The Howard Hughes Company, LLC f.k.a. The Howard Hughes Corporation, and Subsidiaries v. Commissioner
This text of 142 T.C. No. 20 (The Howard Hughes Company, LLC f.k.a. The Howard Hughes Corporation, and Subsidiaries v. Commissioner) is published on Counsel Stack Legal Research, covering United States Tax Court primary law. Counsel Stack provides free access to over 12 million legal documents including statutes, case law, regulations, and constitutions.
Opinion
142 T.C. No. 20
UNITED STATES TAX COURT
THE HOWARD HUGHES COMPANY, LLC, f.k.a. THE HOWARD HUGHES CORPORATION, AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
HOWARD HUGHES PROPERTIES, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 10539-11, 10565-11. Filed June 2, 2014.
Ps are in the residential land development business and develop land in and adjacent to Las Vegas, Nevada. Ps sell land to builders and, in some cases, individuals, who construct and sell houses. Ps generally sell land through bulk sales, pad sales, finished lot sales, and custom lot sales. In bulk sales, Ps develop raw land into villages and sell an entire village to a builder. Ps do not otherwise develop the sold village. In pad sales, Ps develop villages into parcels and sell the parcels to builders. Ps do not develop within the sold parcels. In finished lot sales, Ps develop parcels into lots and sell whole parcels of finished lots to builders. In custom lot sales, Ps sell individual lots to individual purchasers or custom home builders, who then construct homes. In all instances, Ps do not construct residential dwelling units on the land they sell. During the years at issue, Ps reported income from purchase and sale agreements under the completed contract method of accounting. R alleges Ps’ contracts are not home -2-
construction contracts within the meaning of I.R.C. sec. 460(e). R further contends the land sale contracts are not long-term construction contracts and are not eligible for the long-term percentage of completion method of accounting under I.R.C. sec. 460.
Held: Ps’ bulk sale and custom lot contracts are long-term construction contracts.
Held, further, Ps’ contracts are not home construction contracts within the meaning of I.R.C. sec. 460(e), and Ps may not report gain and loss from these contracts using the completed contract method of accounting.
Stephen F. Gertzman, Kevin L. Kenworthy, Steven R. Dixon, Mary W.B.
Prosser, and Sat Nam S. Khalsa, for petitioners.
Ronald S. Collins, Jr., Bernard J. Audet, Jr., and John R. Gilbert, for
respondent.
WHERRY, Judge: These cases, consolidated for trial, briefing, and
opinion, are before the Court on petitions for redetermination of Federal income
tax deficiencies. Respondent determined deficiencies for the 2007 and 2008 tax
years of petitioner the Howard Hughes Co., LLC (THHC) (formerly the Howard
Hughes Corp. & Subsidiaries (Old THHC)), and deficiencies for the 2007 and
2008 tax years for petitioner Howard Hughes Properties, Inc. (HHPI). The issue -3-
for consideration concerns the proper method of accounting for income from
certain contracts. Respondent alleges that, with respect to most of petitioners’
contracts, petitioners must use the percentage of completion method of accounting
instead of the completed contract method of accounting. Petitioners, however,
contend that because their contracts qualify as home construction contracts within
the meaning of section 460(e)(6), they properly reported income on the completed
contract method.1 Respondent further alleges that certain other contracts are not
long-term contracts or construction contracts and that petitioners cannot account
for the gain or loss from these contracts under section 460.
FINDINGS OF FACT
The parties’ stipulation of facts and supplemental stipulation of facts, both
with accompanying exhibits, are incorporated herein by this reference. At the time
petitioners filed the petitions, their principal place of business was Dallas, Texas.
Their main business operations, however, are in Las Vegas, Nevada.
Company Background
When Howard Hughes died in 1976, his portfolio of assets, owned by
Summa Corp., included land which was then outside the city of Las Vegas,
1 Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended and in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. -4-
Nevada. In the 1980s this land was selected for development. The land was
called Summerlin, which was the maiden name of Mr. Hughes’ paternal
grandmother. Summerlin was divided into three geographic regions: Summerlin
North, Summerlin South, and Summerlin West.
In 1996 the Rouse Co. (Rouse), a publicly traded corporation based in
Columbia, Maryland, acquired the assets of the Hughes estate, including Howard
Hughes Properties LP (HHPLP), which owned Summerlin. Effective January 1,
1998, Rouse elected to be treated as a real estate investment trust (REIT) in 1998.
As part of this conversion Rouse organized HHPI, which in turn purchased the
undeveloped acreage in Summerlin North and South from HHPLP. In December
1997 HHPLP had distributed Summerlin West to Old THHC. In 2004 General
Growth Properties, Inc. (GGP), a publicly traded REIT, acquired Rouse by merger.
During the tax years at issue, GGP was the general partner in a limited partnership,
which, through another limited partnership, the Rouse Co. LP, and a limited
liability company, Rouse LLC, owned HHPI and the Hughes Corp., which in turn
owned Old THHC.
In 2009 GGP and its affiliated entities filed for bankruptcy under chapter 11
of the U.S. Bankruptcy Code. Effective December 31, 2009, Old THHC converted
from a corporation to a Delaware limited liability company, which is petitioner -5-
THHC in these cases. As part of the plan of reorganization in 2010 GGP spun off
the part of its business that owned Summerlin. A newly formed entity, the
Howard Hughes Corp., an entity distinct from Old THHC, ended up owning, as
second- and third-tier subsidiaries, HHPI and THHC. THHC owns Summerlin
West, and HHPI owns Summerlin North and Summerlin South to the extent that
these properties have not yet been sold to third parties.
Summerlin
During the years at issue petitioners were in the residential land
development business. They generated revenue primarily by selling property to
builders who would then construct and sell homes. In some cases, they also sold
property to individual buyers who would then construct single-family residential
homes. The land petitioners sold and still sell is part of a large master-planned
community known as Summerlin.
Summerlin comprises approximately 22,500 acres on the western rim of the
Las Vegas Valley, about nine miles west of downtown Las Vegas. As of the end
of 2010 approximately 100,000 residents lived in 40,000 homes in Summerlin. At
completion, petitioners expect Summerlin to house approximately 220,000
residents. While Summerlin is largely residential, it is a fully integrated
community, which means it includes commercial, educational, and recreational -6-
facilities. It contains about 1.7 million square feet of developed retail space, 3.2
million square feet of developed office space, 3 hotels, and health and medical
centers. It has 25 public and private schools, 5 higher learning institutions, 9 golf
courses, parks, trails, and cultural facilities.
Summerlin North and Summerlin West are, as a result of annexation, part of
the city of Las Vegas, and Summerlin South is in Clark County, Nevada. The first
residential land sales in Summerlin North took place around 1986, and by the
years at issue HHPI had fully developed Summerlin North. The first land sales in
Summerlin South took place in 1998, and the first land sales in Summerlin West
took place in 2000.
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142 T.C. No. 20
UNITED STATES TAX COURT
THE HOWARD HUGHES COMPANY, LLC, f.k.a. THE HOWARD HUGHES CORPORATION, AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
HOWARD HUGHES PROPERTIES, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 10539-11, 10565-11. Filed June 2, 2014.
Ps are in the residential land development business and develop land in and adjacent to Las Vegas, Nevada. Ps sell land to builders and, in some cases, individuals, who construct and sell houses. Ps generally sell land through bulk sales, pad sales, finished lot sales, and custom lot sales. In bulk sales, Ps develop raw land into villages and sell an entire village to a builder. Ps do not otherwise develop the sold village. In pad sales, Ps develop villages into parcels and sell the parcels to builders. Ps do not develop within the sold parcels. In finished lot sales, Ps develop parcels into lots and sell whole parcels of finished lots to builders. In custom lot sales, Ps sell individual lots to individual purchasers or custom home builders, who then construct homes. In all instances, Ps do not construct residential dwelling units on the land they sell. During the years at issue, Ps reported income from purchase and sale agreements under the completed contract method of accounting. R alleges Ps’ contracts are not home -2-
construction contracts within the meaning of I.R.C. sec. 460(e). R further contends the land sale contracts are not long-term construction contracts and are not eligible for the long-term percentage of completion method of accounting under I.R.C. sec. 460.
Held: Ps’ bulk sale and custom lot contracts are long-term construction contracts.
Held, further, Ps’ contracts are not home construction contracts within the meaning of I.R.C. sec. 460(e), and Ps may not report gain and loss from these contracts using the completed contract method of accounting.
Stephen F. Gertzman, Kevin L. Kenworthy, Steven R. Dixon, Mary W.B.
Prosser, and Sat Nam S. Khalsa, for petitioners.
Ronald S. Collins, Jr., Bernard J. Audet, Jr., and John R. Gilbert, for
respondent.
WHERRY, Judge: These cases, consolidated for trial, briefing, and
opinion, are before the Court on petitions for redetermination of Federal income
tax deficiencies. Respondent determined deficiencies for the 2007 and 2008 tax
years of petitioner the Howard Hughes Co., LLC (THHC) (formerly the Howard
Hughes Corp. & Subsidiaries (Old THHC)), and deficiencies for the 2007 and
2008 tax years for petitioner Howard Hughes Properties, Inc. (HHPI). The issue -3-
for consideration concerns the proper method of accounting for income from
certain contracts. Respondent alleges that, with respect to most of petitioners’
contracts, petitioners must use the percentage of completion method of accounting
instead of the completed contract method of accounting. Petitioners, however,
contend that because their contracts qualify as home construction contracts within
the meaning of section 460(e)(6), they properly reported income on the completed
contract method.1 Respondent further alleges that certain other contracts are not
long-term contracts or construction contracts and that petitioners cannot account
for the gain or loss from these contracts under section 460.
FINDINGS OF FACT
The parties’ stipulation of facts and supplemental stipulation of facts, both
with accompanying exhibits, are incorporated herein by this reference. At the time
petitioners filed the petitions, their principal place of business was Dallas, Texas.
Their main business operations, however, are in Las Vegas, Nevada.
Company Background
When Howard Hughes died in 1976, his portfolio of assets, owned by
Summa Corp., included land which was then outside the city of Las Vegas,
1 Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended and in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. -4-
Nevada. In the 1980s this land was selected for development. The land was
called Summerlin, which was the maiden name of Mr. Hughes’ paternal
grandmother. Summerlin was divided into three geographic regions: Summerlin
North, Summerlin South, and Summerlin West.
In 1996 the Rouse Co. (Rouse), a publicly traded corporation based in
Columbia, Maryland, acquired the assets of the Hughes estate, including Howard
Hughes Properties LP (HHPLP), which owned Summerlin. Effective January 1,
1998, Rouse elected to be treated as a real estate investment trust (REIT) in 1998.
