Howard Hughes Company, L.L.C. v. Comm. (CA 5 10/27/2015) 116 AFTR 2d ¶ 2015-5368
The Court of Appeals for the Fifth Circuit, affirming the Tax Court, has concluded that none of the taxpayers’ contracts were home construction contracts under Code Sec. 460(e), so they couldn’t account for them using the completed contract accounting method.
Background. A long-term contract is any contract for the manufacture, building, installation, or construction of property, if not completed in the tax year in which entered into. With some exceptions, taxpayers must account for long-term contracts under the percentage-of-completion method. (Code Sec. 460) A contract is considered completed under the long-term contract rules on the earlier of: (a) when the contract’s subject matter is used by the customer for its intended purpose and at least 95% of the total allocable contract costs have been incurred by the taxpayer; (Reg. § 1.460-1(c)(3)(i)(A)) or (b) when there is final completion and acceptance. (Code Sec. 460(e)(1), Reg. § 1.460-1(c)(3)(i)(B))
Code Sec. 460 generally prohibits the use of the completed contract method. However, the completed contract method may be used instead of the percentage-of-completion method for (1) home construction contracts; and (2) and other real property construction contracts if (a) the taxpayer estimates (when entering into the contract) that the contracts will be completed within two years of the contract commencement date, and (b) the taxpayer satisfies a $10 million gross receipts test. (Reg. § 1.460-1(a)(2)) Under the completed contract method, a taxpayer doesn’t report income until a contract is complete, even if payments are received in years before completion. (Reg. § 1.460-4(d))
Under Code Sec. 460(e)(6)(A), a home construction contract is a construction contract where 80% or more of the estimated total contract costs are reasonably expected to be attributable to activities referred to in Code Sec. 460(e)(4) (i.e., building, construction, reconstruction, rehabilitation, or integral component installation) with respect to (emphasis added):
- Dwelling units (as defined in Code Sec. 168(e)(2)(A)(ii)) contained in buildings containing four or fewer dwelling units, (Code Sec. 460(e)(6)(A)(i)) and
- Improvements to real property directly related to such dwelling units and located on the site (emphasis added) of such dwelling units. (Code Sec. 460(e)(6)(A)(ii))
Reg. § 1.460-3(b)(2)(iii) (dealing with home construction contracts) provides that: “A taxpayer includes in the cost of the dwelling units their allocable share of the cost that the taxpayer reasonably expects to incur for any common improvements (e.g., sewers, roads, clubhouses) that benefit the dwelling units and that the taxpayer is contractually obligated, or required by law, to construct within the tract or tracts of land that contain the dwelling units”.
Facts. The Howard Hughes Co., LLC (THHC) (formerly the Howard Hughes Corp. & Subsidiaries (Old THHC)), and Howard Hughes Properties, Inc. (HHPI), collectively taxpayers, were in the residential land development business and developed land in and adjacent to Las Vegas, Nevada. The taxpayers sold land to builders and, in some cases, individuals, who constructed and sold houses. The taxpayers generally sold land through bulk sales, pad sales, finished lot sales, and custom lot sales, as explained below:
- In bulk sales, the taxpayers developed raw land into villages and sold an entire village to a builder. The taxpayers did not otherwise develop the sold village.
- In pad sales, the taxpayers divided villages into parcels, constructed all of the infrastructure in the village up to a parcel boundary, and sold the parcels to builders. The taxpayers did not develop within the sold parcels.
- In finished lot sales, the taxpayers divided villages into parcels, constructed any needed parcel infrastructure, divided the parcels into lots, and sold whole parcels of finished lots to builders.
- In custom lot sales, the taxpayers sold individual lots to individual purchasers or custom home builders, who then constructed homes.
In all instances, the taxpayers did not construct residential dwelling units on the land they sold. During the years at issue, the taxpayers reported income from purchase and sale agreements under the completed contract accounting method.
On audit, IRS challenged the taxpayers’ accounting practices, contending that the custom lot contracts and the bulk sale agreements weren’t long-term eligible for the percentage-of-completion accounting method under Code Sec. 460. Further, IRS argued that none of the taxpayers’ contracts were home construction contracts under Code Sec. 460(e).
