Home builders won a significant victory in a recent Tax Court case, allowing them to defer income recognition until the entire development is complete, not on a house-by-house basis under the completed contract method of accounting.
The U.S. Tax Court concluded in the case of California-based Shea Homes (Shea Homes, Inc. v. Commissioner, 142 TC No. 3, Feb. 12, 2014) that Shea did not have to recognize income under the completed contract method until the year the development has been completed.
Developers are warned to take caution because the case was based on specific facts that may not be present in all situations.
The amenities of the development were a crucial aspect of the developer’s sales effort, the attainment of governmental approval of the development and the buyers’ purchase decision. Accordingly, the amenities were an essential element of the home purchase and sale contract.
Shea Homes and its related entities developed large planned residential communities ranging in size from 100 homes to more than 1,000. They sold more than 114 developments across three states: California, Arizona and Colorado.
Shea contended that final completion and acceptance under the completed contract method of accounting did not occur until the last road was paved and the final performance bond required by state and municipal law was released.
The IRS contended that the subject matter of Shea’s contracts consisted only of the houses and the lots upon which the houses were built. Under its interpretation, the contract for each home met the final completion and acceptance test upon the close of escrow for the sale of each home.
The IRS also contended that contracts entered into and closed within the same tax year were not long-term contracts eligible for the completed contract method of accounting.
The Tax Court called the IRS analysis “simplistic and short sighted; it does not acknowledge the complex relationships created by the purchase and sales agreement, especially obligations that continue long after the first home is built.”
The court determined that Shea was permitted to use the completed contract method of accounting and that the subject matter of the contracts consisted of the home and the larger development, including amenities and other common improvements.
The court reasoned that the primary subject matter of the contracts included the house, the lot, improvements to the lot and common improvements to the development.