Recent Tax Court Decisions Will Have a Big Impact on Real Estate Developers

July 7, 2014

The Tax Court recently handed down two long-awaited decisions that will have a significant impact on many real estate developers. Both decisions deal with the circumstances under which real estate developments can use the completed contract method of accounting to report income and gain from development projects. While decisions on accounting methods might sound esoteric, their impact on the bottom line can be dramatic because they determine how long developers can defer recognizing income from ongoing projects. Taxpayers who cannot use the completed contract method of development typically must use the percentage of completion method, which generally requires developers to recognize income more quickly at times when ongoing development costs can make payment of taxes difficult.

In Shea Homes, Inc. v. Commissioner, 142 T.C. No. 3, the court considered use of the completed contract method with regard to homebuilders. In Howard Hughes Co. v. Commissioner, 142 T.C. No. 20, the court addressed use of the completed contract method by land developers. The court held that homebuilders can use the completed contract method; however, land developers cannot use the completed contract method and must instead use the percentage of completion method.

In distinguishing between home building and land development, the court said, "[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." Thus, absent actual home construction, land developers must recognize gain over the life of a particular project despite incurring large up-front development costs. Despite the court's adverse finding with respect to land developers, advance planning may be available so that the developers may yet be able to use the completed contract method of accounting with proper planning.

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