As part of this conversion Rouse organized HHPI, which in turn purchased the
undeveloped acreage in Summerlin North and South from HHPLP. In December
1997 HHPLP had distributed Summerlin West to Old THHC. In 2004 General
Growth Properties, Inc. (GGP), a publicly traded REIT, acquired Rouse by merger.
During the tax years at issue, GGP was the general partner in a limited partnership,
which, through another limited partnership, the Rouse Co. LP, and a limited
liability company, Rouse LLC, owned HHPI and the Hughes Corp., which in turn
owned Old THHC.
In 2009 GGP and its affiliated entities filed for bankruptcy under chapter 11
of the U.S. Bankruptcy Code. Effective December 31, 2009, Old THHC converted
from a corporation to a Delaware limited liability company, which is petitioner -5-
THHC in these cases. As part of the plan of reorganization in 2010 GGP spun off
the part of its business that owned Summerlin. A newly formed entity, the
Howard Hughes Corp., an entity distinct from Old THHC, ended up owning, as
second- and third-tier subsidiaries, HHPI and THHC. THHC owns Summerlin
West, and HHPI owns Summerlin North and Summerlin South to the extent that
these properties have not yet been sold to third parties.
Summerlin
During the years at issue petitioners were in the residential land
development business. They generated revenue primarily by selling property to
builders who would then construct and sell homes. In some cases, they also sold
property to individual buyers who would then construct single-family residential
homes. The land petitioners sold and still sell is part of a large master-planned
community known as Summerlin.
Summerlin comprises approximately 22,500 acres on the western rim of the
Las Vegas Valley, about nine miles west of downtown Las Vegas. As of the end
of 2010 approximately 100,000 residents lived in 40,000 homes in Summerlin. At
completion, petitioners expect Summerlin to house approximately 220,000
residents. While Summerlin is largely residential, it is a fully integrated
community, which means it includes commercial, educational, and recreational -6-
facilities. It contains about 1.7 million square feet of developed retail space, 3.2
million square feet of developed office space, 3 hotels, and health and medical
centers. It has 25 public and private schools, 5 higher learning institutions, 9 golf
courses, parks, trails, and cultural facilities.
Summerlin North and Summerlin West are, as a result of annexation, part of
the city of Las Vegas, and Summerlin South is in Clark County, Nevada. The first
residential land sales in Summerlin North took place around 1986, and by the
years at issue HHPI had fully developed Summerlin North. The first land sales in
Summerlin South took place in 1998, and the first land sales in Summerlin West
took place in 2000. Each of these three geographical regions is further divided
into villages, each of which averages about 500 acres. Villages are further divided
into parcels, or neighborhoods, which contain the individual lots. These cases
involve only petitioners’ sales of land in Summerlin South and Summerlin West.
Petitioners’ sales generally fell into one of four categories: pad sales,
finished lot sales, custom lot sales, and bulk sales.2 In a pad sale, petitioners, after
dividing the village into parcels, constructed all of the infrastructure in the village
up to a parcel boundary. Petitioners then sold the parcel to a buyer, who was
2 The parties disagree over whether the bulk sales contracts are in substance different from the pad sales contracts. We resolve this issue infra. -7-
usually a homebuilder. The builder, with petitioners’ approval, was responsible
for all of the infrastructure (such as streets and utilities) within the parcel and
subdividing the parcel into lots. In a finished lot sale, petitioners also divided the
village into parcels. They then further constructed any additional needed parcel
infrastructure, divided the parcels into lots, and sold the neighborhoods to a buyer,
usually a homebuilder. In finished lot sales, petitioners constructed all of the
infrastructure up to the lot line. In both the pad sales and the finished lot sales,
petitioners contracted with homebuilders through building development
agreements (BDAs). The BDAs were more than just simple sales contracts that,
for consideration, pass title. We discuss the parties’ responsibilities infra. In
doing so, we do not purport to cover all of the details but simply address some
important aspects of the BDAs.
Custom lot sales were essentially the same as finished lot sales except that
petitioners sold the individual lots. The buyers of these individual lots were
individuals who were contractually bound to build a residential dwelling unit.3
3 The parties stipulated that the sales in all custom lot contracts were made to “an individual purchaser”. A review of the list of custom lot contracts, however, reveals that some of the buyers appear to be builders (e.g., Executive Home Builder, Six Star Construction, Inc., and PMR Homes, Inc.). This apparent discrepancy may result from the meaning of “individual purchaser” but is irrelevant to our ultimate holding. For simplicity, we will rely on the parties’ (continued...) -8-
The purchase sales contracts required the individuals to agree that they would
occupy the home for at least one year or, if the home was sold before then to a
third party, to pay additional consideration of 10% of the third-party price.
Finally, in a bulk sale, petitioners sold an entire village to a purchaser. The
purchaser was responsible for subdividing the village into parcels and lots and for
constructing all of the infrastructure improvements within the village.
Even though the builders were ultimately responsible for building and
selling homes to the end user--the homebuyer--petitioners marketed to the
homebuyers. Petitioners’ marketing strategy embodied the idea of the master-
planned community, and they viewed Summerlin as a brand that evokes thoughts
of an attractive lifestyle and community. But petitioners did not bear the sole
burden of the marketing cost. In fact, their agreements with the builders required
the builders to pay into an advertising program promoting Summerlin. The
builders paid, upon the close of escrow of a home sale, a fee equal to 1% of the
purchase price.
We discuss infra the general process THHC and HHPI undertake in their
home development business. Much of the trial was devoted to the details of the
3 (...continued) stipulation. -9-
process, and we by no means purport to address every step. Our intention is not to
discount those important steps not addressed but to provide a general picture of
how the development process worked.
Developing Summerlin--Entitlements
Petitioners were parties to master development agreements with Las Vegas,
Nevada, and Clark County, Nevada, that govern the planned development of
Summerlin West and Summerlin South, respectively. These long-term, 30-year
agreements assure petitioners that they will be able to develop the land in
accordance with the agreements and remove any necessity to negotiate
development agreements and entitlements village by village.
Summerlin West
Las Vegas, pursuant to powers delegated by the State of Nevada by chapter
278 of the Nevada Revised Statutes, adopted in April 1992 the City General Plan,
which is a master land use plan. HHPLP and Las Vegas signed a development
agreement (LVDA) in February 1997. The LDVA was recorded in the Clark
County, Nevada, Recorder’s Office and was approved by the Las Vegas City
Council. Along with approvals and plans referenced within the agreement, the
LVDA governed land development in Summerlin West. Las Vegas also amended
its City General Plan to incorporate the Summerlin West General Development - 10 -
Plan, which conceptualized future development of Summerlin West, and rezoned
Summerlin West from a rural district to a planned community district.
The Summerlin West Development Standards, attached to the LVDA, set
minimum requirements for development, including “residential densities; building
height and setbacks; signage; landscaping; parking and open space requirements;
as well as procedures for site plan review and for modifying the Planned
Community Program.” The LVDA states that development of Summerlin West
will occur in phases called villages. The owner has to prepare and submit for city
approval a Village Development Plan for each village. A village traffic study and
a village drainage study also had to accompany the village development plan.
Initially, the LVDA permitted 20,250 residential units, 5.85 million square
feet of office, retail, or industrial space uses on 508 acres of land, golf courses
featuring up to 90 holes of golf, and related facilities. Other uses described in the
Summerlin West General Development Plan were also contemplated. The LVDA
required HHPLP to maintain medians but allowed HHPLP to assign that
responsibility to homeowners associations. HHPLP granted the city the right to
construct traffic signals, turn lanes, and similar improvements as necessary. The
LVDA also required HHPLP to donate land to the city and construct a fire station
on that land and to donate up to five acres of land to the city for a satellite - 11 -
government center. In addition, HHPLP was to donate land to the city for a public
park with sports and recreational facilities and assume the cost of constructing a
sewer interceptor. With respect to traffic and transportation, the LVDA required
HHPLP to provide, or at least provide adequate assurance that it would provide,
standard improvements in connection with each village. Standard improvements
were “mitigation measures and improvements required for intersections and
roadways immediately adjacent to the Planned Community.” HHPLP also agreed
to dedicate land needed for the right of way to the city for a major arterial road, the
Summerlin Parkway extension.
In November 2003 Old THHC, as the successor in interest to HHPLP, and
the city amended the LVDA to require Old THHC to allocate a certain minimum
amount of recreational space per 1,000 residents, construct a neighborhood pool,
and design and construct a police substation with a helicopter landing pad. The
amended LVDA also increased the allowed number of residential units from
20,250 to 30,000. Petitioner THHC was and is, as successor in interest to Old
THHC, subject to the LVDA as amended.
Summerlin South
Clark County, Nevada, pursuant to the powers delegated by the State of
Nevada, adopted the Clark County Master Plan in 1983. It and HHPLP also - 12 -
signed and recorded a development agreement (CCDA) in February 1996 to
govern the development of Summerlin South. Before the CCDA, Clark County
had amended its County Master Plan to include the Land Use and Development
Guide for Summerlin’s Southern Comprehensive Planned Community (Land Use
and Development Guide). Clark County also rezoned Summerlin South from a
rural district to a planned community district.
The CCDA provided that Summerlin South would be developed in
accordance with the Summerlin Master Plans, which consisted of the Land Use
and Development Guide, a Summerlin Master Parks and Public Facilities Plan, a
Summerlin Master Transportation Plan, and a Summerlin Master Drainage Plan.
As with the LVDA, the CCDA envisioned development by phases called villages,
and HHPLP agreed to submit a Village Development Plan before beginning
development of a village. HHPLP also agreed to submit with the Village
Development Plan a traffic study, a drainage study, and a parks and public
facilities plan.
Under the CCDA, Summerlin South could contain up to 18,000 residential
dwelling units, 740 acres for nonresidential private uses, 90 holes of golf and
related facilities, 3 hotels/casinos, and other land uses and facilities. The CCDA
obligated HHPLP to construct a fire station, donate up to 5 acres of land for a - 13 -
satellite government center, which may include the fire station, and dedicate up to
20 acres of land for a community sports park. The CCDA also obligated HHPLP
to submit the Master Parks and Public Facilities Plan, which was to generally
identify the location and development timing of parks, trails, and public spaces
systems. HHPLP also was to submit a Master Transportation Study, provide the
necessary improvements to mitigate the development’s traffic impact, provide
village access roads for each village, and bear all public and private expenses,
such as roadway construction, lighting, drainage, signage, and landscaping
expenses related to Summerlin South’s internal roadway network. The CCDA
further required HHPLP to prepare a technical drainage study and construct flood
facilities which were to be integrated where possible with the trails and parks
systems.
