Big Win for Residential Homebuilders

Written on July 28, 2014

The United States Tax Court recently issued an opinion that gives homebuilders more flexibility in recognizing revenue under the completed contract method. In Shea Homes, Inc. and Subsidiaries, et al. v. Commissioner of Internal Revenue[1], the Tax Court held that contractors using the completed contract method were not required to recognize revenues upon completion of an individual home, but rather the contracts would be deemed completed upon the completion of the larger development, including amenities and other common improvements.

Shea Homes, Inc. and its subsidiaries (“Shea”) operate as one of the largest private homebuilders in the United States, building planned communities in Colorado, California and Arizona.  Shea promoted itself as more than a homebuilder. As part of its marketing and advertising, Shea emphasized the importance of lifestyle and community associated with a planned development. Shea’s marketing was aimed at selling the development’s lifestyle, and not just a home’s “bricks and sticks.” Shea invested up to 30 percent of the total cost into different amenities for the development, including pools, golf courses and clubhouses. In addition, Shea put up bonds with state and local governments to ensure the “common improvements” were finished.

Completed Contract Method

Shea recognized income from the sale of the homes under the completed contract method.[2] Under this method, income from a long-term “home construction contract” may be recognized when it meets one of two tests. The first is known as the use and 95 completion test, and the second is known as the final completion and acceptance test. These two tests are to be determined without regard to “secondary items.”

If the contract is completed within the same year, under either test, the contract is deemed short-term and the income must be recognized when it is earned or received, whichever is earlier. If the contract qualifies for long-term treatment because neither test is met within a year, income should be recognized using the percentage of completion method. However, there is an exemption for “home construction contracts” that allows for the completed contract method.

Home Construction Contract

A “home construction contract” is “any construction contract if 80 percent of the estimated total contract costs are reasonably expected to be attributable to building, construction…or improvements of, real property with respect to (1) dwelling units… and (2) improvements to real property directly related to such dwelling units and located on the site of such dwelling units.” The wording “on the site” can cause many homebuilders to fail the 80 percent test, especially in Shea’s case, because a large percentage of the costs are attributable to the amenities and other common improvements not located on the dwelling’s site. Regulations do, however, include costs “that the taxpayer reasonably expects to incur for any common improvements (e.g., sewers, roads, clubhouses), benefit the dwelling unit and which are contractually obligated, or required by law.”[3] Therefore, for the 80 percent test, common improvements are directly allowed to be included in the total contract costs.

Shea recognized income based on the first test, the use and 95 percent completion test. Shea, therefore, recognized income when the customer used “the subject matter of the contract… for its intended purpose and 95 percent of the total allocable costs have been incurred by the taxpayer.”[4] Shea concluded that the common improvements were part of the total costs.

The Commissioner of the Internal Revenue Service (“Commissioner”) argued that Shea’s method of accounting was incorrect and income should be reported based on the second test, the final completion and acceptance test. The Commissioner also argued the common improvements and amenities should not be used in the determination of the subject matter of the contract. Accordingly, the Commissioner argued that income should have been recognized in the years in which the individual home contracts closed in escrow. Because Shea argued that the entire development should be considered the subject matter of the contract, Shea believed that even if the second test is used, the contract is completed when the last road of the development has been paved and the final bonds have been released.

The Court’s analysis hinged upon the determination of the “subject matter of the contract.” After looking at Shea’s marketing strategy, the contract documents, as well as each individual state law regarding integration clauses and what the court believed the customer was contracting into, the Tax Court ruled that the purchasers were not simply buying a home, but rather were buying the idea and lifestyle of the development and its accompanying amenities. The Tax Court determined that Shea appropriately accounted for its income based on the completed contract method, deferring revenue until 95 percent of the entire development was completed. Shea deferred nearly $900 million in income to later years.

Contact Us

If you have any questions about how this tax opinion could affect you and your business, please contact your Warren Averett Advisor.

 


[1] Shea Homes, Inc. and Subsidiaries, et al. v. Commissioner, 142 T.C. No. 3 (02/12/2014) (Code Sec(s) 446; 460).

[2] IRC §460 (e)(1)(A)

[3] IRC Sec. 1. 460-3(b)(2)(iii).

[4] IRC Sec. 1. 460-1(c)(3)(i)(A).

Back to Resources
Top