Potential Opportunity for Developers to Defer Income

Is a contract for the sale of a house – that is part of a larger development – considered “complete” when that particular home is sold? Or is the sale not completed until the entire development, including common improvements, is finished? The answer, according to a recent decision by the Tax Court, creates a potential opportunity for homebuilders to defer significant income.

The Shea Controversy

In Shea v. Commissioner, 142 T.C. 3 (2/12/2014), the Tax Court permitted a homebuilder using the so-called “completed contract method” to defer the recognition of income related to the sale of homes within a development, until that entire development in which the homes were located was complete. The controversy involved Shea Homes, a home development business in Arizona, California and Colorado (a corporation and two partnerships related through common ownership).

Every case is based on its facts and circumstances, and the facts in this case were quite favorable to Shea Homes. Specifically, Shea opted to develop planned communities, typically ranging from 100 to 1,000 homes. They emphasized the features and lifestyle of the planned community to those potential buyers, rather than merely providing “bricks and sticks.”

On one hand, according to the IRS, the purchase contract for an individual home identified that house as the subject matter of the contract. On the other hand, Shea emphasized that the contract obliged the builder to complete the amenities – pools, golf courses and clubhouses – for the entire neighborhood – typically upwards of 30% of total budgeted costs.

The Completed Contract Method

In preparing its tax returns, Shea reported the income from the sale of homes using the completed contract method. The good news is that certain contractors and home builders, such as Shea, typically recognize income related to so-called “long-term contracts” only when those contracts are complete. The bad news is that “completion” is determined on a contract-by-contract basis, since it is not defined by tax code section 460.

Instead, the IRS issued regulations that a contract is completed when it meets two tests: 1) the “use and 95% completion test,” and 2) the “final completion and acceptance test.” In this case, the IRS and Shea disagreed how to apply the cost of common improvements to those tests, for purposes of determining if Shea’s home sales qualified as “long-term contracts.”

A Favorable Outcome

In determining when its contracts to sell a home were complete, Shea took the position that the subject matter of its sales was not merely the home, but rather the broader development, including the common improvements. Under this methodology, Shea deferred recognizing income related to the sale of a home until the last road in the development was paved and the final bond was released.

The Tax Court agreed with Shea’s argument: The subject matter of the home-sale contracts included not only the house, but also the common improvements that are shared by all homeowners within the development, and even the development as a whole. After all, it was the entire development, rather than a specific home, that attracted buyers.  By broadening this definition of the subject matter of the contract, Shea argued that the costs incurred to complete these improvements and the entire development must be included within the total costs to be incurred for purposes of determining when a contract was complete.

As a result, Shea could defer recognizing the income related to homes that had sold and closed until 95% of all costs to complete the development were complete. By using this methodology, Shea deferred nearly $900 million of income from the sale of homes under the completed contract method until a later year. Shea would only recognize the income when it determined that 95% of the total cost of the developments – including the common improvements – had been incurred.

Going Forward

Based on the Tax Court’s decision in Shea, all home developers should reevaluate their use and application of the completed contract method. In many instances, a contract to complete the construction of a home that is part of a larger development will not be considered “complete” for purposes of the completed contract method until the entire development is complete. The result: substantial deferrals of income.

But recall that this decision was based on the particular facts of the case where Shea Homes:

• ggressively marketed its developments as a whole;
• devoted a large part of the total budget to common improvements; and
• operated in three jurisdictions (AZ, CA, CO) whose definition of “real estate” included allocable common improvements.

The bottom line: Home developers should be aware of the planning opportunities from the Shea decision. Please don’t hesitate to contact me or your EisnerAmper tax advisor if you’d like to discuss whether the completed contract method could allow you to defer significant amounts of revenue.