The parties, Clark County and HHPI, as successor in interest to HHPLP,
have amended the CCDA three times, most recently in July 2005. The most recent
amendment increased the number of permissible residential dwelling units to
32,600. In return, HHPI agreed, inter alia, at its expense to purchase and provide a
100-foot aerial fire truck with operating equipment; design, construct, and convey
a second fire station; and convey 2.5 acres of land to the county for a third fire
station. In addition, HHPI agreed to convey 25 acres or more of land to the county - 14 -
for recreational purposes or 30 acres or more for a sports park to be designed and
constructed by HHPI, and a community center and outdoor aquatic center to be
designed and constructed by HHPI.
Developing Summerlin--Covenant, Conditions, and Restrictions
Petitioners and their predecessors in interest recorded Master Declarations,
which govern use of the land by subsequent owners. These declarations, also
known as covenants, conditions, and restrictions (CC&Rs), not only imposed use
restrictions and protective covenants, but also created homeowners associations.
The Master Declarations served as the governing documents for the homeowners
associations. The declarations applied to an initial set of properties within
Summerlin, but allowed petitioners to annex property, thereby expanding the
community subject to the declarations.
The Master Declarations provided for the establishment of village
subassociations through new declarations. The subassociation declarations
supplemented the Master Declarations. These subassociations were responsible
for owning and maintaining certain common elements and/or exclusive amenities
associated with a neighborhood and for enforcing their own covenants, conditions,
and restrictions. A neighborhood, which could include a gated community,
consists of properties which share exclusive amenities or common areas. - 15 -
The Summerlin South Master Declaration established the Summerlin South
Design Review Committee. This committee had to approve “construction,
alteration, grading, additions, excavation, modification, decoration, redecoration
or reconstruction of an Improvement or removal of any tree in any Phase of
Development”. The Summerlin West Master Declaration established a similar
review process. In both cases, petitioners retained control over the review process
until such time as they no longer owned an interest in the respective Summerlin
West and Summerlin South geographic regions.
Developing Summerlin--Villages
Petitioners developed Summerlin in village phases starting with the villages
adjacent to existing development to take advantage of the infrastructure.
Subsequent villages could likewise take advantage of the additional infrastructure
created by the adjacent villages.
Generally, the first step in petitioners’ development activities was to survey
the property and create and file a parcel map. The parcel map broke off a village-
size piece for development and sale by petitioners. Petitioners also had to grant
easements for utilities and drainage and dedicate public streets. The parcel map
reflected these easements and dedications. - 16 -
Often, Clark County or Las Vegas imposed obligations on petitioners with
respect to street grading, surfacing, and alignment and provisions for drainage,
water quality and supply, sewerage, and particular lot designs. Before developing
the land, petitioners prepared and filed a tentative map. Along with this map,
petitioners conducted technical studies, such as traffic and drainage studies, and
established a village development plan, which is required by the LVDA and the
CCDA and established the specific zoning, uses, and entitlements within the
villages. Normally, the governing agency required petitioners to design and
construct the improvements on the tentative map as a condition of approval of the
map. But in certain cases, petitioners requested waivers. For instance, if a road
was not immediately necessary, petitioners could request a waiver delaying
construction until it was necessary. In addition, the tentative maps did not show
all of the improvements that petitioners would construct on the parcels. For
instance, they did not show landscaping, wall, and dry utility improvements.
Petitioners also prepared improvement plans for the improvements shown
on the tentative maps. It took about nine months to one year to prepare these plans
and for the governing agency to review and approve them.
Once the various governmental bodies approved the tentative map,
petitioners were required to also submit a final subdivision map. In the case of - 17 -
pad sales, the builders also had to prepare and submit tentative and final maps to
further subdivide the pad land into lots. The pad purchase contracts governing pad
sales also required the builders to first submit these maps to petitioners for
approval.
The final map showed roads and easements that petitioners intended to
dedicate to the public. These easements included those for wet utilities, such as
sewer and water, and dry utilities, such as electric, telecommunications, and gas.
Absent a Special Improvement District (SID), the approving governmental body
could require petitioners to enter agreements whereby petitioners posted bonds to
ensure completion of the agreed upon improvements. These improvements may
have included streets, alleys, curbs, gutters, sidewalks, medians, streetlights,
traffic signals, sewer systems, drainage facilities, open space improvements, trails,
parks, and landscaping. Petitioners obtained and posted bonds based on the unit
rate times required material as determined by the agency that requires the bond.
The agency commented on and required modifications to or approved the bond,
and it exonerated petitioners only when the improvements were fully constructed
and inspected and the agency took ownership.
Petitioners also used tax-exempt SIDs financing to finance construction of
some Summerlin infrastructure improvements. In a project financed by SID - 18 -
bonds, petitioners did not have to post performance bonds. These SID bonds
financed public improvements such as street, water, sewer, and storm drainage
improvements. Petitioners were entitled to reimbursement from the money raised
from the sale of the SID bonds when they incurred the relevant construction costs,
subject to the approval of the relevant municipal authority. Special assessments
on the property within the SID covered the scheduled bond payments. SID
financing was not available to cover dry utilities, landscaping, and walls.
Summerlin West and Summerlin South contain seven SIDs. The total amount of
the SID bonds was $183,685,000.
Villages at Issue
Respondent’s determinations concern income from 107 BDAs4 for the sale
of land in 9 of petitioners’ villages. Those villages are: Village 13 (Summerlin
Centre), Village 14B (The Gardens), Village 15B (Siena), Village 16 (The Mesa),
Village 18 (The Ridges), Village 19 (Summerlin Centre West), Village 20 (The
4 The parties provided a stipulated exhibit that purports to be a list of BDAs at issue. This list of 130 BDAs includes 23 contracts for sales in Village 14A. But the parties also stipulated that petitioners recognized the gain on BDAs involving Village 14A in 2000. Other stipulated exhibits, such as a map highlighting the villages at issue and the calculations attached to the 30-day letters, also reveal that the contracts for sales of land in Village 14A are not in issue. We disregard the contracts from Village 14A in arriving at the total number of BDAs at issue. - 19 -
Vistas), Village 23A/B (The Paseos), and Village 26 (Reverence). All of the
villages except Villages 15B, 19, and 26 contained land sold in pad sales.5
Finished lot sales occurred in Villages 16, 18, 19, 20, and 23.
Also at issue are 279 custom lot contract sales. All custom lot contracts
involved the sale of lots in Village 18. Of the custom lot contracts, 94% were
entered into and closed in the same tax year. The remaining custom lot contracts
closed in the tax year following the one in which they were entered into.
The parties have agreed that Villages 16, 18, 20, and 23 are generally
representative of the villages at issue. The parties have also agreed on a BDA that
is representative of finished lot sales (Ladera BDA), a BDA that is representative
of pad sales (Lyon BDA), and two custom lot contracts, Redhawk and Arrowhead,
that are generally representative of the custom lot contracts at issue.
In addition to the pad sales, the finished lot sales, and the custom lot
contracts, petitioners also sold villages 15B and 26 in bulk sales essentially
equivalent to very large pad sales. Within the boundaries of the property sold in a
bulk sale, petitioners do nothing. Rather, the purchaser is responsible for all
5 The parties disagreed over whether Villages 18 and 19 contained land sold in pad sales. This dispute is immaterial to our ultimate holding, but we find that the weight of the evidence suggests Village 18 contained land sold in pad sales whereas Village 19 did not. - 20 -
development. With respect to Village 26, known as Reverence, the first half of the
sale to Pulte Homes, Inc., now known as Pulte Group, Inc., occurred in December
2006, just before the 2007 housing market collapse, and neither petitioners nor the
purchaser have done any work on this property. In fact, the sale of Village 26 was
to occur in two parts, but the purchaser defaulted on the second half of the
contract. With bulk sales, petitioners still incurred regional costs that benefit the
two villages, such as costs for water lines, regional drainage, and road extensions.
Common Improvements Generally
The BDAs, loan agreements, governmental laws, and other legal obligations
required petitioners to build common improvements in Summerlin. These
improvements included rough grading, roadways, sidewalks, utility infrastructure
such as water, sewer, gas, electricity, and telephone, storm water drainage, parks,
trails, landscaping, entry features, signs, and perimeter walls. Upon completion of
a common improvement, petitioners transferred ownership or granted easements to
the respective community association or, where appropriate, the municipality.
Generally, community associations received some roads, swimming pools, open
spaces, and medians, whereas the municipalities received police stations, fire
stations, other roads, traffic signals, and street lights. - 21 -
Some of these improvements were necessary for construction of the
dwelling units. The allocable costs attributable to petitioners’ improvement
construction activities exceeded 10% of the various total contract prices.
Petitioners designed all of the common improvements in an effort to make
Summerlin an attractive community. In addition, petitioners monitored and
maintained approval control over all construction in Summerlin, including
construction of the dwelling units.
Representative Contracts
Finished Lot Sale--Ladera BDA
With respect to the BDAs, the parties stipulated that these contracts are
construction contracts within the meaning of section 460(e)(4). The Ladera BDA
is a purchase and sale agreement between HHPI and KB Home Nevada, Inc. (KB
Home), for finished lots in Village 16 in a neighborhood called Ladera. The
Ladera BDA called for the land sale to be completed in three phases. Village 16,
known as The Mesa, consisted of a mix of residential uses including single family
and multifamily units. The style of The Mesa drew its inspiration from the
mountains in the backdrop, and petitioners required builders to use natural
building materials, such as stone, and to include at least two outdoor living spaces
per residence. - 22 -
In addition to the purchase price, the Ladera BDA entitled HHPI to certain
participation payments as well as payments tied to power company refunds. HHPI
received a lot premium participation payment equal to 50% of the lot premium less
a credit calculated by reference to any commission paid to an unrelated broker.
HHPI also received a payment equal to the greater of 3% of the net sale price or
HHPI’s percentage share, 38% of the net sale price less the finished lot costs.6
The power company refund payments stemmed from the fact that HHPI paid the
Nevada Power Co. to construct electric feeder lines. As homeowners subscribed
to electrical service, the power company refunded all or part of the costs. HHPI
assigned the rights to the refunds to KB Home but then required KB Home to
make three lump-sum payments equal to the estimated amount of the refund.
The Ladera BDA required HHPI to develop the parcel into finished lots.
