Cbiz in touch_march2014


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Cbiz in touch_march2014

  1. 1. 1 | P a g e March 2014 A Victory for Income Deferral in Shea Homes In February, the Tax Court (Shea Homes, Inc. v. Commissioner, 142 T.C. No. 4 (Feb. 2014)) awarded a big victory to some home builders by allowing the use of the completed contract method not only on a house-by- house basis, but effectively on an entire development. This ruling may pave the way for residential real estate developers to defer income recognition until the entire development is virtually complete. Developers should proceed cautiously, however, as the ruling is based on a very specific fact pattern that may not align with your situation. The completed contract method generally allows the builder to defer recognition of income until the earlier of the date that the “subject matter” of the “contract” is 95% complete, or passes a final completion and acceptance test. Larger developers (average annual gross receipts of $10 million or more) may only use the completed contract method on a “home construction contract”, defined as: any construction contract if 80 percent 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 [building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property] with respect to — (i) dwelling units * * * contained in buildings containing 4 or fewer dwelling units * * *, and (ii) improvements to real property directly related to such dwelling units and located on the site of such dwelling units. The regulations instruct a taxpayer to “include … in the cost of the dwelling units their allocable share of the cost that the taxpayer reasonably expects to incur for any common improvements (e.g., sewers, roads, clubhouses) that benefit the dwelling units and that the taxpayer is contractually obligated, or required by law, to construct within the tract or tracts of land that contain the dwelling units.” The builder took the position that the costs of these “off site” expenses should also apply to the calculation of the completed contract method, not just to the determination of whether the contract was a home construction contract. As stated by the court, the builders “contend that … the final completion and acceptance does not occur until … the final road is paved and the final bond is released. … [The builders] contend that because the 80% test for a home construction contract includes the allocable share of the costs of common improvements, the 95% test also must include these costs.” The IRS, on the other hand, took the position that “the subject matter of the contract is the home and the lot upon which it sits.” The court did an extensive analysis of the contractual rights and obligations of the builders, along with what the home purchaser was actually buying, including: • The lifestyle advertised for the developments • The amounts budgeted and incurred for indirect costs • The performance bonds securing completion of the common improvements In This Issue…  A Victory for Income Deferral in Shea Homes  Real Estate Sales: Capital Gains or Ordinary Income?
  2. 2. 2 | P a g e • The obligations imposed by the CC&Rs (Covenants, Conditions and Restrictions) • Homeowners’ Association rules The court concluded that “the State laws do not necessarily restrict the subject matter of a real estate contract to just a house and the lot upon which it sits. [The IRS’s] analysis is simplistic and short sighted; it does not acknowledge the complex relationships created by the purchase and sales agreement, especially [the] obligations that continue long after the first home is built.” The court then addressed what was included in the “subject matter of the contract,” concluding that it “includes the house, the lot, and improvements to the lot as well as the common improvements in the development. Thus, for the purpose of the 95% completion test, [the builders] correctly tested the total allocable costs associated with the development against the costs incurred to date. For purposes of the final completion and acceptance test, [the builders] appropriately decided that, on the basis of the facts and circumstances, final completion did not occur until the final bonds were released and the final road paved.” Obviously, for large residential developments the ability to defer income recognition until “the final bonds [are] released and the final road paved” presents a very attractive tax opportunity for developers. All developers should be cognizant of this decision and determine whether it is appropriate to switch to the completed contract method for income recognition on future contracts. On the other hand, as is evident from the above analysis, Shea Homes was a very fact specific case where the court conducted extensive analysis of the contract laws of numerous states. Furthermore, it is based in part on the lack of clarity in the regulations, and similar cases are currently working their way through the system. Treasury has already indicated that it may change the regulations, and the results of the other cases may vary from Shea Homes. The case should not be read as a “green light” to use the completed contracted method in every situation. If you think this might be a good idea for you, contact your CBIZ MHM tax professional today to discuss the merits and risks. Return to Top Real Estate Sales: Capital Gains or Ordinary Income? A recent Tax Court decision has provided a good set of guidelines when considering whether a sale of real estate is an investment activity or a trade or business. In Pool v. Commissioner, TC Memo 2014-3, the court held favor of the IRS, deciding that the income was trade or business ordinary income, not capital gain. Although the facts and lack of proof in this case strongly favored the IRS, the case provides insight on what to avoid in structuring a real estate transaction. A capital asset is defined by way of exclusions, and one such exclusion is property held by a taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business (“inventory”). In one of the landmark cases in this area (Pritchett v. Commissioner, 63 T.C. 149 (1974)), the Court looked at several critical factors to decide if property is held for investment or held as inventory. The key factors the Court in Pritchett considered were:
  3. 3. 3 | P a g e 1. The nature of the acquisition of the property; 2. The frequency and continuity of sales over an extended period; 3. The nature and the extent of the taxpayer's business; 4. The activity of the seller regarding the property; and 5. The extent and substantiality of the transactions. The Court in the Pool case considered the Pritchett factors in deciding for the IRS, as follows: Nature of Acquisition: The IRS contended that the taxpayer acquired the land to subdivide and sell to customers. In fact, the taxpayer listed its business activity as “development” on its tax return in an earlier year. In addition, the taxpayer did not have any evidence that it changed its intention from development to investment during the time the land was held. The court agreed with the IRS on this and concluded the taxpayer failed to show that it held the land for investment. Frequency and Continuity of Sales: Frequent and substantial sales of real property typically indicate a sale in the ordinary course of a trade of business. The Court found that the record was not clear as to the frequency and substantiality of the sales. Therefore, the court decided that the taxpayer failed to show that its sales were not frequent or substantial. Nature and Extent of Business: The Court found that the taxpayer’s activities during the time the real property was held was consistent with a developer as opposed to an investor. The taxpayer was obligated to make water and wastewater improvements, brokered the land deals, and found additional investors. The Court held that the development activity was sufficient to conclude the property was held as inventory. Activity of the Seller Regarding the Property: The Court felt that the taxpayer was unable to show that it did not spend large amounts of time participating in the sales of the property. In fact, there were 81 purchasers of portions of the property. One key fact was that a development-related company, with identical ownership, was the other party in parts of these transactions. Extent and Substantiality of the Transaction: The Court found that the development company acquired the land from the taxpayer at an inflated price (presumably in an attempt to maximize capital gain and reduce ordinary income). The Court did not have an issue with the identical ownership; rather, the Court took exception with the lack of any evidence supporting a bona fide, arms-length transaction. You often hear of court cases where bad facts make bad law. Sometimes, no facts can also make bad law. The Pool case had both. Either the facts presented did not support the taxpayer’s position or the taxpayer was unable to produce facts that rebutted the IRS’s determinations. In many of these types of taxpayer situations, there likely are some factors that favor an investment motive while other factors favor a trade or business motive. Taxpayers and advisors can learn from cases like Pool and Pritchett and structure their dealings to tip the scale towards the desired result. All of that structuring may be meaningless, however, if the taxpayer doesn’t contemporaneously document facts that support the position. Ultimately, the taxpayer has the burden of proving the Government’s determinations to be incorrect, and a failure of evidence may be as costly as bad facts. If you have concerns about your status as a dealer or investor, consult your local CBIZ MHM tax professional.
  4. 4. 4 | P a g e Return to Top Copyright © 2014, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we inform you that—unless specifically indicated otherwise—any tax advice in this communication is not written with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue Code, or to promote, market, or recommend to another person any tax related matter. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein. CBIZ MHM is the brand name for CBIZ MHM, LLC and other Financial Services subsidiaries of CBIZ, Inc. (NYSE: CBZ) that provide tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies.