Home construction contracts are one of the two exceptions from some of the requirements of IRC Section 460. The small contractor’s exception is the other one that is discussed in earlier chapter. Contracts that meet the home construction contracts definition are exempt from the following:
1. The requirement to use percentage of completion method; 2. The application of the look-back provisions; and
3. The requirement to use percentage of completion method for alternative minimum tax purposes.
Even though exempt from the above requirements, construction period interest is still required to be capitalized under IRC Section 460(c)(3).
IRC Section 460(e)(1)(A) exempts any home construction contract and thus is not based on neither the length of the contract nor the gross receipts of the contractor as with the small contractors exception. However, the last sentence of IRC Section 460(e)(1) provides that home construction contracts that do not meet the 2-year or $10,000,000 gross receipts test are subject to the application of IRC Section 263A. These contractors are commonly termed Large Home Builders and are discussed separately.
IRC Section 460(e) provides an exception for certain construction contacts. In general, subs (a), (b), and (c)(1) and (2) shall not apply to:
1. Any home construction contract, or
2. Any other construction contract entered into by a taxpayer:
A. Who estimates (at the time such contract is entered into) that such contract will be completed within the 2-year period beginning on the contract commencement date of such contract, and
B. Who averages annual gross receipts for the 3 taxable years preceding the taxable year in which such contract is entered into do not exceed $10,000,000. In the case of a home construction contract with respect to which the requirements of clauses (i) and (ii) of subparagraph (B) are not met, 263A shall apply notwithstanding subparagraph (c)(4). Land developers are discussed later in this chapter because they are closely related to the home construction industry. The land developer may also construct the homes or only sell the improved lots to the homebuilders.
Home Construction Contract Defined
A home construction contract is any contract where 80% or more of the estimated total contract costs, as of the close of the tax year that the contract was entered into, is 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 improvements to real property that are directly related to such dwelling unit. The distinction between a home construction contract and a residential construction contract is important because residential construction contracts do not meet the exception to the use of percentage of completion and look-back provided by IRC Section 460(e). Residential construction contracts contain more than 4 dwelling units (e.g. apartments, condominiums). Residential construction contracts are discussed in more detail in an earlier chapter.
IRC Section 460(e)(6)(A) provides that the term “home construction contract” means any construction contract if 80 percent of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to activities referred to in paragraph (4) with respect to:
1. Dwelling units as defined in IRC Section 168(e)(2)(A)(ii)) contained in buildings
containing 4 or fewer dwelling units as so defined. For this purpose, each townhouse or rowhouse shall be treated as a separate building, and
2. Improvements to real property directly related to such dwelling units and located on the site of such dwelling units.
Treasury Regulation 1.460-3(b)(2) provides that a contract of a subcontractor working for a general contractor is included in the definition of home construction contracts if it otherwise qualifies, and that common improvements that benefit the dwelling units being constructed or located at the site of the dwelling units are included as part of the 80% test.
Treasury Regulation 1.460-3(b)(2) provides that a long-term construction contract is a home construction contract if a taxpayer (including a subcontractor working for a general contractor) reasonably expects to attribute 80 percent or more of the estimated total allocable contract costs (including the cost of land, materials, and services), determined as of the close of the contracting year, to the construction of:
1. Dwelling units, as defined in IRC 168(e)(2)(A)(ii)(I), contained in buildings containing 4 or fewer dwelling units (including buildings with 4 or fewer dwelling units that also have commercial units); and
2. Improvements to real property directly related to, and located at the site of, the dwelling units.
Townhouses and Rowhouses
Each townhouse or rowhouse is a separate building.
Common improvements
A taxpayer includes in the cost of the dwelling units their allocable share of the cost that the taxpayer reasonably expects to incur for any common improvements (e.g., sewers, roads, clubhouses) that benefit the dwelling units and that the taxpayer is contractually obligated, or required by law, to construct within the tract or tracts of land that contain the dwelling units.
Mixed Use Costs
If a contract involves the construction of both commercial units and dwelling units within the same building, a taxpayer must allocate the costs among the commercial units and dwelling units using a reasonable method or combination of reasonable methods, such as specific identification, square footage, or fair market value.