HHPI constructed all of the infrastructure up to the individual lot lines. Thus, wet
and dry utilities were “stubbed” to the lot boundaries. HHPI was also responsible
for the streets and street improvements such as traffic signals, the driveway
depressions, the perimeter and retaining walls, entry monumentation, and
landscaping. HHPI also graded the parcel, including the lots. And HHPI agreed
6 As used in the contracts, net sale price means the gross sale price less credit for any lot premium and any costs of amenities, such as swimming pools. Finished lot costs is the purchase price KB Home paid for the lot. - 23 -
to construct a community park with a swimming pool, for which KB Home paid
HHPI a community park fee of $2,000 per residence.
Improvement plans governed the work HHPI had to perform as part of the
contract. HHPI, through the engineering firm G.C. Wallace, Inc. (GCW), created
their plans, one for each phase, for approval by Clark County, the public utilities,
and other agencies. The plans governed the curbs, gutters, and other paving
improvements, street signs, streetlights, driveway depressions, and wet utilities,
such as sewer mains, manholes, water mains, fire hydrants, and water and sewer
service stubbed to each lot. Another set of plans prepared by the utility companies
governed the dry utilities, such as telephone and gas. In addition, HHPI was
responsible for any improvement necessary for the issuance of a building permit or
certificate of occupancy and for landscaping, design, and construction of perimeter
and screen walls, entry monumentation, and community open space.
On the purchaser’s side, the Ladera BDA obligated KB Home to build
dwelling units subject to a development declaration and a development plan. The
BDA also annexed the property to the Summerlin South Community Association,
making KB Home also subject to the CC&Rs of that association. The
development declaration, entered at the time of closing of phase 1, contained a
number of additional restrictions on KB Home. The declaration allowed KB - 24 -
Home to construct only single-family homes in accordance with a development
plan. The declaration preserved HHPI’s control over design of homes and
landscaping by requiring that they conform to HHPI’s residential design criteria
for The Mesa Village and to the landscape standards. The design criteria
governed everything from lot grading to home finishes.
The declaration required KB Home to create a development plan. The
development plan had to describe landscaping improvements as well as building
improvements. With respect to the plans for the homes, the declaration required
KB Home to create a concept plan, with floor plans and sketches of the home
exteriors visible from the street, preliminary and final plot plans, which showed
the location of the home and other improvements on the lot, an architectural
materials sample board, which included samples of the building materials to be
used, and a marketing signage plan, which contained details on all signage.
The development plan was subject to the approval of HHPI. If HHPI or a
governmental agency disproved or rejected an item as not being in conformity
with the development plan, KB Home was obligated to correct the defect at its
own cost. In addition to requiring KB Home to construct single-family homes in a
certain manner, the Ladera BDA also required KB Home to construct sidewalks,
driveways, model homes, interior screen walls, curb scribes, and water meters. - 25 -
Pad Sale--Lyon BDA
The second purchase and sale agreement is an example of a pad sale. This
agreement was between Old THHC and William Lyon Homes, Inc. (Lyon), for the
sale of Parcel M in Village 20. As part of this agreement, THHC transferred fee
simple title to Lyon subject to a number of encumbrances, including the
Summerlin West Master Declaration, a supplemental declaration of annexation, a
development declaration, and the Summerlin West Development Agreement. The
agreement limited Lyon to constructing single-family homes.
The agreement also placed substantial restrictions on Lyon’s use of the
property. The supplemental declaration of annexation subjected Parcel M to the
CC&Rs in the Summerlin West Master Declaration and imposed its own
restrictions, such as those governing satellite dishes and signs. Similarly, the
development declaration required Lyon to submit a development plan for THHC’s
approval before it could begin any construction. The development declaration
also required improvements to conform to an architectural concept plan, a
preliminary plot plan, an architectural materials sample board, a final plot plan, a
marketing signage plan, and the Summerlin Design Standards. If any item did not
conform to the development plan or was otherwise defective, Lyon had to, at its
own cost, correct the problem. - 26 -
The agreement also required Lyon to build entry monumentation and
landscaping, a minipark, and pedestrian access ways. The parties agreed to share
costs of boundary walls between the property and adjacent parcels if the parties
thought such walls were desirable.
THHC, as part of the agreement, agreed to perform all other obligations,
except those inuring solely and specifically to the subject property or specifically
under the LVDA necessary for the purchaser’s project. THHC also agreed to
construct the roads bordering the parcel, Vista Run Drive and Trail View Lane,
and associated roads, curbs, gutters, and street lighting. The agreement further
required petitioners to construct a perimeter boundary wall along the roads
bordering the property and to stub the wet and dry utilities to the parcel.
Custom Lot Contracts
The parties provided two custom lot contracts for the sale of property in
Village 18 to individual purchasers through custom lot contracts. Each custom lot
contract involved the sale of a lot(s) in one of seven neighborhoods in Village 18,
known as The Ridges. The two representative contracts were for the sale of a lot
in the Arrowhead neighborhood and for the sale of a lot in the Redhawk
neighborhood. These contracts are representative of the other custom lot contracts
at issue in these cases. - 27 -
Each contract sold a lot described in final maps recorded with the Office of
the County Recorder of Clark County, Nevada. The contracts required the
purchaser to build a single-family home on the lot. In addition, the contracts
stated that HHPI must construct or have constructed certain improvements and the
individual lot purchaser is to be solely responsible for other lot improvements.
For instance, section 7 of the Arrowhead contract stated in part:
HHP’s Improvements. HHP has installed roads providing access to the Lot, together with underground improvements for sanitary sewer, potable water, telephone, natural gas and electric power. All such utility improvements have been stubbed out to the Lot. It shall be Purchaser’s responsibility to activate water service * * * prior to commencing construction on the Lot. Purchaser is responsible for all utility connections from the property line to Purchaser’s Home and for making all necessary arrangements with each of the public utilities for service. Purchaser acknowledges that HHP is not improving the Lot and has not agreed to improve the Lot for Purchaser except as provided in this Section 7. Purchaser will be responsible for finish grading and preparation of the building pad and acknowledges that HHP has not agreed to provide any grading of the Lot beyond its present condition.
Section 7 of the Redhawk contract was substantially similar, but it implied that
HHPI’s work was not yet completed at the time of the purchase and sale
agreement.
As part of the custom lot contract, HHPI explicitly stated that it “made no
representations or warranties concerning zoning * * * or the future development of - 28 -
phases of Arrowhead, The Ridges or the surrounding area or nearby property”. A
similar provision was in the Redhawk contract. The contracts also contained
integration clauses. Paragraph 23 of the representative contracts stated:
This Agreement constitutes the entire agreement and understanding between Purchaser and HHP with respect to the purchase of the Lot and may not be amended, changed, modified or supplemented except by an instrument in writing signed by both parties. This Agreement supersedes and revokes all prior written and oral understandings between Purchaser and HHP with respect to the Lot.
But the purchasers also initialed a page of the custom lot contracts that states:
“ALL OF THE DOCUMENTS LISTED BELOW ARE IMPORTANT TO THE
PURCHASE OF THE LOT, SHOULD BE READ BY THE PURCHASER AND,
AT THE CLOSE OF ESCROW, SHALL BE DEEMED TO HAVE BEEN READ
AND APPROVED BY PURCHASER. * * * PURCHASER HEREBY
ACKNOWLEDGES RECEIPT OF COPIES” of those listed documents. Among
the documents that purchasers acknowledged receipt of and were deemed to have
read are CC&Rs, articles of incorporation, and bylaws of the Summerlin South
Community Association, copies of the recorded subdivision map for the
neighborhood in which the lot was located, the neighborhood design criteria, and a
public offering statement.7
7 The parties did not provide copies of the attachments to the two (continued...) - 29 -
The purchasers and the purchased lots were subject to the various CC&Rs
that govern Summerlin South, Village 18, and the subassociation within Village
18, and they were contractually required to conform their lot to the relevant
architectural declaration. The architectural declaration required that all
construction on the lot be approved by HHPI. If HHPI delegated the approval
power to a review committee for The Ridges, then that committee must approve
the declaration. In addition, the CC&Rs for the Village 18 association granted
access to homeowners to their lots by way of one of two circular roadways
accessible by two guard houses and private gates, all of which were to be designed
and constructed by HHPI, including associated landscaping. These improvements
became common elements owned by the community association as did other
elements such as entry features, recreational facilities, landscaped medians, and
cul-de-sacs.
The recorded subdivision maps identified the common areas, including
private roads such as Drifting Shadow Way and Sun Glow Lane, which were
7 (...continued) representative custom lot contracts. Rather, they provided the attachments to a different custom lot contract, which involved the sale of a lot in The Azure community in Village 18. The parties have stipulated that these attachments are generally representative of the exhibits attached to a contract for the purchase and sale of a custom lot in Village 18. - 30 -
granted to the relevant community association. These maps also showed the
location of storm drain easements and flood control and drainage channel right-of-
ways. The neighborhood design criteria contained maps showing the walls and
fences HHPI had to construct. The design criteria also contained a map that
showed a community and fitness center, which the parties stipulated was available
to residents of Village 18. The public offering statements not only stated that the
private roads, guard houses, and landscaping improvements are to be owned by the
community association, but they also recited that HHPI was responsible for utility
connections to the lots and landscaping improvements in common lots.
Tax Reporting
For the years at issue, petitioners used the completed contract method of
accounting in computing gain or loss from their contracts for sale of residential
real property in Summerlin West and South intended for residential buildings
planned to contain four or fewer residential units per building.8 Petitioners
reported gain from BDAs, custom lot contracts, and the bulk sale agreements,
when they incurred 95% of the estimated costs allocable to each BDA, custom lot
contract, or bulk sale agreement.
8 For example, petitioners did not use the completed contract method of accounting to account for gain or loss from the sale of property upon which large multiunit apartment and commercial buildings were ultimately to be built. - 31 -
Petitioners broke down estimated BDA costs into three categories: direct
village costs, regional costs, and finished lot costs. Direct village costs consisted
of the cost for the common improvements that benefit only the village that was the
subject matter of the contract. These costs included the following cost categories:
planning; engineering; inspection, testing, and processing; rough grading;
water/sewer storm drain; street improvements; dry utilities; walls/fencing;
landscaping; parks; deposits; other; and contingency. Regional costs consisted of
common improvements that benefited more than one village and included the
following cost categories: regional water, regional sewer, regional drainage,
regional roads, regional traffic signals, regional entry features, regional annual
costs, regional other costs, and townwide arterial costs. Finished lot costs were
the costs that benefit only the neighborhood or parcel in which the finished lots
were located.
