Completed-contract method allowed for grading and soil compaction

By Jie Wu, CPA, Pomona, Calif.

Editor: Mark G. Cook, CPA, CGMA

In Technical Advice Memorandum (TAM) 201650014, the IRS concluded that a taxpayer's long-term construction contracts requiring grading and soil compaction qualify for the completed-contract method of accounting.

In general, under Sec. 460, taxpayers with long-term construction contracts are required to use the percentage-of-completion method to determine their reportable income. This method requires taxpayers to report income by applying a percentage of completion to the gross contract price determined by comparing the costs incurred before the close of the tax year with the estimated total contract costs (Sec. 460(b)(1)).

As an exception to the general rule, certain exempt contract methods are available to taxpayers to account for their long-term construction contracts. The completed-contract method is one of the exempt contract methods allowing taxpayers to defer their tax liability to future periods until the contract is completed as defined in Regs. Sec. 1.460-1(b)(6), which provides that a contract is completed the earlier of when at least 95% of the total allocable contract costs have been incurred or upon final completion and acceptance of the contract. Under Regs. Sec. 1.460-4(d)(1), taxpayers using the completed-contract method must take into account in the year the contract is completed the gross contract price and all allocable contract costs incurred by the completion year. A taxpayer can use the completed-contract method to account for home construction contracts (Regs. Sec. 1.460-4(c)).

As defined in Sec. 460(e)(6)(A), a contract qualifies as a home construction contract if 80% or more of the estimated total contract costs are attributable to construction activities for buildings containing four or fewer dwelling units and improvements to real property directly related to and located on the site of those units.

In this case, the taxpayer entered into contracts with both land developers and owner/homebuilders in private subdivision housing projects. These contracts required the taxpayer to perform grading and soil compaction of the pad area that were necessary for the structure that would be built on the lot. The IRS was required to determine whether the taxpayer performed construction activities for the dwelling units, within the meaning of Sec. 460(e)(6)(A)(i). If it did, the contracts qualified for the completed-contract method.

Based on the facts and circumstances, the IRS concluded that the taxpayer's contracts requiring grading and soil compaction of the pad area were home construction contracts within the meaning of Sec. 460(e)(6)(A)(i) because:

  1. The taxpayer's work is regulated by state and local building codes and is subject to home warranties;
  2. The grading and soil compaction of the pad area necessary for the construction of the foundations are as essential to the support of the houses as the foundations themselves and should be considered construction of a portion of the dwelling units; and
  3. Replacement of a rental house and its foundation would require the contemporaneous physical destruction of the pad, so that the cost of the pad is part of the cost basis of the rental house.

In this case, the construction of the pads was closely associated with the foundations where the houses would be built. The fact that the taxpayer's work was regulated by state and local building codes and was subject to home warranties supported the view that the taxpayer's construction activities were a part of the home construction. Further, if the houses were to be rebuilt, the foundations and the pads would be replaced contemporaneously. Therefore, the grading and soil compaction of the pad area qualified for the treatment of the completed-contract method because the construction activities are within the meaning of Sec. 460(e)(6)(A)(i).

To further support this conclusion, the IRS cited cases and IRS guidance addressing the issue of whether the cost of land preparation can be included in the basis of a building. In Eastwood Mall, Inc., 47 F.3d 1168 (6th Cir. 1994), the court found that the creation of the plateau on which a shopping mall was built was a permanent change of the natural configuration of 100 acres of mountainous land. Once the plateau was built, none of the work performed to create the plateau would have to be repeated if a similar project were to be constructed on the site in the future. Therefore, the costs of reshaping mountainous land into the plateau were nondepreciable because the plateau was inextricably associated with the land itself and was not intimately related to the construction for which the costs were incurred.

In Rev. Rul. 2001-60, the IRS determined that the cost of land preparation of the modern golf course greens by the taxpayer was closely associated with depreciable assets such as a network of underground drainage tiles or pipes. That land preparation would be retired, abandoned, or replaced contemporaneously with those depreciable assets. Therefore, the cost of the land preparation of the modern greens should be capitalized and depreciated over the recovery period of the associated depreciable assets.

In Rev. Rul. 68-193, the IRS reached a similar conclusion allowing a depreciation deduction of the cost paid or incurred for roadway grading since in that specific situation, the grading was directly associated with depreciable buildings and the grading would be retired, abandoned, or replaced contemporaneously with the buildings.

In the TAM, the IRS noted that rough grading of the lot or clearing trees would not qualify as construction of a dwelling unit because those are nondepreciable improvements to land. Installation of retaining walls and a driveway for a rental building would qualify as the construction of depreciable improvements to land but not ones that are part of the dwelling unit itself.

The IRS also acknowledged a recent interpretation of the home construction contract by the court in Howard Hughes Co., LLC, 805 F.3d 175 (5th Cir. 2015), but noted that the taxpayer's case in the TAM's analysis is not governed by the court's interpretation because the land developer in Hughes solely incurred common improvement costs, while the taxpayer's construction activities in the TAM were within the individual lots.

In Hughes, a land developer incurred improvement costs to the land that was divided into various types of lots. The developer would construct all of the necessary infrastructure up to a parcel boundary or to individual lot lines. The buyer of the individual lots would be responsible for the further development work on the property. The court denied the use of the completed-contract method because the developer did not perform construction activities within the boundaries of any lots, and thus its contracts did not qualify for the completed-contract method under the home construction contract exemption.


Mark G. Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.

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