Howard Hughes Decision May Have a Big Impact on Residential Real Estate DevelopersFebruary 2016
A recent decision by the Fifth Circuit Court of Appeals affects many residential real estate developers. In Howard Hughes Co., LLC v. Commissioner, 805 F.3d 175 (5th Cir. 2015), the court addressed when a developer may use the completed contract method of accounting rather than the percentage of completion method. The issue is significant because developers entitled to use the completed contract method need to recognize income only when the contract is completed and accepted. In contrast, developers who are required to use the percentage of completion method must generally recognize income whenever significant progress is made toward completing the contract. By using the completed contract method, taxpayers are often able to defer for multiple years the recognition of income from a long-term project.
Generally, income from long-term contracts must be reported using the percentage of completion method. However, I.R.C. Section 460, which was affirmed in Shea Homes, Inc. v. Commissioner, 142 T.C. 60 (2014), provides an exception that allows home builders to use the completed contract method. The issue in Howard Hughes was whether this exception also applied to land developers. The Fifth Circuit affirmed an earlier decision by the Tax Court holding that land development costs alone (including infrastructure costs), without any related home construction costs, do not meet the narrow "home builder" exception provided by I.R.C. Section 460. In distinguishing between home building and land development, the court said that "[a] taxpayer's contract can qualify as a home construction contract only if the taxpayer builds, constructs, reconstructs, rehabilitates, or installs integral components to dwelling units or real property improvements directly related to and located on the site of such dwelling units." (emphasis added). Thus, absent some actual home construction, land developers cannot use the completed contract method and must recognize gain over the life of a particular project, despite incurring large up front development costs.
Although the Fifth Circuit upheld the Tax Court's decision as it related to the land development conducted by Howard Hughes Co., LLC, land developers who might meet the Fifth Circuit's criterion for a home construction contract are advised to consult an attorney about the possibility of utilizing the completed contract method of accounting for income tax purposes.