Petitioners used the engineering firm GCW to calculate most cost estimates.
For the actual construction cost categories, the “hard costs”, GCW used a market
price unit rate for each improvement, which was based on its experience with past
bids as well as prevailing bond rates. The unit rate generally reflected labor and
materials cost for the relevant improvement. The unit rate was applied differently
to different improvements. For instance, GCW applied the unit rate based on - 32 -
length for improvements such as curbs, sewer lines, and sidewalks, on area for
improvements such as paving and some landscaping, and on number of units of a
designated improvements such as street lights and fire hydrants. “Soft costs”, or
costs other than the actual construction costs such as engineering, inspection,
testing, and processing, were calculated as a percentage of the hard costs.
For regional water costs, GCW allocated the costs to villages according to
the percentage of village acreage in the relevant water zone. GCW assigned costs
to each water zone for water mains, pump stations, reservoirs, and inlet and outlet
pipes in the water zone. For regional sewer costs, GCW allocated the cost among
villages in proportion to their acreage. These costs included costs for the sewer
systems, including pipes and mains, paving, manholes, flowmeters, and traffic
controls. Drainage, regional roads, regional entry features, regional annual,
regional other, and townwide arterial costs were all also allocated in proportion to
village acreage. Traffic signal costs, however, were allocated to the village(s)
adjacent to the street corners (for example, one-fourth to each corner at a four-way
intersection) of the relevant signal and then prorated by acreage.
For the finished lot costs, petitioners and GCW used a formula based on
historical actual costs. This formula yielded an estimated incremental cost of
improvements of $40,000 per lot. - 33 -
Deficiencies
For the tax years at issue, petitioners reported income from the sale of land
within Summerlin using the completed contract method of accounting. Under
petitioners’ methods of accounting, each BDA, custom lot contract, and bulk sale
agreement was a home construction contract, and they were not completed within
the meaning of section 460 until petitioners incurred 95% of the direct and indirect
costs allocable to the agreement or contract.
Respondent issued notices of deficiency to both petitioners. As part of his
determinations, respondent changed petitioners’ methods of accounting from the
completed contract method of accounting to the percentage of completion method
of accounting. Respondent adjusted petitioners’ income as follows
Petitioner 2007 2008 Total THHC $209,875,725 $19,399,420 $229,275,145 HHPI 156,303,168 37,192,046 193,495,214
The total additional cumulative taxable revenue THHC would have recognized
through its 2008 tax year under the percentage of completion method of
accounting is $239,897,451. The difference between this number and the total
$229,275,145 adjustment in the notice of deficiency is due to adjustments for (1)
gain recognized in the 2003 tax year pursuant to a prior audit, (2) overreported - 34 -
gain for nonexempt development activities, and (3) underreported gain for
nonexempt development activities.
The total additional cumulative taxable revenue HHPI would have
recognized through the 2008 tax year under the percentage of completion method
of accounting is $231,791,739. The difference between this number and the total
$193,495,214 adjustment in the notice of deficiency is due to (1) gain recognized
in the 2003 tax year pursuant to a prior audit, (2) overreported gain for nonexempt
development activities, and (3) overreported gain for exempt development
activities.
Respondent’s adjustments resulted in his determination of the following
deficiencies:
Petitioner 2007 2008 THHC $73,456,504 $6,789,797 HHPI 50,633,554 13,228,620
Petitioners timely petitioned this Court for redetermination, and a trial was held in
Las Vegas, Nevada. - 35 -
OPINION
I. Burden of Proof
Generally, the Commissioner’s determination of a taxpayer’s liability for an
income tax deficiency is presumed correct, and the taxpayer bears the burden of
proving that the determination is improper. See Rule 142(a); Welch v. Helvering,
290 U.S. 111, 115 (1933). If a taxpayer’s method of accounting does not clearly
reflect income, section 446(b) allows the Commissioner to change the taxpayer’s
method of accounting to one that does clearly reflect income. The Commissioner
is granted broad discretion in determining whether an accounting method clearly
reflects income, and that determination is entitled to more than the usual
presumption of correctness. Commissioner v. Hansen, 360 U.S. 446, 467 (1959);
RECO Indus., Inc. v. Commissioner, 83 T.C. 912, 920 (1984). The question of
whether a particular accounting method clearly reflects income is a question of
fact. Sam W. Emerson Co. v. Commissioner, 37 T.C. 1063, 1067 (1962).
To prevail, the taxpayer must establish that the Commissioner abused his
discretion in changing the method of accounting. Prabel v. Commissioner, 91 T.C.
1101, 1112 (1988), aff’d, 882 F.2d 820 (3d Cir. 1989). But the Commissioner
may not change a taxpayer’s method of accounting from an incorrect method to
another incorrect method. Id. Nor may the Commissioner change a taxpayer’s - 36 -
method of accounting “[w]here a taxpayer’s method of accounting is clearly an
acceptable method” and clearly reflects income. Id.
II. Custom Lot Contracts and Bulk Sale Agreements as Long-Term Contracts
First, we must determine whether petitioners’ contracts are long-term
contracts. The parties stipulated that the BDAs are long-term construction
contracts. The notices of deficiency determined deficiencies as if all of
petitioners’ contracts were long-term contracts. On brief respondent has departed
from that determination and contends that the custom lot contracts and the bulk
sale agreements are not long-term contracts. Generally, the Court will not allow a
party to raise an issue on brief if consideration of that issue would surprise and
prejudice the opposing party. Chapman Glen Ltd. v. Commissioner, 140 T.C. 294,
349 (2013). Because we do not think that petitioners need additional evidence to
respond to the new issue and respondent has not carried the issue, we address it
below. See id. (looking to “the degree to which the opposing party is surprised by
the new issue and the opposing party’s need for additional evidence to respond to
the new issue” to determine prejudice). As to new issues, respondent bears the
burden of proof. See Rule 142(a)(1). - 37 -
A. Custom Lot Contracts
Respondent alleges that none of petitioners’ custom lot contracts qualify
even for accounting under the percentage of completion method because they are
not long-term contracts. Initially, respondent contends that many of the contracts
were entered into and closed within the same tax year and they therefore cannot be
considered long term within the meaning of section 460. Second, respondent
contends that because petitioners did not have a legal obligation to perform the
construction activities contemplated by the contracts, the contracts are not
construction contracts. Petitioners, on the other hand, first assert that the contracts
are complete, for the purposes of section 460, when they incur at least 95% of the
total allocable contract costs attributable to the contract’s subject matter. They
also contend that their contracts are construction contracts that impose legal
obligations upon them.
A long-term contract is “any contract for the manufacture, building,
installation, or construction of property if such contract is not completed within
the taxable year in which such contract is entered into.” Sec. 460(f)(1). The
relevant regulation provides that the date a contract is completed is the earlier of
(A) Use of the subject matter of the contract by the customer for its intended purpose (other than for testing) and at least 95 percent - 38 -
of the total allocable contract costs attributable to the subject matter have been incurred by the taxpayer; or
(B) Final completion and acceptance of the subject matter of the contract.
Sec. 1.460-1(c)(3)(i), Income Tax Regs. But taxpayers determine the contract
completion date “without regard to whether one or more secondary items have
been used or finally completed and accepted.” Sec. 1.460-1(c)(3)(ii), Income Tax
Regs. In addition, the regulation directs taxpayers to “consider all relevant facts
and circumstances” in determining whether final completion and acceptance has
occurred. Sec. 1.460-1(c)(3)(iv), Income Tax Regs.
If the subject matter of the custom lot contracts is solely the sale of the piece
of land, then petitioners’ custom lot contracts would be complete upon close of
escrow. The custom lot contracts do indeed provide for the sale of a piece of land,
but they also reference numerous other documents, including CC&Rs,
development plans, and subdivision maps. Under Nevada law, “‘[w]ritings which
are made a part of the contract by annexation or reference will be so construed; but
where the reference to another writing is made for a particular and specified
purpose, such other writing becomes a part for such specified purpose only.’”
Lincoln Welding Works, Inc. v. Ramirez, 647 P.2d 381, 383 (Nev. 1982) (quoting
Orleans M. Co. v. Le Champ M. Co., 284 P. 307 (Nev. 1930)). However, if the - 39 -
reference “indicates an intention to incorporate * * * [the documents] generally,
such reference becomes a part of the contract for all purposes.” Id.
The custom lot contracts contain a page whereon the purchaser(s)
acknowledge receipt of copies of numerous documents, which are listed on the
page.9 We believe that this sentence incorporates the documents listed, and,
because there is no indication that the reference is for a specific purpose, we
incorporate these documents generally.
After reviewing the custom lot contracts, the documents referenced therein,
and the testimony regarding Summerlin as a master-planned community marketed
as such by petitioners, we are convinced that the subject matter of the contracts
encompasses more than just the sale of the lot. The costs incurred for a custom lot
contract are not really different from the costs for the finished lot sales. At the
time of trial, petitioners still had to complete a water service line, traffic signals,
landscaping, and construction of a park. Therefore, we agree that final completion
and acceptance does not necessarily occur at the close of escrow, but rather occurs
when final completion and acceptance of the subject matter of the contracts, which
9 As previously noted, the page reads in part: “ALL OF THE DOCUMENTS LISTED BELOW ARE IMPORTANT TO THE PURCHASE OF THE LOT, SHOULD BE READ BY THE PURCHASER AND, AT THE CLOSE OF ESCROW, SHALL BE DEEMED TO HAVE BEEN READ AND APPROVED BY PURCHASER.” - 40 -
includes improvements whose costs are allocable to the custom lot contracts,
occurs. Cf. Shea Homes, Inc. & Subs. v. Commissioner, 142 T.C. ___, ___ (slip
op. at 73) (Feb. 12, 2014). Consequently, petitioners are entitled to account for the
gain or loss from these contracts on the appropriate long-term method of
accounting under section 460 to the extent the contracts are not completed within
the taxable year in which they are entered into.
In so holding, we reject respondent’s contention that the contracts impose
upon petitioners no separate legal obligation to complete the required
improvements. The regulations provide that a contract is a long-term contract
under section 460 “if the manufacture, building, installation, or construction of
property is necessary for the taxpayer’s contractual obligations to be fulfilled and
if the manufacture, building, installation, or construction of that property has not
been completed when the parties enter into the contract” and the contract is not
completed within the contracting year. Sec. 1.460-1(b)(1), (2)(i), Income Tax
Regs.; see also Foothill Ranch Co. P’ship v. Commissioner, 110 T.C. 94, 98-99
(1998).
