An important victory for residential builders who wish to defer recognition of project income was recently reported. In Shea Homes Inc. et al. v. Commissioner (142 TC No. 3 (Feb. 12, 2014)), the U.S. Tax Court decided that planned community developers can use the completed contract method to recognize income. The contracts at issue were long-term contracts that qualified under IRC Section 460 as home construction contracts.

The taxpayers elected to use the completed contract method to recognize taxable income under the contracts. At issue was the point in time when the contracts were completed under Section 460. The relevant test in the Section 460 regulations provides that completion occurs upon “[u]se of the subject matter of the contract by the customer for its intended purpose (other than for testing), and at least 95% of the total allocable contract costs attributable to the subject matter have been incurred by the taxpayer.” 

The IRS took the position that the subject matter of the contract was each individual home in the development and that each contract was completed upon the sale of the home. The contractor took the position that the subject matter of the contract was broader and encompassed the entire development, or in some cases even larger developments, and the completion and sale of the home was only a part of the development phase. Under such an interpretation, the costs of the contract included all common improvements associated with the development. After applying the applicable provisions of state law, the court found that the method of accounting used by the taxpayers clearly reflected income and that that IRS was not permitted to change their method of accounting, even to a method that more clearly reflected income.

The significance of the opinion is that the completed contract method for multi-phase residential projects is a permitted way to defer contract income for closed sales to later years. The interest savings on deferred tax payments could be substantial and might be a material element in funding a project.

In order to take advantage of this method, a residential developer will be required to construct the project using a special purpose entity that is not ignored for federal income tax purposes. For example, a limited liability company or a partnership that has two or more members, even though the interests of the entity are controlled by the same members or partners, would be acceptable. Use of this type of entity will permit the developer to adopt the completed contract method for that specific project, subject to the anti-avoidance restrictions contained in partnership tax regulations.

David Tavolier regularly represents clients in real estate activities, and Padric Kelly O’Brien represents clients in revenue and expense recognition planning before the IRS.