Many real estate developers use the Completed Contract Method (CCM) of income recognition as they develop large tracts of land into buildable lots and ultimately residential housing around the nation. This special method of revenue recognition is allowed for small developers earning less than $10 million who anticipate a 2 year date of completion on their project. Also qualifying are general residential construction developers regardless of size or cost as long as their project qualifies under IRC section 460(e)(1)(A) as “home construction” If you use this method of income tax deferral be aware that the IRS has in recent years become very suspect of the use of CCM. A 2009 IRS Memorandum asserts that the abuse of CCM is a growing trend within the residential construction industry.
The IRS further asserts that “Taxpayers are improperly treating residential land sales contracts and long-term construction contracts (including contracts for subcontract work for common improvements) as home construction contracts eligible for CCM. The IRS also says that taxpayers are postponing recognition that a contract is considered complete to improperly defer income (and expenses) under CCM. However a 2014 US Tax Court case appears to grant wider latitude to real estate developers on how long taxes can be deferred. This is great news for the hardworking real estate developer community. So listen up all real estate developers in America: We are headed to US Tax Court to learn about a case that may change your life: Shea Homes v IRS 142 Tax Court 3 (2014)
The Shea family developed real estate through various family entities (Shea) for more than 40 years. Their business involved the analysis and acquisition of land for development and the construction and marketing of homes and the design and/or construction of developments and homes on the land they acquired. Shea entered into standard sales contracts with prospective homebuyers requiring earnest money deposits. Contracts could not close until all improvements were made or bond was posted. Shea used CCM for all its qualifying developments. Shea was audited by the IRS for year 2004 2005 and 2006 and ultimately appealed to US Tax Court on the key issue of when income tax deferral should have ended. The Government said the contracts were completed sooner than Shea reported and claimed that Shea should recognize income when the actual contracts closed and the buyer moved into the house. Shea argued that closing the contracts did not complete them as per the clear language of the contracts even if the buyer moved into the house. Shea further argued specifically that the contract language encompassed the entire development and therefore was not yet complete at closing. Shea concluded that final completion and acceptance triggering the end of the tax deferral did not occur until the final road was paved and the final bond was released. After an in depth analysis of the various contracts Judge Wherry brilliantly observes the “buyers of their homes understood and believed that the parties had contracted for the entire lifestyle of the development and its amenities, more than just the purchase of the home itself.”
Judge Wherry continued: “Thus, at the very minimum, the 95% completion test, as applied here, looks to costs beyond just those associated with the house, the lot, and improvements to the lot….The final completion and acceptance test also indicates that the subject matter of the contract in these cases is more than just the house, the lot, and improvements to the lot. Ultimately, this outcome is supported by our conclusion that Shea’s contracts consist of more than the purchase and sale agreement alone. When the contract documents are read together, the subject matter of the contract is quite clearly more than just the house, the lot, and improvements to the lot.” Id at 71.
This is great news for developers but I advise caution: Judge Wherry in his final footnote on page 82 warns: We are cognizant that our Opinion today could lead taxpayers to believe that large developments may qualify for extremely long, almost unlimited deferral periods. We would caution those taxpayers that a determination of the subject matter of the contract is based on all the facts and circumstances. Further, sec. 1.460-1(c)(3)(iv)(A), Income Tax Regs., may prohibit taxpayers from inserting language in their contracts that would unreasonably delay completion until such a super development is completed.
In conclusion, if you are a real estate developer who qualifies to use the completed contract method for income tax deferral, I advise you to work carefully with your contract attorney and your tax attorney in the same room at the same time to make absolutely certain prior to filing your 2014 tax return that your contracts have the appropriate language to defer income tax under Shea case law. Once the contracts are finalized, I would recommend you consult with your tax advisor and CPA to include at minimum in the tax return prior to filing that return the necessary contract summery explanation specifically focusing on Shea requirements to bullet proof the tax return against IRS attack in anticipation of a government audit. A bullet proof tax return with the necessary contract documentation is absolutely critical if you expect to win in US Tax Court as Shea did. Thank you all for visiting Taxview with Chris Moss CPA.
See you next time. Kindest regards from Chris Moss CPA