For contracts that provide for the provision of land, the regulations also
contain a de minimis rule, under which if the allocable costs attributable to
construction activities do not exceed 10% of the total contract price, the contract is - 41 -
not a construction contract under section 460. Sec. 1.460-1(b)(2)(ii), Income Tax
Regs. To calculate the allocable costs, the regulation allows a taxpayer to “include
a proportionate share of the estimated cost of any common improvement that
benefits the subject matter of the contract if the taxpayer is contractually obligated,
or required by law, to construct the common improvement.” Id. Petitioners’
allocable costs attributable to construction activities exceed the 10% threshold.
Respondent appears to read this regulation as requiring a taxpayer to have a legal
obligation independent of any other preexisting duty.
While we agree with respondent that work completed by petitioners at the
time the contracts are entered into cannot transform a contract into a construction
contract under section 460, we disagree that the statute and the regulations
necessarily require that all construction activity obligations be solely enforceable
because of the contract. Respondent believes that section 1.460-1(b)(2)(i), Income
Tax Regs., codifies the common law preexisting duty doctrine. Therefore, he says
that because petitioners are already obligated by statute to complete various
improvements, the obligations are not contractual obligations.
The preexisting duty rule states that “a promise to do that which the
promisor is already legally obligated to do is unenforceable.” Johnson v. Seacor
Marine Corp., 404 F.3d 871, 875 (5th Cir. 2005). Nevada follows the preexisting - 42 -
duty rule. Cnty. of Clark v. Bonanza No. 1, 615 P.2d 939, 944 (Nev. 1980). The
Nevada Common-Interest Ownership Act requires sellers, such as petitioners, to
complete all improvements depicted on any site plan or similar documents except
those labeled “NEED NOT BE BUILT”, Nev. Rev. Stat. sec. 116.4119(1) (1991),
and provides purchasers with a cause of action, id. sec. 116.4117 (1997).10
It is not clear that the preexisting duty rule applies in these cases. The
contracts between petitioners and the purchasers are valid contracts with valid
consideration independent of the duties with respect to the development. Second,
while the Nevada statute does indeed seem to grant purchasers a cause of action if
petitioners fail to construct improvements as shown on site plans or plats, the
statute explicitly provides: “The civil remedy provided by this section is in
addition to, and not exclusive of, any other available remedy or penalty.” Id. sec.
116.4117(5). Therefore, it is uncertain whether a Nevada court would apply the
preexisting duty rule to petitioners’ contracts. See Johnson, 404 F.3d at 875
(“[A]s long as the contracting parties gain some legally enforceable right as a
result of the contract which they previously did not have, consideration is
10 We note that Nev. Rev. Stat. sec. 116.4117 (1997) has been amended numerous times since it was enacted in 1991. We refer to the statute as amended and in effect for the years in which the contracts were entered into. - 43 -
present[.]”). The public policy concerns that underpin the pre-existing duty rule
do not seem to be present here.11
In addition, we do not agree with respondent that section 1.460-1(b)(2),
Income Tax Regs., codifies the preexisting duty rule. The regulation clearly states
that “how the parties characterize their agreement (e.g., as a contract for the sale of
property) is not relevant” in determining the existence of a section 460
construction contract. Sec. 1.460-1(b)(2)(i), Income Tax Regs.; see also Koch
Indus., Inc. & Subs. v. United States, 603 F.3d 816, 822 (10th Cir. 2010) (citing
the regulation). As to the allocable costs attributable to common improvements in
the de minimis rule, the regulation does not require that the obligation be solely
contractual. Sec. 1.460-1(b)(2)(ii), Income Tax Regs. Rather, the regulation
allows a taxpayer to include the allocable costs “if the taxpayer is contractually
obligated, or required by law, to construct the common improvement.” Id.
Nothing in the regulation requires that the contract be the sole source of the
obligation, and, in fact, it indicates the opposite--that the obligation may be
noncontractual.
11 In fact, the Nevada Common-Interest Ownership Act appears to enable parties other than those in contractual privity with the developer to have standing to institute a lawsuit. See Nev. Rev. Stat. sec. 116.4117(2) (allowing suit to be brought by a unit’s owner, not just the original purchaser of the land from the developer). - 44 -
B. Bulk Sale Contracts
Respondent similarly contends that the bulk sale contracts do not qualify as
long-term construction contracts under section 460. Specifically, respondent
alleges that petitioners have not established that they were obligated to construct
anything under these contracts. Respondent bases this position on his belief that
the terms of the bulk sale contracts are unknown and that petitioners failed to carry
their burden of proving that the contracts are entitled to a long-term contract
method of accounting.
We disagree that the bulk sale contracts are substantially different from the
pad sale BDAs. The parties stipulated that the pad sale BDAs are construction
contracts. The bulk sale agreements are merely pad sale BDAs on a larger scale.
The record supports this conclusion. We heard credible testimony from the vice
president of finance for petitioners that the bulk sale contracts were BDAs and that
petitioners were obligated to build the same types of common improvements that
benefited the property sold, such as regional water lines, traffic signals, and
detention basins. Thus, we hold that these contracts too are construction contracts
that may be accounted for under section 460 as long-term contracts to the extent
consistent with this Opinion. - 45 -
III. Completed Contract Method of Accounting
Because the Court has concluded that all of petitioners’ contracts are long-
term construction contracts, we turn to the question of whether the contracts are
home construction contracts. Section 460(a) provides generally that taxpayers
must determine taxable income from long-term contracts under the percentage of
completion method of accounting. Under this method of accounting, taxpayers
generally recognize gain or loss throughout the duration of the contract. See sec.
1.460-4(b), Income Tax Regs. (rules concerning percentage of completion
method). But in some instances taxpayers may account for income from certain
construction contracts under other methods of accounting such as the completed
contract method. Sec. 460(e).
This section provides an exception to the percentage of completion method
of accounting for home construction contracts and an exception for other
construction contracts where the taxpayers complete the contract within 24 months
and meet a gross receipts test. Sec. 460(e)(1)(A) and (B). The parties have
stipulated that most of petitioners’ contracts are construction contracts as defined
in section 460(e)(4). Petitioners do not contend that they qualify for the second
exception, so the question before us is whether petitioners’ contracts qualify as
home construction contracts. - 46 -
Deferral of income tax, like exemptions and deductions, is a matter of
legislative grace, and exceptions to the normal income recognition rules must be
strictly construed. See, e.g., Bingler v. Johnson, 394 U.S. 741, 752 (1969)
(“[E]xemptions from taxation are to be construed narrowly[.]”); Estate of Bell v.
Commissioner, 928 F.2d 901, 903 (9th Cir. 1991) (“The deferral [of estate tax
payment] benefits of section 6166 are a ‘matter of legislative grace’ that is similar
to the benefits conferred by other statutory provisions dealing with deductions,
exemptions and exclusions from tax. Thus, a strict and narrow construction
should be applied to the deferral benefit provisions[.]”), aff’g 92 T.C. 714 (1989).
The parties disagree over whether contracts such as petitioners’, where the
seller does not build the house or any improvements on the lot, qualify as home
construction contracts. Section 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 - 47 -
(ii) improvements to real property directly related to such dwelling units and located on the site of such dwelling units.
For purposes of clause (i), each townhouse or rowhouse shall be treated as a separate building.
We refer to this definition as the 80% test. Paragraph (4) referred to by
section 460(e)(6)(A) provides: “For purposes of this subsection, the term
‘construction contract’ means any contract for the building, construction,
reconstruction, or rehabilitation of, or the installation of any integral component
to, or improvements of, real property.” Sec. 460(e)(4). The statute defines
dwelling unit by cross-reference as “a house or apartment used to provide living
accommodations in a building or structure, but does not include a unit in a hotel,
motel, or other establishment more than one-half of the units in which are used on
a transient basis”. Sec. 168(e)(2)(A)(ii).12 The parties do not dispute that pursuant
12 The relevant regulation largely follows the statute. It defines home construction contracts as follows:
(i) In general.--A long-term construction contract is a home construction contract if a taxpayer (including a subcontractor working for a general contractor) reasonably expects to attribute 80 percent or more of the estimated total allocable contract costs (including the cost of land, materials, and services), determined as of the close of the contracting year, to the construction of--
(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I), (continued...) - 48 -
to the contracts, agreements, and government development rules, the structures to
be ultimately built upon the land petitioners sell in the contracts at issue are
dwelling units.
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. The bulk sale agreement for Village 26
is especially troubling as no construction had yet occurred years later and, because
the purchaser-builder defaulted on the contract, THHC still owned half of the
12 (...continued) contained in buildings containing 4 or fewer dwelling units (including buildings with 4 or fewer dwelling units that also have commercial units); and
(B) Improvements to real property directly related to, and located at the site of, the dwelling units.
(ii) Townhouses and rowhouses.--Each townhouse or rowhouse is a separate building.
(iii) Common improvements.--A taxpayer includes 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.
Sec. 1.460-3(b)(2), Income Tax Regs. - 49 -
village. As far as we know, no qualifying dwelling units will ever be built on
these lands,13 and deferral of income from contracts that might not ever result in
qualifying dwelling units seem entirely inappropriate under these circumstances.
Cf. Shea Homes, Inc. & Subs. v. Commissioner, 142 T.C. at ___ (slip op. at 75-76)
(permitting deferral of income from contracts where the completed qualifying
dwelling units were, themselves, included in the property being sold and giving
rise to the asserted taxable income). Petitioners close the contracts and receive
revenue without needing to build a single home. 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. Id. at ___
13 We note that in a case of an insolvent builder, a bankruptcy court may direct the trustee of the bankruptcy estate to petition the local government for rezoning. See In re Lloyd, 37 F.3d 271, 274 (7th Cir. 1994) (affirming the bankruptcy court’s direction to the trustee to seek to rezone property from agricultural to residential to allow the debtor a homestead exemption). We also note that the Summerlin West and the Summerlin South development agreements with Las Vegas and Clark County have been amended from time to time by the parties. Thus, contractual promises or obligations of third parties alone are, at least in this factual context, insufficient to ensure that qualifying dwelling units will in fact be constructed on the sold land. When it comes to yet-to-be completed common improvements, presumably bonds are posted, whereas the purchasers of the land do not post or purchase bonds promising construction of homes. We cannot therefore conclude that governmental zoning and entitlement agreements and land sale contracts alone are enough to meet petitioners’ evidentiary burden of establishing that the qualifying dwelling units requirement of sec. 460(e)(6)(A) is or will be met. - 50 -
(slip op. at 33). Petitioners are under no contractual obligation to build homes as
their contracts are merely for the sale of land, developed to varying degrees, to
builders or individual customers who may eventually build homes on that land.
