Collect Now, Report Later?
SACRAMENTO—If you could invoice your customers now but report the income for tax purposes later, you’d do it, wouldn’t you? After all, if you’re like most developers, you could probably use that money in your business rather than simply turning it over to the IRS. But as we’ll see, the rules around this are a bit murky—at least for developers involved with land-only improvements.
Typically, contractors with average receipts over $10 million are required to report taxable income on long-term contracts (those completed over two or more tax reporting years) on a percentage-of-completion method. This requires them to estimate a contract's overall profit and recognize it proportionately over the life of the project.
To encourage homebuilding in the US, the tax code allows for an exception to this requirement on home construction contracts. Homebuilders and their subcontractors can use the “completed contract method” and wait until the project has incurred 95% of its anticipated costs, and would be presumably paid in full, by the time they’d need to pay their income tax. In contrast, taxes on percentage-of-completion contracts may need to be paid before much of the revenue has been received or when they truly know whether the project is profitable. As a result, homebuilders can avoid the problem of either overpaying tax or having to pay it when they’re at a cash-poor stage of a project.
That brings us back to those contractors who get the land ready for homebuilding. Can they benefit from the completed contract method deferral as well? The language in the tax code and regulations is a little unclear on whether a contract solely for residential land development items such as grading, roads, infrastructure, and other common area improvements also qualify for the home construction contract exception. Many land developers believe they do, and the IRS has been debating with them for years.
The IRS has issued guidance in several instances advising that contracts for residential land improvements by taxpayers not directly involved with the physical construction of homes don’t qualify for the exception. Although these sources state the IRS’s perspective on the issue, they weren’t the final word by any means. In fact, proposed tax regulations were issued in 2008 that appear to include residential land improvement contracts as home construction contracts regardless of whether the taxpayer also builds homes. Since these regulations are only proposed, they can’t yet be relied on, but they at least indicate where the authority may eventually land. If anything, it was very encouraging to those using the completed contract method for such projects.
The Tax Court has also weighed in on the matter. In February 2014 its ruling in Shea Homes Inc. and Subsidiaries et al. v. Commissioner of Internal Revenue came out in favor of the taxpayer, allowing it to include the cost of common improvements and amenities of its home development project in determining income under the completed contract method. In this case Shea was building both the homes and common areas. The court agreed with the taxpayer that the homebuilding contracts included the common amenities Shea was providing to the home buyers. Therefore, the contracts weren't closed until these improvements were 95% complete, even though individual homes may have already been sold and occupied.
In June the same judge ruled in the case of a company that sold land to home builders with commitments to provide infrastructure and common improvements to the sites. In the case, Howard Hughes Company LLC v. Commissioner of Internal Revenue, the court determined that these were not home construction contracts because “petitioners did not build homes on the land they sold, nor did qualifying units exist on the sold land at the time of the sales.” The court went on to state that a contract can qualify “only if the taxpayer builds, constructs, reconstructs, rehabilitates, or installs integral components to dwelling units or real property improvements directly related to and located on the site of such dwelling units.” Based on these cases, the court appears to be establishing that a taxpayer needs to be involved in building homes to use the completed contract method for common area improvements.
So when does a residential land developer need to pay taxes? If it’s also involved in building homes, the developer may be able to wait until it’s more or less finished with the project. If the developer isn’t also the homebuilder, it appears that now more than ever it will need to follow a “pay as you go” method as far as contracts are concerned.
But there’s still hope. If the proposed regulations as currently drafted become final, it would likely bless the use of the completed contract method. However, until that happens, land developers need to be very cautious about their use of this method. As a result, if this has been your practice up until now, it’s a good time to evaluate with your tax advisor how to move forward.
Cameron Williams provides real estate and partnership taxation compliance and consulting services to investors, developers, homebuilders, and owner-operators. He routinely advises on transactions regarding real estate sales and acquisitions, 1031 exchanges, debt modifications, and partnership and LLC formations, sales, and dissolutions. You can reach him at (916) 503-8165 or firstname.lastname@example.org. The views expressed in this column are the author’s own.
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