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Building Success: An EisnerAmper Real Estate Blog

Potential Opportunity for Developers to Defer Income

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March 19, 2014

Ken WeissenbergBy Kenneth Weissenberg, CPA

Is a contract for the sale of a house – that is part of a larger development – considered “complete” when that particular home is sold? Or is the sale not completed until the entire development, including common improvements, is finished? The answer, according to a recent decision by the Tax Court, creates a potential opportunity for homebuilders to defer significant income.

The Shea Controversy

In Shea v. Commissioner, 142 T.C. 3 (2/12/2014), the Tax Court permitted a homebuilder using the so-called “completed contract method” to defer the recognition of income related to the sale of homes within a development, until that entire development in which the homes were located was complete. The controversy involved Shea Homes, a home development business in Arizona, California and Colorado (a corporation and two partnerships related through common ownership).

Every case is based on its facts and circumstances, and the facts in this case were quite favorable to Shea Homes. Specifically, Shea opted to develop planned communities, typically ranging from 100 to 1,000 homes. They emphasized the features and lifestyle of the planned community to those potential buyers, rather than merely providing “bricks and sticks.”

On one hand, according to the IRS, the purchase contract for an individual home identified that house as the subject matter of the contract. On the other hand, Shea emphasized that the contract obliged the builder to complete the amenities – pools, golf courses and clubhouses – for the entire neighborhood – typically upwards of 30% of total budgeted costs.

The Completed Contract Method

In preparing its tax returns, Shea reported the income from the sale of homes using the completed contract method. The good news is that certain contractors and home builders, such as Shea, typically recognize income related to so-called “long-term contracts” only when those contracts are complete. The bad news is that “completion” is determined on a contract-by-contract basis, since it is not defined by tax code section 460.

Instead, the IRS issued regulations that a contract is completed when it meets two tests: 1) the “use and 95% completion test,” and 2) the “final completion and acceptance test.” In this case, the IRS and Shea disagreed how to apply the cost of common improvements to those tests, for purposes of determining if Shea’s home sales qualified as “long-term contracts.”

A Favorable Outcome

In determining when its contracts to sell a home were complete, Shea took the position that the subject matter of its sales was not merely the home, but rather the broader development, including the common improvements. Under this methodology, Shea deferred recognizing income related to the sale of a home until the last road in the development was paved and the final bond was released.

The Tax Court agreed with Shea’s argument: The subject matter of the home-sale contracts included not only the house, but also the common improvements that are shared by all homeowners within the development, and even the development as a whole. After all, it was the entire development, rather than a specific home, that attracted buyers.  By broadening this definition of the subject matter of the contract, Shea argued that the costs incurred to complete these improvements and the entire development must be included within the total costs to be incurred for purposes of determining when a contract was complete.

As a result, Shea could defer recognizing the income related to homes that had sold and closed until 95% of all costs to complete the development were complete. By using this methodology, Shea deferred nearly $900 million of income from the sale of homes under the completed contract method until a later year. Shea would only recognize the income when it determined that 95% of the total cost of the developments – including the common improvements – had been incurred.

Going Forward

Based on the Tax Court’s decision in Shea, all home developers should reevaluate their use and application of the completed contract method. In many instances, a contract to complete the construction of a home that is part of a larger development will not be considered “complete” for purposes of the completed contract method until the entire development is complete. The result: substantial deferrals of income.

But recall that this decision was based on the particular facts of the case where Shea Homes:

  • ggressively marketed its developments as a whole;
  • devoted a large part of the total budget to common improvements; and
  • operated in three jurisdictions (AZ, CA, CO) whose definition of “real estate” included allocable common improvements.

The bottom line: Home developers should be aware of the planning opportunities from the Shea decision. Please don’t hesitate to contact me or your EisnerAmper tax advisor if you’d like to discuss whether the completed contract method could allow you to defer significant amounts of revenue.

Final Tangible Property Regulations Create Big Opportunities for Small Real Estate Owners

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February 5, 2014

By Eric McCutcheon, CPA, and Mariana Moghadam, CPA


As many taxpayers are aware, the IRS issued the Final Tangible Property Regulations in September 2013, a culmination of almost 10 years of planning and numerous revisions.  The final Regulations are an update of the temporary regulations issued in 2011 and generally apply to taxable years beginning on or after January 1, 2014.  While many taxpayers are aware of the more common provisions of the Regulations (e.g., de minimis safe harbor) and have already taken the necessary steps to take advantage of the new benefits offered by the Regulations, they may be unaware of several other provisions that could lead to potential tax savings and accelerated write-off of expenses that previously were required to be capitalized. 