In respondent’s mind, the definitions foreclose petitioners from using the
completed contract method of accounting. Only the section 460(e)(4) costs
directly associated with building the actual house or improvements thereto qualify
for purposes of meeting the 80% test. Petitioners assert that construction activity
costs count in meeting the 80% test even though they do not build the four walls
or roof of a dwelling unit. Under their interpretation, the “allocable costs” include
the costs of required infrastructure and common improvements attributable to the
dwelling units. Even if true, this point, without more, would not be determinative
of their right to use section 460(e).
The starting point for interpreting a statute or a regulation is its plain and
ordinary meaning unless such an interpretation “would produce absurd or
unreasonable results”. Union Carbide Corp. v. Commissioner, 110 T.C. 375, 384
(1998). Undefined words take their “ordinary, contemporary, common meaning”.
Hewlett-Packard Co. & Consol. Subs. v. Commissioner, 139 T.C. 255, 264 (2012). - 51 -
A. Costs Attributable to Dwelling Units
Section 460(e)(6) defines a home construction contract, as of the end of the
taxable year when the contract was entered into, by reference to the estimated total
contract costs attributable to construction activity “with respect to” (i) dwelling
units and (ii) improvements to real property directly related to the units and
located on the site of the dwelling units. The regulations clarify that the allocable
contract costs to be included in the 80% test must be attributable to the
construction of the units and the improvements thereto. Sec. 1.460-3(b)(2)(i),
Income Tax Regs.14
What does the statute mean when it says “attributable to” construction
activities “with respect to” dwelling units and improvements directly related to
real property? Sec. 460(e)(6)(A). Respondent asserts that only costs incurred in
the actual construction of the dwelling units or their related real property
improvements count. Respondent contends that the home construction contract
14 Petitioners do not challenge the regulations, and accordingly we give them their due deference. See sec. 460(h); Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. __, __, 131 S. Ct. 704, 713 (2011) (applying to regulations the test announced in Chevron, U.S.A. Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 842-843 (1984)); cf. Shea Homes, Inc. & Subs. v. Commissioner, 142 T.C. ___, ___ (slip op. at 64 n.18) (Feb. 12, 2014). - 52 -
exception requires the taxpayer to build dwelling units or to build improvements
to real property directly related to and located on the site of such dwelling units.
Petitioners claim the statute contemplates a broader definition of home
construction costs. Under their interpretation, they believe that their costs benefit
dwelling units and real property improvements related to and located on the site of
such dwelling units. Because the costs benefit dwelling units, petitioners contend
that the costs are therefore attributable to the dwelling units and that these costs
should count towards meeting the 80% test. Under petitioners’ view, because all
of their development costs are attributable to construction activity with respect to
dwelling units and real property improvements related to and located on the site of
those dwelling units, section 460(e) is applicable even though they do not
construct the dwelling units.
Petitioners assert that because the costs are allocable to the contracts and
because the costs benefit the property sold to the homebuilders and ultimately to
individual buyers, the costs are attributable to construction activities with respect
to the dwelling units or real property improvements. This conclusion follows,
according to petitioners, because the statute does not confine the availability of the
completed contract method of accounting to those taxpayers who build the - 53 -
dwelling units’ “sticks and bricks” and/or real property improvements related to
and located on the dwelling units’ lots.
Petitioners’ interpretation of the statute would make any construction cost
tangentially related to a dwelling unit or real property improvement related to and
located on the site of the dwelling unit a cost to be counted in determining whether
a contract is a home construction contract. Without petitioners’ development
work, the pads and lots would be mere patches of land in a desert. Petitioners’
work may indeed be necessary for the ultimate home to feasibly be built and
occupied.
But these correlations do not mean that those costs are necessarily incurred
“with respect to” qualifying dwelling units. “With respect to” implies a stronger
proximate causation than petitioners’ interpretation permits. The prepositional
phrase “with respect to” can mean “as regards: insofar as concerns: with reference
to”. Webster’s Third New International Dictionary 1934 (2002). So the
construction activities that count towards meeting the 80% test are defined by
reference to the dwelling unit. The phrase does not imply a correlation as loose as
proposed by petitioners, nor does it encompass real property improvement
activities that are merely related to land which at some indeterminate future time
may perhaps become the site of a qualified dwelling unit(s). Consequently, - 54 -
petitioners have failed to establish that such construction costs are incurred with
respect to qualifying dwelling units.
At most the statute is ambiguous, and we look to section 1.460-3(b)(2)(i),
Income Tax Regs., which clarifies the statute. “Attribute” as used in the
regulation means “to explain as caused or brought about by: regard as occurring in
consequence of or on account of”. Webster’s Third New International Dictionary
142. The word implies causation, and as used in the regulation, the plain meaning
of “attribute to” is “caused by”.15 None of these costs, in our view, are attributable
to the construction of the dwelling units, because petitioners do not intend to build
such units and neither the units nor the real property improvements related to and
located on the site of the dwelling units have yet been built. The regulation is
reasonable, and we conclude it forecloses petitioners’ interpretation. See Chevron
U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 842-843 (1984).
Congress added the exception for home construction contracts in 1988.
Technical and Miscellaneous Revenue Act of 1988 (TAMRA), Pub. L. No. 100-
647, sec. 5041, 102 Stat. at 3673. Senator Dennis DeConcini and Representative
Richard T. Schulze were concerned that homebuilders would have to recognize
15 Cf. Lawinger v. Commissioner, 103 T.C. 428, 435 (1994) (discussing the definition of “attributable to” in the context of sec. 117(m) of the Internal Revenue Code of 1954 and sec. 108(g)(2)(B) of the Internal Revenue Code of 1986). - 55 -
income not yet received and that costs would no longer match revenues. 134
Cong. Rec. 20722-20723 (Aug. 5, 1988) (Sen. DeConcini); 134 Cong. Rec.
29962-29963 (Oct. 12, 1988) (Sen. DeConcini); 134 Cong. Rec. 20202 (Aug. 3,
1988) (Rep. Schulze). While the conference report is ultimately silent as to why
the exception was added in its final form, it is clear that the intended beneficiaries
of this relief measure were taxpayers involved in “the building, construction,
reconstruction, or rehabilitation of” a home and not land developers who do not
build homes, even if essential development work paves the way for, and thus
facilitates, home construction. TAMRA sec. 5041.16
That Congress changed the wording of section 460(e)(4) from “reasonably
expected to be attributable to the building, construction, reconstruction, or
rehabilitation of” to “reasonably expected to be attributable to activities referred to
in paragraph (4)” only confirms our view. Omnibus Budget and Reconciliation
16 The Congressional Record reveals that Chairman Rostenkowski of the House Ways and Means Committee, when moving to suspend the rules so that the House could adopt the Conference Committee Report on H.R. 4333, stated that the conference report exempted “single family homebuilders from the provision” that restricted the completed contract method of accounting. 134 Cong. Rec. 33112 (Oct. 21, 1988). Likewise, Representative Archer, the ranking House Conference Committee member, stated in support of the conference report: “I was particularly pleased that we changed the ‘completed contract method of accounting’ provisions under current law to exempt single family residential construction--thereby reducing the cost of homes.” Id. - 56 -
Act of 1989, Pub. L. No. 101-239, sec. 7815(e)(1)(A) and (B), 103 Stat. at 2419.
This change added “the installation of any integral component to, or improvements
of, real property” to the list of construction activity. Id. The purpose of this
change was to ensure that costs incurred in installing integral components such as
heating or air conditioning systems were qualifying costs. H.R. Rept. No. 101-
247, at 1411 (1989), 1989 U.S.C.C.A.N. 1906, 2881; Staff of J. Comm. on
Taxation, Description of Technical Corrections Proposed to the Technical and
Miscellaneous Revenue Act of 1988, The Revenue Act of 1987, and Certain Other
Pension-Related Tax Legislation 4 (J. Comm. Print 1989).17 Congress intended to
extend this relief provision only to taxpayers who have some direct dwelling
construction costs, as defined in section 460(e)(4).
In summary, the terms “with respect to”, sec. 460(e)(6)(A), or “attribute
* * * to”, sec. 1.460-3(b)(2)(i), Income Tax Regs., do not qualify contracts as
home construction contracts when petitioners do not construct the home, prove
that a qualifying dwelling unit was built, or, in the case of pad and bulk sales, even
develop the immediate neighborhood. We do not agree with petitioners’ assertion
that the term “dwelling units” encompasses more than the home. Petitioners urge
17 We cite the Joint Committee on Taxation’s report for its persuasive merit. See United States v. Woods, 571 U.S. ___, ___, 134 S. Ct. 557, 568 (2013). - 57 -
us not to confine “dwelling unit” to the structure built on the lot and would instead
have that term encompass all the relevant infrastructure that makes the unit
suitable for habitation. The regulations clarify this point by providing a separate
relief provision for such common improvements. Sec. 1.460-3(b)(2)(B)(iii),
Income Tax Regs. We recognize the potential tension with our Opinion in Shea
Homes, Inc. & Subs., and we address such concerns infra.
B. Section 406(e)(6)(A)(ii) Real Property Improvements
We disagree with petitioners that the statute allows their construction
activity costs to qualify because they are related to and located on the site of the
dwelling units. “Site”, according to petitioners, means Summerlin, not the
individual lot on which a house is later built. Petitioners reason that because the
statute uses the plural of dwelling unit--“on the site of such dwelling units”--but
does not use the plural of “site”, then the statute necessarily envisions a
development, like Summerlin, containing multiple dwelling units and requires that
a site be more than the lot upon which the dwelling unit is built. Be that as it may,
this argument is not controlling here because it ignores the fact that the statute
allows a construction contract for a building with four or fewer dwelling units to
still be considered a home construction contract. Sec. 460(e)(6)(A)(i). Such a - 58 -
building would necessarily consist of dwelling units (plural), but would sit on a
single site.
Petitioners read the preposition “on” in the phrase “on the site” to connote
proximity. Indeed, “on” can be used to indicate contiguity. Webster’s Third New
International Dictionary 1574 (“location closely adjoining something”). But “on”
is also used “to indicate position over and in contact with that which supports from
beneath”. Id. By using the phrase “at the site” in the regulations, respondent did
not necessarily interpret “on” to indicate proximity rather than the narrower usage.
While “at” can be used “to indicate presence in, on, or near”, id. at 136, we do not
think that in choosing the word “at”, as opposed to a phrase like “on or nearby”,
the regulation intended to interpret “on the site” broadly.
