The Howard Hughes Company, LLC, et al. v. Commissioner, (2014) 142 TC No. 20
In recent consolidated cases, the Tax Court concluded that none of taxpayers' contracts were home construction contracts and, therefore, were not eligible for the completed contract accounting method. In 2007 and 2008, taxpayers developed infrastructure for residential communities in Las Vegas. Using the completed contract accounting method, taxpayers deferred gains from the sales of property made to builders who constructed homes on the developed land. The Tax Court found that these sales did not meet the home construction contract requirements in Internal Revenue Code (“IRC”) Section 460(e), which allows the completed contract method of accounting, but instead were long-term contracts that qualified for the percentage-of-completion method of accounting. The Tax Court assessed more than $144 million in back taxes for the years at issue.
The Howard Hughes Co., LLC and Howard Hughes Properties, Inc. (collectively “Hughes”) developed land in the Las Vegas area. Hughes sold the land through various types of agreements to builders who constructed and sold the houses. Under the sales contracts, Hughes was required to develop the necessary infrastructure for the communities including the water, sewer, gas and electrical lines, roadways, parks and other open space improvements. In all instances, Hughes did not construct residential dwelling units on the land they sold. On audit, the IRS challenged the taxpayers' accounting practices, alleging that none of the contracts were home construction contracts. Additionally, the IRS asserted that some of the contracts were not long-term contracts eligible for the percentage-of-completion accounting method, but were strictly land sales which would require immediate revenue recognition.
A long-term contract is any contract for the manufacture, building, installation, or construction of property, if not completed in the tax year in which the project began. In general, Section 460 requires long-term contracts be accounted for under the percentage-of-completion method. Under this method, revenue is recognized as contract costs are incurred. However, Section 460(e) carves out two exceptions in which the completed contract method may be used instead of the percentage-of-completion method:
1) Home construction contracts where 80% or more of the estimated total contract costs are reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of dwelling units contained in buildings containing four or fewer dwelling units, and to improvements to real property directly related to the dwelling units; and
2) Any other construction contracts, if:
(a) The taxpayer estimates (when entering into the contract) that the contracts will be completed within two years of the contract commencement date; and
(b) The taxpayer has less than $10,000,000 of average annual gross receipts for the three taxable years preceding the year in which the contract is entered.
Under the completed contract method, a taxpayer does not report income until a contract is complete, even if payments are received in years before completion.
The Tax Court Decision
The Tax Court determined that all of Hughes's contracts were long-term contracts. The Court reasoned that if the subject matter of some of the contracts was solely the sale of a piece of land, then income would be recognized upon close of escrow. However, the court found that the subject matter of the contracts encompassed more than just the sale of land, as Hughes had obligations under the contracts to complete certain required improvements. Accordingly, the Tax Court rejected the IRS’s position that these contracts were not long-term contracts.
However, the Tax Court held that none of Hughes's contracts were home construction contracts under Code Sec. 460(e). The Court concluded that a “contract can 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. It is not enough for the taxpayer to merely pave the road leading to the home, though that may be necessary to the ultimate sale and use of a home.” Accordingly, Hughes could not report gain and loss from these contracts using the completed contract method of accounting.
The Court also clarified that while the allocable costs of common improvements can be taken into account when determining if a contract qualifies as a home construction contract as concluded in Shea Homes, Inc. & Subs. v. Commissioner, the Court did not say that a home construction contract could consist solely of common improvement costs. Additionally, the Court confirmed that in order to qualify as a home construction contract, a contract does not necessarily have to be for the actual sale of a home. For instance, a subcontractor who does the electrical work inside a home may have a home construction contract even though they do not sell the home.
The Tax Warrior Perspective
This case highlights the increased scrutiny the IRS is giving long-term real estate development contracts, especially as construction is beginning to pick up now that the real estate market is beginning to recover. The rules in this area of the Code are dense and when mastered, can provide excellent tax deferral opportunities for certain taxpayers. Unfortunately for Hughes and other Real Estate Developers who deal exclusively in Land Development, this case brings new clarity to the Code, Regulations and case law that is not favorable. If you are a Land Developer using the Completed Contract method of accounting you may want to consult your tax advisor and consider filing an Application for Change in Accounting Method (Form 3115).
The Tax Warriors® at Drucker & Scaccetti have extensive experience in representing individuals and businesses that develop, invest, own and operate in the real estate industry. We are able to help you navigate this section of the IRC to make you as tax efficient as possible. Contact us via the “Ask A Tax Warrior” button below if you have any questions about your specific situation. We are always prepared to help you with this or any other tax matter related to real estate ownership.