Tax Court decision. The Tax Court determined that the taxpayers’ custom lot and bulk sale contracts were long-term contracts. The Court also held that the bulk sale contracts (like the pad sale building development agreements which IRS had not challenged) were construction contracts that could be accounted for under Code Sec. 460 as long-term contracts. However, the Court found that none of taxpayers’ contracts were home construction contracts under Code Sec. 460(e). A taxpayer’s contract can qualify as a home construction contract 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. It is not enough for the taxpayer to merely pave the road leading to the home, though that may be necessary to the ultimate sale and use of a home. Accordingly, the taxpayers couldn’t report gain and loss from these contracts using the completed contract method of accounting. (Howard Hughes Company, LLC, et al., (2014) 142 TC 355)
Drawing a bright line, the Court distinguished this case from Shea Homes, Inc. and Subsidiaries, et al, (2014) 142 TC No. 3. In Shea Homes, the Tax Court concluded that, in determining whether a contract was a home construction contract, taxpayers could include the allocable share of the cost that they reasonably expected to incur for any common improvement. Thus, those taxpayers, who developed land and built homes, when testing whether their contracts were home construction contracts, were allowed by the regs to add, to the costs of the dwelling units they constructed, their common improvement costs. The starting point in Shea Homes, was that the taxpayers’ contracts were for the construction of qualifying dwelling units. But at no point in Shea Homes, did the Court say that a home construction contract could consist solely of common improvement costs.
The Court clarified that, in order to qualify as a home construction contract, a contract does not necessarily have to be for the actual sale of a home. The regs make clear that a subcontractor’s contract may qualify as a home construction contract. For instance, a subcontractor who does the electrical work inside the home may have a home construction contract. While the Court found the taxpayers’ attempt to characterize their relationship with the homebuilders as a general contract or subcontractor relationship to be an “interesting and innovative” approach, it rejected it. It concluded that this was not the actual relationship that these parties had chosen.
Appellate decision. Applying a statutory analysis of Code Sec. 460(e)(6)(A), the Fifth Circuit concluded that the Tax Court correctly construed the statute. Code Sec. 460(e)(6)(A)(i) applies only if the taxpayer builds, constructs, reconstructs, rehabilitates, or installs integral components to dwelling units (i.e., a house or apartment used to provide living accommodations). A taxpayer seeking to use the completed contract method must be engaged in construction, reconstruction, rehabilitation, or installation of an integral component of a home or apartment. Such a reading of Code Sec. 460(e)(6)(A)(i) is further supported by the definition of “activities” in Code Sec. 460(e)(4) as “building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property”. This requirement doesn’t limit eligibility to use the completed contract method to homebuilders (as the taxpayers contended), and the activities listed in Code Sec. 460(e)(4) can encompass subcontractors so long as their costs come from work done on a dwelling unit. The Fifth Circuit concluded that because the costs that the taxpayers incurred weren’t the actual homes’ structural, physical construction costs, or weren’t related to work on dwelling units, they did qualify under Code Sec. 460(e)(6)(A)(i).
Like the Tax Court, the Fifth Circuit rejected the taxpayers’ contention that the phrase “with respect to” in the statute only requires some causal relationship between the dwelling units and construction costs incurred. This interpretation couldn’t be harmonized with the narrow exceptions to the percentage of completion method for long-term contracts provided by Congress in Code Sec. 460(e)(1) and the principle that tax deferments are to be strictly construed. Further, such an approach would make Code Sec. 460(e)(6)(A)(ii) superfluous.
The Fifth Circuit, again like the Tax Court, also found that the taxpayers didn’t fall within Code Sec. 460(e)(6)(A)(ii). Because the taxpayers never made improvements on the lots where homes were built, their construction activities did not come within the plain language of the statute. The Court rejected the taxpayers’ argument that the words “located on the site” refers to construction that occurs in the residential subdivision or at least the entire village. Further, the taxpayers couldn’t rely on Reg. § 1.460-3(b)(2)(iii), which refers to the type of common improvements they constructed, to allow them to count their common improvement costs in the 80% test. Correctly interpreted, Reg. § 1.460-3(b)(2)(iii) provides that a taxpayer that has at some point incurred some construction cost with respect to the dwelling unit can include common improvement costs in those dwelling unit cost. The reg sets out how common improvement costs can be eligible for inclusion in the 80% test, and taxpayers’ costs were not eligible under the plain terms of the reg.
The Fifth Circuit also rejected the taxpayers attempt to rely on Prop Reg § 1.460-3(b)(2) (a 2008 proposed reg that has not been adopted as final) which would have provided that taxpayers can meet the 80% test with a contract for the construction of common improvements even if the contract is not for the construction of any dwelling unit. The Court, concluding that proposed regs are entitled to no deference until finalized, gave no weight to the proposed regs.