Even if we were to view the statute as ambiguous in its use of “on the site
of”, the Secretary has resolved any ambiguity through regulatory gap-filling. And
we are required to defer to an agency’s permissible interpretation of an ambiguous
statute. Chevron U.S.A., Inc., 467 U.S. at 842-843.
The Secretary believed that the statutory phrase might prevent taxpayers
from counting the costs of common improvements towards the 80% test, and as a
result many large homebuilders might be unable to qualify for the completed
contract method of accounting for home construction contracts. He rightly - 59 -
ameliorated this problem by adopting section 1.460-3(b)(2)(B)(iii), Income Tax
Regs., which allows taxpayers to count such costs as part of the cost of building
dwelling units for the purposes of the 80% test. The regulation reflects a
permissible--inescapable in our minds--construction of the statute, and we defer to
that construction. See id.18
The costs petitioners incur are, if anything, common improvement costs as
defined in section 1.460-3(b)(2)(iii), Income Tax Regs. The regulations make
clear that taxpayers may include the allocable share of these common
improvement costs in the cost of the dwelling units. Id. But we agree with
respondent that the taxpayer must at some point incur some construction cost with
18 In addition, the legislative history supports our interpretation of “site” as limited to the site of the home. The conference committee report states:
[A] contract is a home construction contract if 80 percent or more of the estimated total costs to be incurred under the contract are reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of, or improvements to real property directly related to and located on the site of, dwelling units in a building with four or fewer dwelling units. * * * [Emphasis added.]
H.R. Conf. Rept. No. 100-1104 (Vol. II), at 118 (1988), 1988-3 C.B. 473, 608. This sentence clearly shows that Congress used “dwelling units” in the plural as opposed to the singular in sec. 460(e)(6)(A)(ii) because a construction contract for a building with four or fewer dwelling units could qualify as a home construction contract. Congress did not intend the plural to expand the definition of “site” from the geographic limitations of the immediate lot to the geographic boundaries, and even beyond, of the whole development. - 60 -
respect to the dwelling unit to include these costs in the dwelling unit cost. We do
not believe that section 1.460-3(b)(2)(i) and (iii), Income Tax Regs., allows a
taxpayer with zero direct construction costs with respect to dwelling units to
simply add common improvement costs for the purposes of the 80% test. Rather,
the regulation states that the taxpayer may “include” such costs. Sec. 1.460-
3(b)(2)(iii), Income Tax Regs. The regulation allows the taxpayer to include only
the share of the common improvement costs allocable to the dwelling unit. Id. If
the taxpayer does not construct or intend to construct qualified dwelling units,
there is no allocable share of common improvement costs.
Petitioners have no dwelling unit costs in which to include the common
improvement costs. The costs petitioners incur are not the actual homes’
structural, physical construction costs. Nor are they costs for improvements
“located on” or “located at” the site of the homes. Therefore, petitioners may not
include these costs in testing whether 80% of their allocable contract costs are
attributable to the dwelling units and real property improvements directly related
to and located on the site of the yet to be constructed dwelling units.
After reviewing the plain and ordinary meaning of the statute and the
regulation, we conclude that petitioners’ contracts and agreements do not qualify - 61 -
as home construction contracts.19 Recently, we held that availability to
homebuilders of the completed contract method of accounting is “generously
broad and reflects a deliberate choice by Congress that home construction
19 We also do not think that respondent’s current position is inconsistent with the Internal Revenue Service (IRS) material petitioners cite. For instance, the IRS Non-Docketed Service Advice Review they referenced does not say that a home construction contract need not involve the building of a home. 2003 IRS Non- Docketed Service Advice Review 20006 (Jan. 18, 2003). Rather this document states that the activities enumerated by sec. 460(e)(4) encompass more than just building a house, such as rehabilitating a home or installing integral components. Id. As mentioned supra, when Congress changed sec. 460(e)(6) to reference para. (4), thereby including “the installation of any integral component to, or improvement of, real property” in the qualifying costs of sec. 460(e)(6), it intended to allow taxpayers who build components such as air conditioning and heating systems to potentially qualify their construction contracts as home construction contracts. Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101-239, sec. 7815(e)(1)(A), 103 Stat. at 2419; H.R. Rept. No. 101-247, at 1411 (1989), 1989 U.S.C.C.A.N. 1906, 2881. For an explication of the IRS’ current position, see Tech. Adv. Mem. 200552012 (Dec. 30, 2005), indicating that the IRS believes the home construction exception is only available to the party who actually builds or produces a dwelling unit. Consequently, a land developer who did not build any dwelling unit(s) could not qualify.
We recognize that the proposed regulations, which would redesignate sec. 1.460-3(b)(2)(iii), Income Tax Regs., as sec. 1.460-3(b)(2)(iv), if adopted, would expand the scope of the qualifying costs. Proposed Income Tax Regs., 73 Fed. Reg. 45182 (Aug. 4, 2008). These regulations would modify the definition of “improvements to real property directly related to, and located on the site of, the dwelling units” by including costs of common improvements within that definition even if the contract does not provide for the construction of any dwelling unit(s). Id. Not only does the preamble to the proposed regulations explicitly caution taxpayers not to rely on these regulations, id. at 45181, but by negative inference they add credence to our view that petitioners’ position is unsupported by the wording of the current statute and regulation. - 62 -
contracts should be treated differently”, but only as to homebuilders. Shea Homes,
Inc. & Subs. v. Commissioner, 142 T.C. at ___ (slip op. at 78-79). As for other
construction contracts, “[t]he completed contract method of accounting is a narrow
exception to the legislated rule that most long-term contracts must now be
accounted for under the percentage of completion method of accounting”, which
should be strictly construed. Id. at ___, slip op. at 78. Petitioners were not
homebuilders, and their contracts were not home construction contracts.
Petitioners cannot account for gain or loss from these contracts using the
completed contract method of accounting.
C. Shea Homes
In Shea Homes, we held that the subject matter of the home construction
contracts of the taxpayers, developers who both developed land and built homes,
included the home, the lot on which the home sat, and the common improvements
and amenities. Therefore, we held that in testing contract completion, the
taxpayers were entitled to apply the use and 95% completion test by using the
contract costs, after including the allocable share of the costs of the common
improvements and amenities of the development or development phase which
included the dwelling unit(s). - 63 -
In reaching this conclusion, we looked in part at the definition of home
construction contract to inform our understanding of the regulation’s use of
“subject matter” of the contract. We concluded that section 460(e)(6)(A) defined a
home construction contract, and that “the regulations expand this definition to
allow taxpayers to include ‘the allocable share of the cost that the taxpayer
reasonably expects to incur for any common improvement.’” Shea Homes, Inc. &
Subs. v. Commissioner, 142 T.C. at ___ (slip op. at 70) (quoting section 1.460-
3(b)(2)(iii), Income Tax Regs.). We believed that the fact that the regulations
expanded the universe of costs to be considered when deciding whether a contract
qualified as a home construction contract was “at minimum instructive” when
deciding when that contract is subsequently completed.
But at no point in Shea Homes did we say that a home construction contract
could consist solely of common improvement costs. The starting point in Shea
Homes was that the taxpayers’ contracts were for the construction of qualifying
dwelling units. Those taxpayers developed land and built homes, and so when
testing whether their contracts were home construction contracts, they were
permitted by the regulations to add to the costs of the dwelling units they
constructed their common improvement costs. And, when testing the contract - 64 -
completion date, they looked to when they incurred 95% of the costs of the subject
matter of the contract.
Our Opinion today draws a bright line. 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. It
is not enough for the taxpayer to merely pave the road leading to the home, though
that may be necessary to the ultimate sale and use of a home. If we allow
taxpayers who have construction costs that merely benefit a home that may or may
not be built, to use the completed contract method of accounting, then there is no
telling how attenuated the costs may be and how long deferral of income may last.
We cautioned in a footnote in Shea Homes, Inc. & Subs. v. Commissioner, 142
T.C. at ___ n.24 (slip op. at 82), that there is a temporal component to the home
construction contract exception and contract completion.20 We think it consistent
20 The regulations caution that “taxpayers may not delay the completion of a contract for the principal purpose of deferring federal income tax.” Sec. 1.460- 1(c)(3)(iv)(A), Income Tax Regs. In these cases, petitioners would often build infrastructure as needed. For instance, the costs of a road or a water line that is anticipated to benefit a village may upon request, see supra p. 16, not be incurred for many years. This may lead to a situation where the contract completion date could be substantially delayed. We do not suggest that developers intentionally build ghost towns by building out infrastructure in excess of demand, but we (continued...) - 65 -
with congressional intent that a line should be drawn here so as to exclude
petitioners’ contracts, when we cannot conclude that qualifying dwelling units will
ever be built.
Of course, the contract does not necessarily have to be for the actual sale of
a home. The regulations make clear that a subcontractor’s contract may qualify as
a home construction contract. For instance, a subcontractor who does the
electrical work inside the home may have a home construction contract.
Petitioners attempt to characterize their relationship with the homebuilders as a
general contract or subcontractor relationship. In an interesting and innovative
twist, petitioners try to characterize themselves as the subcontractor in the
relationship, as if the builders are subcontracting out all of this infrastructure and
extra-home development work to petitioners. But this is not the relationship the
parties have chosen. See Commissioner v. Nat’l Alfalfa Dehydrating & Milling
Co., 417 U.S. 134, 149 (1974) (“[W]hile a taxpayer is free to organize his affairs
as he so chooses, nevertheless, once having done so, he must accept the tax
20 (...continued) suggest that such costs would not necessarily be a proper part of a home construction contract. This is especially important for contracts qualifying for the completed contract method of accounting where such a delay coupled with just-in- time, as-needed improvements construction indeterminately defer recognition of income. - 66 -
consequences of his choice, whether contemplated or not, and may not enjoy the
benefit of some other route he might have chosen to follow but did not.” (Citations
omitted.)).
IV. Conclusion
Petitioners’ contracts are not home construction contracts within the
meaning of section 460(e). Petitioners may not account for these contracts using
the completed contract method of accounting. The custom lot contracts and the
bulk sale agreements are, however, long-term construction contracts for which
petitioners, if those contracts are entered into in a year before their completion,
may use a permissible method of accounting for long-term contracts, such as the
percentage of completion method.
The Court has considered all of the parties’ contentions, arguments,
requests, and statements. To the extent not discussed herein, the Court concludes
that they are moot, irrelevant, or without merit.
Decisions will be entered for
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