Attachment 5 to Industry Director Directive on Super Completed Contract Method
Proforma Form 5701 – Land developer deferring sales of improved lots under the completed contract method until the entire development is considered complete.
Whether the contracts between the Developer Partnership (taxpayer) and Home builder Partnership for the sale of residential lots are "home construction contracts" as described in section 460(e)(6) of the Code.
A consolidated group of corporations is involved in developing large master planned residential communities. In an effort to effectively manage these large developments, two partnerships are formed: a Developer Partnership (the taxpayer) and a Home builder partnership. The taxpayer purchases the tract of land, obtains approvals, permits, required zoning, builds the roads and other improvements. The lots are sold to the Home builder Partnership who eventually builds homes on the improved lots. The completed homes are then sold to unrelated third parties. The taxpayer and the Home builder Partnership are owned 100% by members of a consolidated corporate group.
The taxpayer enters into a single contract with the Home Builder Partnership. In addition to the sale of the real estate, the taxpayer is required to provide paved roads, curbs, gutters, and utilities (up to the perimeter of the lots) to service the lots. The sale of the real estate to the Home Builder Partnership is determined on an annual “take-down” schedule in which a specific number of lots are sold to the Home Builder Partnership each year.
The taxpayer does not build houses or dwelling units in the communities. The Home builder partnership and its subcontractors build the dwelling units in the communities.
During the years under examination, at the time of the sale of lots to the Home Builder Partnership, the taxpayer has not completed all the lot improvements or common improvements that are required to be provided within the community. The estimated construction costs to be provided by the taxpayer exceed 10% of both total contract price and the contract price on a lot-by-lot basis. Therefore, the taxpayer's contracts are long-term construction contracts. The contract does not meet the de minimis construction activities standards defined in Treas. Reg. Reg. 1.460-1(b) (2) (ii).
For tax purposes, the taxpayer has adopted the completed contract method under the premise that the single contract with the Home Builder Partnership is a home construction contract. The taxpayer is deferring the income recognition on the sale of all the lots until the date of final completion of its obligations under the contract and acceptance by the Home Builder Partnership of the improved lots even though many of these lots have already been sold to unrelated third parties. For financial statement purposes, the taxpayer defers the sale of the lots until the lot is sold outside of the controlled group (i.e. sold by the Home Builder Partnership to an unrelated third party).
Tax Law and Argument:
HOME CONSTRUCTION CONTRACT
I.R.C. § 460(a) generally requires the use of the percentage-of- completion method of accounting for long term contracts. See also Treas. Reg. § 1.460-1(a)(1) and Treas. Reg. § 1.460-3(a).
I.R.C. § 460(e)(1)(A) provides an exception from the general rule requiring use of the percentage-of-completion method, namely "any home construction contract."
I.R.C. § 460(e)(6)(A) defines a home construction contract:
460(e)(6)(A) HOME CONSTRUCTION CONTRACT. —The term “home construction contract” means any construction contract if 80 percent of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to activities referred to in paragraph (4) with respect to —
460(e)(6)(A)(i) dwelling units (as defined in section 168(e)(2)(A)(ii)) contained in buildings containing 4 or fewer dwelling units (as so defined), and
460(e)(6)(A)(ii) improvements to real property directly related to such dwelling units and located on the site of such dwelling units.
For purposes of clause (i), each townhouse or rowhouse shall be treated as a separate building.
For purposes of I.R.C. § 460(e)(6)(A), dwelling unit is defined at I.R.C. § 168(e)(2)(A)(ii) as "a house or apartment used to provide living accommodations in a building or structure... ."
Treas. Reg. § 1.460-3(b)(2) further defines a home construction contract:
(2) Home construction contract
(i) In general. —A long-term construction contract is a home construction contract if a taxpayer (including a subcontractor working for a general contractor) reasonably expects to attribute 80 percent or more of the estimated total allocable contract costs (including the cost of land, materials, and services), determined as of the close of the contracting year, to the construction of —
(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I), contained in buildings containing 4 or fewer dwelling units (including buildings with 4 or fewer dwelling units that also have commercial units); and
(B) Improvements to real property directly related to, and located at the site of, the dwelling units.
(ii) Townhouses and rowhouses. —Each townhouse or rowhouse is a separate building.
(iii) Common improvements. —A taxpayer includes in the cost of the dwelling units their allocable share of the cost that the taxpayer reasonably expects to incur for any common improvements (e.g., sewers, roads, clubhouses) that benefit the dwelling units and that the taxpayer is contractually obligated, or required by law, to construct within the tract or tracts of land that contain the dwelling units.
Treas. Reg. 1.460-3(b)(2)(i) describes which long-term construction contracts are home construction contracts. In general, 80 percent of the contract costs must be attributable to construction of the dwelling unit and improvements to real property “directly related to, and located at the site of, the dwelling units” being constructed under the contract in Treas. Reg. 1.460-3(b)(2)(i)(A). For purposes of meeting the 80 percent test, builders with contracts calling for the type of construction described in Treas. Reg. 1.460-3(b)(2)(i) may, under Treas. Reg. 1.460-3(b)(2)(iii), include the costs of common improvements (required by law or by the contract) in the costs of the dwelling unit being constructed under the contract. Thus, a contract provided for the construction of a house cannot fail the 80 percent test because the cost of common improvements required by the contract is over 20 percent of the contract costs.
However, a contract solely for the construction of common improvements cannot be a home construction contract for two reasons. First, the contract does not require construction activity described in Treas. Reg. 1.460-3(b)(2)(i). Therefore, the contract will have no dwelling unit cost to which the costs of the common improvements will be added as required by Treas. Reg. 1.460-3(b)(2)(iii). Second, common improvement costs, although added to Treas. Reg. 1.460-3(b)(2)(i) costs, do not qualify by themselves as Treas. Reg. 1.460-3(b)(2)(i) costs. This is because common improvements, regardless of whether they are located on a particular building lot or not, benefit more than one dwelling unit. Therefore they are not “directly related to” any particular dwelling unit being constructed. In summary, Treas. Reg. 1.460-3(b)(2)(iii) is a cost allocation rule for home construction contracts and does not provide an alternative means to qualify a long-term construction contract as a home construction contract.
Because taxpayer’s contract for the development and sale of lots is not a home construction contract, taxpayer may not use the completed contract method of accounting but must use the percentage of completion method of accounting to report income and costs.