By: Roger Gingerich, CPA/ABV, CVA, CCA
In a decision that proves favorable for residential real estate developers, the U.S. Tax Court ruled that California-based home-builder Shea Homes LP could use the completed contract method to defer the recognition of income related to the sale of homes within the development until the entire development was complete.
Under the completed contract method, income from a long-term contract is recognized when the contract is complete. Completion is determined by when the subject matter of the contract is used for its intended purpose and at least 95% of total allocable contract costs attributable to the subject matter have been incurred; or final completion and acceptance.
It its case against the IRS (Shea v. Commissioner), Shea Homes argued that the subject matter of its sale was not just each individual home, but the entire development, which included pools, golf courses, clubhouses, and other common area improvements and amenities. Shea pitched these amenities to potential buyers as part of a “community” beyond the “bricks and sticks” of the homes.
According to an article by Tony Nitti of Forbes Magazine, “This was more than just marketing chatter, however, as Shea invested significant funds—upwards of 30% of total budgeted costs, in some developments—in the amenities—such as pools, golf courses, and clubhouses—for each neighborhood. In addition, Shea was held to its promise by state and municipal law, which required the builder to post bonds to secure its performance with regards to completing these common improvements.”
The IRS argued that the subject matter of the contract is solely the house and its lot. Therefore, the IRS maintained that the common area costs should not be considered in regard to meeting the substantial completion test; and Shea Homes should pay taxes as it sold each home and not wait until the developments—including amenities—were completed. However, the Tax Court sided in favor of Shea Homes, stating that its use of the completed contract method was a “permissible method of accounting” and that the company could continue deferring the income until later years after the development has been completed.
This ruling presents substantial opportunities for developers building homes within larger developments to defer income through the completed contract method. The Real Estate and Construction advisors at Skoda Minotti are happy to answer questions about how this ruling may affect your business. For more information, please contact Roger Gingerich, CPA/ABV, CVA, CCA at 440-449-6800 or email firstname.lastname@example.org.
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