Dwelling Units
Dwelling units are defined in IRC Section 168(e)(2)(A)(ii)(I). The term dwelling unit means a house or apartment used to provide living accommodations in a building or structure, but does not include a unit in a hotel, motel, or other establishment more than one-half of the units in which are used on a transient basis.
Mixed Use Buildings
If a contract requires construction of a mixed-use building (e.g. a building that will include both dwelling units and offices) the costs are allocated among the commercial units and the dwelling units using a reasonable method, pursuant to Treasury Regulation 1.460-3(b)(2)(iv).
Proposed Regulations Expand Definition of Home Construction Contract
On August 1, 2008 the Treasury and IRS released proposed regulations that expand the definition of a home construction contract. Prior to this date, the IRS and the industry were at odds as to whether a land developer providing common improvements without also constructing a home and subcontractors providing common improvements within a residential area were
considered a home construction contract. The proposed regulations expanded the home construction definition to include these construction contracts. Additionally, the proposed regulations expanded the home construction definition to condominium developments that contain more than 4 dwelling units in a building. The condominiums are considered the same as rowhouse or townhouse in which each condominium unit is considered a single building. The proposed regulations also provide guidance to taxpayers electing to change their long-term method of accounting, providing which changes are accounted for under the cut-off method and which changes are accounted for using an IRC Section 481(a) adjustment.
At the time of the writing this chapter, these proposed regulations have not yet been finalized, and any user of this guide should research this area for the issuance of subsequent guidance.
Taxation of Homebuilders
To avoid confusion in the tax accounting rules, for both income and expenses, the following types of construction or development will be discussed separately:
1. Homes Built for Speculation without a Contract 2. Contractors Building Homes with a Contract 3. Land Developers
Homes Built for Speculation (No Contract)
Homebuilders will purchase a number of lots from a developer of a subdivision to build houses. The homebuilder may build some of the homes as speculative (spec) homes. Speculative homes
are not built under a contract. In the industry, homes built for speculation that are on hand at year end are referred to as inventory of unsold houses or work in process. These speculation houses do not meet the definition of inventory in the Code. The Internal Revenue Code defines inventory as tangible personal property. Speculation houses are capital assets as defined in IRC Section 263. The builder owns the real property (land) and the house inherently attached to the land. Courts have consistently held that developed real property must be accounted for under a capitalization method. See W.C. & A.N. Miller Development Co. v. Commissioner,81 T.C. 619 (1983); Homes by Ayres v. Commissioner,T.C. Memo. 1984-475, aff’d,795 F.2d 832 (9th Cir. 1986). See also Revenue Ruling 86-149, 1986-2 C.B. 67; Revenue Ruling 66-247, 1966-2 C.B. 198.
Income Recognition
Since speculation homes are not built under a contract, long-term contract accounting methods such as the completed contract and percentage of completion do not apply. Speculative
homebuilders report their income from the sale of a speculative house at the time of settlement or closing under IRC Section 1001.
Sometimes speculative homes are started but sold during the construction phase, which could become a long-term construction contract if not completed within the same tax year subject to the taxpayer’s long-term contract method of accounting. However, in most cases, the completed contract method is the one elected and the sale would not constitute a taxable event until completion.
Cost Recognition
The direct and indirect costs incurred by a taxpayer in the construction of a house for speculative sale (including the cost of the land, direct materials and direct labor) should be capitalized according to the principles in IRC Section 263(a) and IRC Section 263A, regardless of the taxpayer’s overall method of accounting.
Under IRC Section 263(a)(1) and Treasury Regulation Section 1.263(a)-1, costs incurred in the construction of homes and other permanent improvements to real property are not currently deductible. Instead the cost of unsold homes and construction in progress is a capital expenditure that becomes part of the basis of the real estate, which in turn, is recovered either through a depreciation allowance if the property is used in a trade or business (rented), or as an offset against the price received in the sale or disposition of such property.
Treasury Regulation Section 1.263(a)-2 sets forth examples of capital expenditures, including the cost of acquisition, construction, or erection of buildings having a useful life substantially beyond the tax year.
The uniform capitalization rule of IRC Section 263A(a)(1) applies to speculation homes, which mandates certain costs to be allocated to property produced by the taxpayer, and that such costs be capitalized if the property is not inventory in the hands of the taxpayer.
