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Why the Shea Homes case should be important to homebuilders
In the recent Shea Homes v. Commissioner case, the Tax Court affirmed the taxpayer's position that they could consider their entire project development costs, including amenities, for the purpose of qualifying to use the completed contract method of accounting. Taxand USA discusses why this case should be of importance to homebuilders.
In general, Section 460 of the Internal Revenue Code requires the use of the percentage of completion method (PCM). PCM permits (requires) the deferral of recognition of any contract revenue until the conclusion of the contract, but also prevents the deductibility of any costs incurred until the related contract revenue is recognised.
In Shea Homes, the taxpayer took the position on its tax returns that final completion and acceptance does not occur until the last road is paved and the final performance bond required by state and municipal law is released, therefore applying the use and 95% completion test. The IRS argued that the subject matter of the taxpayer's contracts consisted only of the houses and the lots upon which the houses were built. Under this interpretation, the contract for each home met the final completion and acceptance test when the escrow closed for the sale of each home. As a result, the dispositive issue in Shea Homes was whether roads and other community amenities were properly considered as part of the individual home contracts for purposes of Section 460.
The Tax Court agreed with the taxpayer's position that the relevant subject matter of the home contracts included the house, the lot, improvements to the lot and common improvements to the development. The amenities of the development were a crucial aspect of the taxpayer's sales effort, the local government's decision to approve the development, and the buyers' decision to purchase houses in the development.
Also published in Thomson Reuters' Taxnet Pro, 28 March 2014
Even if a taxpayer does not want to make any changes with respect to its active development projects, a homebuilder may use the completed contract method for future phases of development projects or for future projects by using a new entity for those projects. This new entity would then adopt the completed contract method in its initial tax year. Homebuilders should carefully analyse how Shea Homes may apply to their specific facts and circumstances in order to reap the potential benefits from this potentially favourable development. But homebuilders should also be wary of the fact that the completed contract method could be a double-edged sword if a project operates at an overall loss, since its application could result in a deferral of the losses.