On August 4, 2008, the IRS issued proposed regulations (REG-120844-07) expanding the types of contracts eligible for the home construction contract exemption from the percentage of completion method and amending the rules for taxpayer-initiated changes in methods of accounting to comply with Sec. 460 and the regulations thereunder. Tax practitioners and taxpayers generally have viewed these proposed regulations as being favorable to taxpayers. The regulations, if finalized, would permit a greater number of taxpayers in the home construction industry—such as land developers, condominium developers, contractors, and subcontractors—to qualify for the home construction contract exemption.
Home Construction Contracts
In general, Sec. 460(a) requires taxpayers to use the percentage of completion method (PCM) to account for taxable income from any long-term contract. However, Sec. 460(e) excepts home construction contracts from the general requirement to use the PCM and permits the use of an exempt method. Exempt methods commonly used to account for home construction contracts include the completed contract method (CCM) and the accrual method. Sec. 460(e)(6)(A) defines a home construction contract as any construction contract in which 80% or more of the estimated total contract costs, as of the close of the tax year in which the contract was entered into, are reasonably expected to be attributable to the construction of
- Dwelling units contained in buildings containing four or fewer dwelling units; and
- Improvements to real property directly related to such dwelling units and located on the site of such dwelling units.
Townhouses, Rowhouses, and Condominiums
For purposes of the home construction contract exemption, Sec. 460(e)(6)(A) states that each townhouse or rowhouse shall be treated as a separate building. The proposed regulations expand the definition of “home construction contract” in Sec. 460(e)(6)(A) to expressly state that each individual condominium unit will be treated as a separate townhouse or rowhouse for purposes of the home construction contract exemption. Thus, an individual condominium unit would be treated as a separate building. According to the Service, the terms “condominium” and “townhouse” are sometimes used interchangeably to describe similar structures. Further, individual condominium units share many physical and economic commonalities generally associated with townhouses and rowhouses, such as private ownership, shared portions of their structures, residential housing, and the economics of the underlying purchase transactions.
Improvements to Real Property
The treatment of land development and the construction of common improvements in the context of home construction contracts have been issues of controversy between taxpayers and the IRS (see TAM 200552012). Under the home construction contract exemption, a home construction contract includes any construction contract if 80% of the estimated total contract costs are reasonably expected to be attributable to the construction of improvements to real property directly related to qualifying dwelling units and located on the site of such dwelling units. For many years, taxpayers and tax practitioners have suggested that many contracts entered into by land developers in the home construction industry should fall within the definition of a home construction contract, even where the contract is not for the construction of the actual dwelling unit.
The proposed regulations expand the scope of the home construction contract exemption by providing that a contract for the construction of common improvements is considered a home construction contract if it is for the construction of improvements to real property directly related to the dwelling unit(s) and located on the site of such dwelling unit(s), even if the contract is not for the construction of any dwelling unit. As a result, based on the proposed regulations, a land developer (as well as its contractors and subcontractors) that is selling individual lots may have long-term construction contracts that qualify for the home construction contract exemption. The proposed regulations state that examples of common improvements are sidewalks, sewers, roads, and clubhouses. Although a common improvement does not solely benefit any particular dwelling unit or any particular lot on which a dwelling unit is constructed, the proposed regulations clarify that land clearing and grading are common improvements even when performed on a particular lot (Prop. Regs. Sec. 1.460-3(b)(2)).
Method of Accounting
The current rules provide that a taxpayer- initiated change in method of accounting will be implemented only on a cutoff basis (i.e., for contracts entered into on or after the year of change), rather than with a Sec. 481(a) adjustment. The proposed regulations would continue this cutoff method of implementation but only for taxpayer-initiated changes from a permissible PCM to another permissible PCM for long-term contracts for which a PCM is required, and for taxpayer-initiated changes from one cost allocation method of accounting that complies with cost allocation rules to another (Prop. Regs. Sec. 1.460-4(g)(2)). Under the proposed regulations, all other taxpayer-initiated changes in methods of accounting under Sec. 460 must be made with a Sec. 481(a) adjustment. According to the Service, taxpayers may not rely upon the rules contained in the proposed regulations to change or otherwise use a method of accounting until the regulations are finalized..
Completed Contract Method
Under the current regulations, the appropriate severing of a home construction contract requires a facts-andcircumstances analysis based on certain factors that are neither specific nor always relevant to home construction contracts. Similarly, the date that a home construction contract is considered completed and accepted is determined by using a facts-and-circumstances analysis. In the preamble to the proposed regulations, the IRS and Treasury have acknowledged that controversies often arise when using the existing facts-and-circumstances analyses for determining the appropriate severing and final completion and acceptance of home construction contracts accounted for under the CCM. In this regard, the IRS and Treasury expect to issue further guidance to clarify the rules for severing and completing home construction contracts accounted for under the CCM.
Proposed Effective Date
The proposed regulations will apply to tax years beginning on or after the date the final regulations are published in the Federal Register. Treasury has publicly indicated that it is considering guidance that would allow for the early application of the rules in certain situations.
Lorin Luchs is a partner in National Tax Services of BDO Seidman, LLP in Bethesda, MD.
Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.
For additional information about these items, contact Mr. Luchs at (301) 634-0250 or firstname.lastname@example.org.