If you read my last article on the Completed Contract Method of Income Tax Deferral we concluded that Shea v IRS was a big win for the developers. Unfortunately the IRS has come back with a vengeance in June of 2014 with a big win in Howard Hughes v IRS. (Hughes) Why did the government win big against Hughes and lose against Shea? What can you all do differently to avoid this adverse Hughes ruling in the event of an IRS audit against your development company? How can you align yourself with Shea so that you win if your case after IRS audit should proceed to US Tax Court? To answer these questions I suggest anyone out there who is a real estate developer currently developing residential communities to keep reading if you want to protect your income tax deferrals against adverse IRS audit consequences on your 2014 income tax return.
Let’s take a look at the facts in the Hughes case: Hughes was a large land developer of Summerlin, approximately 22,500 acres on the western rim of the Las Vegas Valley about nine miles west of downtown Las Vegas. Hughes created and paid for the massive master planned community as approved by Las Vegas and Clark County, and signed 30-year agreements enabling Hughes to develop the land without the necessity of separate village by village agreements. Hughes profits and sole source of revenue from Summerlin derived primarily from 4 categories, pad sales, finished lot sales, custom lot sales and bulk sales. These sales were made to builders and consumers with the intent the builders and customers would build homes on the land that Hughes sold. Hughes deferred tax on much of their residential related revenue based on the completed contract method asserting that Hughes was in the home construction business. In accordance with IRS regulations, taxable income was recognized when 95% of the estimated costs allocable to each lot were incurred.
The IRS audited Hughes for 2007 and 2008 and disallowed Hughes from using the completed contract to defer what would have been taxable income in various villages throughout Summerlin. As a result the IRS adjusted Hughes income upwards hundreds of millions of dollars resulting in a tax deficiency of over $120 Million. Hughes appealed to US Tax Court. The question presented to US Tax Court Judge Wherry: Whether the long term construction contracts being used by Hughes were “home construction contracts” as defined by 460(e)(1)(A)(B). If Hughes could prove to the Court that their contracts were “home construction contracts” then Hughes wins, if they can not, then the Government wins. Seems to me a pretty black or white case or perhaps not?
The “gray” in this case starts with the basic provision of the IRS Tax Code that allows for this very lucrative tax deferral by defining “home construction.” “Home construction” is defined as 80% or more of the contracts costs are for the construction of dwelling units and improvements to real property directly related to such dwelling units. The IRS argued that Hughes did not build homes on the land they sold and therefore their expenses were not for “home construction”. Hughes argued that the IRS statute “contemplates a broader definition of home construction costs.” Hughes further argued that as long as a cost in some way benefits the dwelling unit those costs should count towards meeting the 80% test. Under this view all their development costs were attributable to dwelling units and real property improvements.
Unfortunately for Hughes, Judge Wherry gave little weight to Hughes argument because Hughes did not offer even one case to support its tax position. Judge Wherry instead attempted to look to the legislative history as to how Congress felt about “home construction”. The Court noted that “While the conference report is ultimately silent as to why the exception was added in its final form, it is clear that the intended beneficiaries of this relief measure were taxpayers involved in the building construction reconstruction or rehabilitation of a home and not land developers who do not build homes, even if essential development work paves the way for and thus facilitates home construction.”
Continuing in his analysis, Judge Wherry distinguishes Hughes from Shea by noting that “…at no point in Shea did we say a home construction contact could consist solely of common improvement costs. The starting point in Shea was that the taxpayer’s contracts were for construction of qualifying dwelling units…Shea developed land and built homes…so we permitted Shea to add the cost of the dwelling units they constructed to their common improvement costs.” Judge Wherry concludes that “our Opinion today draws a bright line. Developers can qualify their home construction contracts for income tax deferral only if the developer builds integral components to dwelling units or real property improvements directly related to the site of each unit. If we allow developers the completed contract method to defer tax who have construction costs that merely benefit a home that may or may not be built then there is no telling how long deferral would last.”
In conclusion, the Court in Hughes has made it very clear to all developers who are counting on a tax deferral based on a completed contact method to make certain that their contracts include residential home building. And yes as I am sure you noticed by now, perhaps by an ironic coincidence, but certainly making the cases interesting, US Tax Court Judge Wherry presided over both Shea and Hughes Finally after the government victory against Hughes I believe that the IRS will be aggressively moving against the completed contract method being used by small and large developers alike. So if you are a developer in residential construction I would advise especially after Hughes for you all to carefully review your contracts with your contract attorney and tax attorney prior to filing your 2014 income tax return to make certain that Shea facts are controlling rather than Hughes in the event of an IRS audit. Thank you for joining us and look forward to seeing you all next time on TaxView with Chris Moss CPA.
Chris Moss CPA