Vernoia, Enterline + Brewer, CPA LLC

A real estate developer could not use the home construction contract method to defer income under Code Sec. 460(e), the Court of Appeals for the Fifth Circuit has found. Affirming the Tax Court, the Fifth Circuit held that the developer should use the percentage of completion method (PCM) to compute gains from sales of real property under long-term construction contracts.

Real estate developer

The taxpayer sold and developed commercial and residential real estate. The taxpayer owned a large plot of land that it divided into villages, parcels, and individual lots. It sold property in the development to various builders and buyers who would construct homes on the property. The taxpayer generally constructed the development’s infrastructure up to individual lot lines. In some cases, the buyer or builder was responsible for some of the infrastructure. The taxpayer did not build any homes, perform home construction work, or make any improvements within the boundaries of any lots.


Under the PCM, a taxpayer must report income annually based on the percentage of the contract completed in that year. Under the completed contract method, a taxpayer can defer reporting any income, even if payments are received, until its costs reach 95 percent of the total estimated contract costs.

A long-term contract is a contract to construct property that is not completed in the same year it is entered into. The PCM applies to this contract. However, if the contract is a home construction contract, the taxpayer can use the completed contract method. Under Code Sec. 460(e)(6)(A), the home construction contract method can be used if at least 80 percent of the total estimated contract costs will involve building, construction, etc. with respect to (1) dwelling units and (2) improvements to real property directly related to the dwelling units and located on the site of the dwelling units.

IRS Reg. §1.460-3(b)(2)(iii) provides that a taxpayer can include in the cost of dwelling units the allocable share of the costs expected to be incurred for any common improvements that benefit the dwelling units and that the taxpayer is obligated to construct within the tract(s) of land that contain the dwelling units.

Court’s analysis

A contract is not a home construction contract unless the taxpayer incurred costs to build houses or dwelling units, the Fifth Circuit found. The Fifth Circuit rejected the taxpayer’s argument that the statute only requires some causal relationship between dwelling units and the construction costs incurred. The law allows costs of improvements to be included in the cost of the dwelling units, but this required that the taxpayer build dwelling units. In this case, the taxpayer did not build any homes and therefore did not incur any dwelling unit costs.

Please contact our office if you have any questions about this decision or the PCM.

Howard Hughes Company, LLC, 2015-2 ustc ¶50,536


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