come within the plain language of the statute.

HHC also argued that they could use the completed contract method as the result of Reg. Sec. 1.460-3(b)(2)(iii), which provides, in general, that taxpayers include in the cost of the dwelling units their share of costs the taxpayer reasonably expects to incur for any common improvements that benefit the dwelling units. HHC argued that this regulation allowed them to count their common improvement costs in the 80 percent test since it directly referred to the type of "common improvements" they constructed.

The Tax Court noted, the Circuit Court said, that the regulation required that the taxpayer must have at some point incurred some construction cost with respect to the dwelling unit to include common improvement costs in the dwelling unit cost. The Circuit Court stated the plain text refers to the "costs of the dwelling units," which meant that there must be dwelling unit costs before taxpayers can count their common improvement costs towards the 80 percent test. Because HHC had no dwelling unit costs in which to include the common improvement costs, the Circuit Court found the Tax Court correctly rejected this argument. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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