In the case of The Howard Hughes Company, LLC v. Commissioner, 142 TC No. 20, the Tax Court clarified the limit of its decision in Shea Homes, Inc. v. Commissioner, 142 TC No.3, denying the completed contract method to a developer that did not actually construct homes in this case. On appeal, the Fifth Circuit accepted the Tax Court’s analysis (The Howard Hughes Company, LLC v. Commissioner, CA5, Nos. 14-60915, 14-60921, AFTR 2d ¶ 2015-5368).

As you may recall, in the Shea Homes case the Tax Court decided that a developer could include the allocable portion of the costs of common area improvements in determining costs of home construction for purposes of meeting the 95% test for a completed contract. The IRS argued, unsuccessfully, that once Shea Homes had incurred over 95 of the costs of constructing the home on the lot it had to treat that home contract as completed regardless of the status of common area improvements.

The Hughes case involved a taxpayer that argued that, not only was the building and completion of the structure not the only issue, but that they should qualify as a homebuilder and be able to use the completed contract method even though this developer merely readied land and then sold it off to homebuilders or individuals who, presumably planned to build homes on the lots (though it turned out some were unable to actually do so).

There does appear to be a certain elegance to the argument given that the Tax Court decided general common area improvements were costs of constructing the homes—but the Court found that to lump it with the basic home construction, the taxpayer had to actually be involved in constructing homes to which the costs could be attached.

IRC §460(e)(6) defines a home construction contract as follows:

(A) Home construction contract.--The term “home construction contract” means any construction contract if 80 percent 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 activities referred to in paragraph (4) with respect to--

(i) dwelling units (as defined in section 168(e)(2)(A)(ii)) contained in buildings containing 4 or fewer dwelling units (as so defined), and

(ii) improvements to real property directly related to such dwelling units and located on the site of such dwelling units.

Hughes argued that their costs were “directly related” to dwelling units.

While agreeing that “the structures to be ultimately built upon the land petitioners sell in the contracts at issue are dwelling units” the Court however noted:

Importantly, however, petitioners 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. Petitioners have not established that at the time of each sale qualifying dwelling units would ever be built on the sold land.

In fact, the Court noted that in the case of one sale the buyer defaulted and years later no homes had yet been built.

As far as we know, no qualifying dwelling units will ever be built on these lands, and deferral of income from contracts that might not ever result in qualifying dwelling units seem entirely inappropriate under these circumstances.

A key difference from the Shea case was that:

In Shea Homes, the taxpayers closed their contracts only after a certificate of occupancy had been issued and simultaneously with the purchaser’s taking possession of their house.

More particularly, the Court held:

If the taxpayer does not construct or intend to construct qualified dwelling units, there is no allocable share of common improvement costs. . . . Petitioners were not homebuilders, and their contracts were not home construction contracts.