Residential land developers must be aware of the tax rules for recording revenue related to their business activities. There are two revenue recognition methods available – completed contract and percentage-of-completion. The use of each is based on determining factors related to the contracts and the work performed.
Long-Term Contracts
Completed Contract vs. Percentage-of-Completion Methods Of Accounting
A long-term contract is defined in the Internal Revenue Code as any contract for the manufacture, building, installation or construction of property if the contract is not completed within the taxable year in which the contract is entered into. The date of contract completion is the earlier of when the contract’s subject matter is used by the customer for its intended purpose (other than for testing) AND the taxpayer has incurred at least 95 percent of the total allocable contract costs OR upon final completion and acceptance of the subject matter of the contract.
Generally, a taxpayer must determine taxable income from long-term contracts under the percentage-of-completion method of accounting. Under this method, a taxpayer recognizes gain or loss throughout the duration of the contract. If a long-term contract is determined to be a home construction contract, a taxpayer may account for income from these contracts under other methods of accounting, such as the completed contract method. Under the completed contract method, a taxpayer does not report income until a contract is complete, even if payments are received in years before completion. The completed contract method may be used instead of the percentage-of-completion method for (1) home construction contracts and (2) other real property construction contracts if, when entering into the contract, a taxpayer estimates that the contract will be completed within two years of the contract commencement date AND a taxpayer satisfies a $10 million gross receipts test.
A home construction contract is a construction contract where 80% or more of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to the building, construction, reconstruction or rehabilitation of dwelling units contained in buildings containing four or fewer dwelling units, and to improvements to real property directly related to the dwelling units.
Howard Hughes Company, LLC 142 TC No. 20
The Howard Hughes Company, LLC (FKA The Howard Hughes Corporation and Subsidiaries) and Howard Hughes Properties, Inc., collectively the taxpayers, are in the residential land development business and develop land in and adjacent to Las Vegas, Nevada. The taxpayers sell land to builders and, in some cases, to individuals, who construct and sell houses. They generally sell land through bulk sales, pad sales, finished lot sales and custom lot sales.
In bulk sales, the taxpayers develop raw land into villages and sell an entire village to a builder. They do not otherwise develop the sold village. In pad sales, the taxpayers divide villages into parcels, construct infrastructure in the village up to the parcel boundaries and sell the parcels to builders. They do not develop within the sold parcels. In finished lot sales, the taxpayers divide villages into parcels, construct parcel infrastructure, divide parcels into lots and sell whole parcels of finished lots to builders. In custom lot sales, the taxpayers sell individual lots to individual purchasers or custom home builders who then construct homes. In all instances, the taxpayers do not construct residential dwelling units on the land they sell. During the years under audit, the taxpayers accounted for their contracts as home construction contracts and reported income from purchase and sale agreements under the completed contract method of accounting.
The Tax Court held that none of the taxpayers’ contracts were home construction contracts. The taxpayers did not build homes on the land they sold, nor did qualifying dwelling units exist on the sold land at the time of the sales. The taxpayers close the contracts and receive revenue without needing to build a single home and are under no contractual obligation to build homes as their contracts are merely for the sale of land, developed to varying degrees, to builders or individual customers who may eventually build homes on that land. Therefore, the taxpayers cannot account for gain or loss from these contracts using the completed contract method of accounting.
Author: Laura Riso, CPA, Partner | [email protected]
The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals for your individual facts and circumstances.
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