IRC Section 263A(a)(1) provides that in the case of any property to which this applies any costs described in paragraph (2) shall be capitalized.
The homebuilder must determine the accumulated production expenditures, described in Treasury Regulation Section 1.263A-11, with respect to each home. This requires the homebuilder to allocate the cumulative amount of direct and indirect costs described in IRC Section 263A(a) that are to be capitalized with respect to the unit of property. A unit of property is
defined by Treasury Regulation Section 1.263A-10(b) as any component of real property that is functionally interdependent, along with an allocable share of any common feature owned by the taxpayer. For example, the components of a single family home (land, foundation and walls) are functionally interdependent; in contrast, condo units separately placed in service in a multi-unit building are each treated as a functionally interdependent unit, even though they are all located in the same building. In the case of property produced for sale, components of real property are functionally interdependent if they are customarily sold as a single unit. All costs that have been accumulated for a particular home are charged to cost of sales at the time of settlement with the purchaser of the home.
Revenue Ruling 66-247
The costs incurred in the construction of a house for speculative sale are capitalized regardless of the taxpayer's overall method of accounting. Such costs shall be applied against the amount realized upon the sale of the house for purposes of determining gain or loss in computing taxable income.
Carpenter v. Commissioner, T.C. Memo 1994-289
A building contractor could not use the cash method of accounting for expenses related to construction of houses that were unsold at the end of the tax year because he was a producer of the property. The contractor was required to capitalize the costs of construction related to the unsold houses under IRC Section 263A.
Inventory vs. Real Estate
In the construction industry, it is common for a contractor to use “inventory” terminology for unsold homes or work-in-progress. However, unsold homes or work-in-progress is real estate which is never considered inventory. Both real estate and inventory are assets but this distinction is important because under several accepted inventory methods, a departure from the actual cost could take place (that is, lower of cost or market). In recent years the real estate market has taken a downturn in market value. Generally Accepted Accounting Principles (GAAP) requires real estate to be written down to market value. See Financial Accounting Standards Board (FASB) Statement No. 144 – Accounting for the Impairment or Disposal of Long-Lived Assets. However, for tax purposes, a write-down in value is not permissible; therefore, there should be a book or tax adjustment reported on Schedule M-1 or M-3.
Atlantic Coast Realty Co. v. Commissioner, 11 B.T.A. 416 (1928), and Revenue Ruling 69-536, 1969-2 C.B. 109 hold that home builders are not allowed to treat real estate held for sale as “inventory” and write their work in process down to market value using a lower of cost or market valuation.
Homes by Ayres v. Commissioner, T.C. Memo 1984-475, aff’d. 795 F.2d 832 (9th Cir. 1986) - Taxpayers engaged in the construction and sale of large-scale tract housing developments could not use the LIFO method to account for the property. The court held that real estate is not inventory, and thus an inventory method to account for the property is not allowed.
W.C. & A.N. Miller Development Co. v. Commissioner, 81 T.C. 619 (1983) - The taxpayer was engaged in the business of developing real estate, which it acquired, and constructed single- family, detached homes. The taxpayer applied a LIFO method to account for its completed homes. All costs related to each home were charged to the cost of sales only at the time of settlement with the purchaser of the home. The court held that the individual homes or lots which
the taxpayer sells are real estate and do not constitute “merchandise” within the meaning of Treasury Regulation Section 1.471-1. Thus, LIFO is not permitted.
There is a fundamental difference between capitalization and an inventory method. Under capitalization, gain will be determined pursuant to 1001 on each individual home when it is sold and such gain is to be determined based generally on the taxpayer’s actual cost for that particular home.
Revenue Ruling 86-149, 1986-2 C.B. 67 involves a real estate developer who filed a Form 970 to apply for the LIFO method of accounting for its “inventory” of completed homes and homes in progress. The construction costs of completed homes and costs of construction in progress are capital expenditures under IRC Section 263. A taxpayer engaged in the business of developing real estate capitalizes its costs in accordance with IRC Section 263.
