Developers of upscale home communities could include common improvements and infrastructure in contract subject matter for the completed-contract method of recognizing income from the sale of homes.
The Tax Court held that in deferring recognition of its home-sales income while the homes’ developments or phases were incomplete, a residential builder and developer and its subsidiaries fairly reflected their income under the completed-contract method.
Facts: Shea Homes, a builder and developer of upscale planned communities in multiple states, prides itself on providing customers with more than just the “bricks and sticks” of a home. Its marketing emphasizes to potential buyers the communities’ features, amenities, and lifestyle. While home sales are its primary source of revenue, Shea Homes’ costs include land acquisition, community design, and construction of amenities. For the 2004 and 2005 tax years, Shea Homes and its subsidiaries deferred income from home sales occurring in those years for homes in developments or development phases that were not yet completed. Denying the deferrals, the IRS assessed deficiencies against Shea Homes and proposed adjustments of partnership income of two subsidiaries.
Issues: Sec. 460 requires taxpayers to report income from long-term contracts (generally, those not completed in the tax year in which they are entered into) by the percentage-of-completion accounting method, except for certain construction contracts including those for home construction, for which taxpayers may use the completed-contract method.
Regs. Sec. 1.460-1(c)(3)(i) provides that a contract is completed under the completed-contract method at the earlier of (1) when the subject matter of the contract is used by the customer for its intended purpose and the taxpayer has incurred at least 95% percent of the total allocable contract costs attributable to the subject matter or (2) upon final completion and acceptance of the subject matter of the contract. The tests are applied “without regard to whether one or more secondary items have been used or finally completed and accepted” (Regs. Sec. 1.460-1(c)(3)(ii)).
The IRS argued that, in this case, the contracts at issue were the purchase-and-sale agreements for the homes sold. As evidence, it pointed to an integration clause in each purchase-and-sale agreement stating that the agreement was the sole and entire agreement between the buyer and seller. The IRS also cited state laws where the developments were located as limiting real estate contract subject matter to a home, lot, and improvements to that lot. Because these agreements only covered the house, the lot, and improvements to the lot, the subject matter of the contracts was limited to these items. Consequently, the subject matter of the contract was accepted at closing, and Shea Homes was required to recognize the income from the sale of a home in the year the sale closed.
Shea Homes, on the other hand, argued that the contracts included not only the purchase-and-sale agreement provided to a homebuyer but also documents referred to by, or incorporated by law into, the agreement and setting forth the buyer’s and seller’s rights and obligations. Thus, the subject matter of the contracts was not just the home, the lot, and the lot improvements, but also the common improvements and common amenities, such as sewers, roads, and clubhouses, that these additional documents required Shea Homes to complete as part of the overall development. Therefore, in determining the completion date for a home-sale contract under the tests in Regs. Sec. 1.460-1(c)(3)(i), the entire development or the phase of the development for each home must be taken into account. Consequently, Shea Homes argued it should be allowed to defer the income from the sale of homes until either the company incurred 95% of the costs of the entire development or development phase of which the home was a part or the development or development phase was completed and accepted.
As a fallback position, the IRS contended that even if the subject matter of the contracts is broader than the house and the lot, the 95% completion test must be applied without regard to the costs attributable to common improvements because they are secondary items under Regs. Sec. 1.460-1(c)(3)(ii).
Holding: The Tax Court held that Shea Homes was entitled to defer the income from a home sale until either the 95% test or the final completion or acceptance test was met for the entire development or development phase for the home. It found that, based on the facts, the integration clauses did not limit the contracts to only the purchase-and-sale agreements and the additional documents were incorporated into contracts. The court further concluded that the IRS’s reliance on state laws was misplaced, since those laws were for the purpose of determining dates of limitation for bringing suit for construction defects. Because the contracts were not limited to the purchase-and-sale agreement, the subject matter of the contracts included the common improvements covered by the documents other than the purchase-and-sale agreement, and thus the tests in Regs. Sec. 1.460-1(c)(3)(i) applied to the entire development or development phase, not just the home and lot.
With respect to the IRS’s fallback argument, the court found that determination of whether the common improvements and amenities were secondary items must be made in the context of the determination that the contractual documents included the documents outside the purchase-and-sale agreement and that the subject matter of the contracts included the common improvements and amenities. Because the facts indicated that the developments’ amenities were crucial to their marketing, governmental approval, and buyers’ decisions, the court concluded that the common improvements and amenities were essential elements of the contract that must be taken into account in the 95% test.
Shea Homes, Inc., 142 T.C. No. 3 (2/12/2014)
By Laura Jean Kreissl, Ph.D., associate professor
of accounting, the School of Business and Economics, Thompson Rivers
University, Kamloops, B.C., Canada, and Darlene Pulliam,
CPA, Ph.D., Regents Professor and McCray Professor of
Accounting, the College of Business, West Texas A&M University,