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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
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?
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• 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.
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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
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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
If you have concerns about your status as a dealer or investor, consult your local CBIZ MHM tax professional.