Under IRC Section 263(a)(1), costs incurred in the construction of homes and other permanent improvements to real property are not currently deductible. Instead the costs of unsold homes and construction in progress are capital expenditure that becomes part of the cost of the real estate, which, in turn, is recovered either through a depreciation allowance if the property is used in a trade of business, or as an offset against the price received in the subsequent sale or disposition of such property.”
Speculation Homes Becoming Long-Term Contracts
A contractor may begin building a speculative home and enter into a “sales” agreement with a customer prior to completion. If the remaining construction on the home, after the contract is entered into, extends beyond the taxable year, the contractor has entered into a long-term construction contract and would then account for the contract under its exempt long-term method of accounting. See Treasury Regulation Section 1.460-4(c)(1).
As previously mentioned, all costs incurred prior to the contract date, when the home is a speculation home, are capitalized under IRC Section 263(a) and IRC Section 263A. Once the contract is entered into, the accumulated costs to date become deferred costs under the
completed contract method and costs incurred after the contract date would be capitalized under the provisions of Treasury Regulation Section 1.460-5(d). However, if the taxpayer were a large homebuilder, the costs incurred after the date of the contract would continue to be capitalized under IRC Section 263A.
If the taxpayer’s exempt long-term method of accounting is a percentage-of-completion method, the accumulated capitalized costs incurred prior to the contract date would become an allocable contract cost in the PCM numerator, and thus be deductible during the year the contract is entered into.
Contractors Building Homes Under Contract
As previously mentioned, any home construction contract is exempt from the requirement to use the percentage of completion method per IRC Section 460(e)(1)(A). Therefore, the contractor may elect a permissible exempt contract method that includes percentage of completion, exempt percentage of completion, completed contract, or any other permissible method under IRC Section 446. See Treasury Regulation Section 1.460-4(c)(1). The contractor must use the elected method to account for all its long-term contracts that are exempt from the requirements of IRC Section 460(a). Even though exempt construction contracts are not subject to the percentage of completion method, production period interest is subject to the cost allocation rules under IRC Section 460(c)(3). See Treasury Regulation Section 1.460-1(a)(2)(i).
Long-Term Methods of Accounting
If a contractor elects a long-term method of accounting for an exempt construction contract (e.g., completed contract method, percentage of completion method, or exempt contract percentage of completion method) it is not relevant who has title to the land on which the home is being built. Within the definition of a contract for the construction of property, Treasury Regulation Section 1.460-1(b)(2) states, “Whether the customer has title to, control over, or bears the risk of loss from, the property manufactured or constructed by the taxpayer also is not relevant.” Treasury Regulation Section 1.460-4 describes the tax recognition of the contract income and expenses attributable to long-term methods of accounting.
Completed Contract Method
Gross contract price and all allocable contract costs incurred are included in taxable income in the year of completion under the completed contract method per Treasury Regulation Section 1.460-4(d).
Percentage of Completion Method (PCM)
A taxpayer generally must include in income the portion of the total contract price that
corresponds to the percentage of the entire contract that the taxpayer has completed during the taxable year. The percentage of completion must be determined by comparing allocable contract costs incurred with estimated total allocable contract costs. Thus, the taxpayer includes in gross income a portion of the contract price as the taxpayer incurs allocable contract costs. See Treasury Regulation Section 1.460-4(b).
Exempt Contract Percentage of Completion Method
Similar to PCM, above, except the percentage of completion may be determined using any method of cost comparison (such as direct labor costs incurred to estimated total direct labor costs) or by comparing the work performed on the contract with the estimated total work to be performed. See Treasury Regulation Section 1.460-4(c)(2).
Other Permissible Accounting Methods
Title to the property is relevant if the taxpayer elects any permissible method, per IRC Section 446, other than a long-term method of accounting, because the appropriate rules for income and expenses are contained in other s of the Internal Revenue Code and regulations.
Treasury Regulation Section 1.460-1(a)(2) provides exceptions to the required use of PCM. The requirement to use the PCM does not apply to any exempt construction contract described in Treasury Regulation Section 1.460-3(b). Thus, a taxpayer may determine the income from an exempt construction contract using any accounting method permitted by Treasury Regulation Section 1.460-4(c) and, for contracts accounted for using the completed-contract method (CCM), any cost allocation method permitted by Treasury Regulation Section 1.460-5(d). Exempt