One such provision of the final Regulations is the “Safe Harbor for Small Taxpayers” intended to simplify compliance with the rules on building improvements. This new provision allows qualifying taxpayers to expense amounts paid during the tax year for repairs, maintenance, improvements, and similar activities with respect to eligible building property, if the amount paid for the tax year does not exceed the lesser of:

  1.  $10,000 or 
  2.  2% of the unadjusted basis of the eligible building property.

NOTE: 

Taxpayers must be aware of the interaction of the Safe Harbor for Small Taxpayers with other safe harbor provisions contained in the final Regulations.  The amount paid for purposes of this safe harbor must also take into account amounts paid that were not capitalized under the “De Minimis Safe Harbor” and amounts not determined to improve the property under the “Routine Maintenance Safe Harbor.”
 
The Safe Harbor for Small Taxpayers is determined on a building property-by-building property basis as long as each meets the guidelines laid out below. This annual election is available to property owners (such as partnerships and S corporations), but not to individual partners and shareholders.


Eligible Taxpayer

To be eligible for this safe harbor, a taxpayer’s  annual average gross receipts for the preceding three years must be less than or equal to $10,000,000 without regard to aggregation.  Gross receipts are defined as gross receipts from total sales (net of returns), receipts from services, and certain investment income items defined in the Regulations. 

Eligible Building Property 

 Eligible building property is each building, condominium, cooperative, or leased building (or portion thereof) that has an unadjusted basis of $1,000,000 or less.  For purposes of those taxpayers who lease properties or a portion of a property, the unadjusted basis is defined as the total amount of undiscounted rent paid or expected to be paid during the entire term of the lease.  This total must also include the total amount expected to be paid for any renewal periods if at the time the taxpayer entered into the lease there was a reasonable expectancy of renewal.

As with many safe harbor provisions provided by the IRS, the Small Taxpayer Safe Harbor has some limits.  If, for instance, a taxpayer exceeds the $10,000/2% threshold explained above, the taxpayer would then have to apply the general improvement rules of the final Regulations to determine the deductibility of the expenses incurred.  Also, for purposes of this provision, the amounts paid are on a building property-by-building property basis. Therefore, the safe harbor may apply for one building property but not another.  

Example:
Assume a taxpayer qualifies as an eligible taxpayer based on the gross receipts test.  The taxpayer owns/leases the following properties:

  1. Owned Building #1 with unadjusted basis of $990,000, expenses paid of $11,000
  2. Owned Building #2 with unadjusted basis of $480,000, expenses paid of $10,000
  3. Leased Building #3 with unadjusted basis of $800,000, expenses paid of $9,600

Based on the information above, the taxpayer would only be able to apply the Small Taxpayer Safe Harbor rules to Building #3 because it is the only one that satisfies the lesser of $10,000/2% unadjusted basis test.  The taxpayer would be allowed to deduct the $9,600 in the year incurred and would have to apply the general improvement rules to the expenses paid for Buildings #1 and #2 (assuming the taxpayer properly elected the Small Taxpayer Safe Harbor).

Small real estate owners should begin preparation now to comply with, and take advantage of, this safe harbor. For questions regarding the Small Taxpayer Safe Harbor, or any of the new provisions of the Final Tangible Property Regulations, please feel free to contact your EisnerAmper advisor.

 

Another Banner Year for the Hospitality Industry

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February 3, 2104

Friedland, DeborahBy Deborah S. Friedland

The sentiment at the Americas Lodging Investment Summit conference this past week was positive with most participants including brokers, lenders, owners and private equity investors expecting revenue per available room (RevPAR) growth of between 5% and 6%, supply remaining in check, and hotel values rising.

Entering its fifth year of recovery, RevPAR growth will be driven mainly by average daily rate growth as demand continues to increase and limited supply growth persists. Forecasts for 3% real GDP growth, an improving job market, and continued growth in the group-demand segment should support further growth and profitability.

Supply growth remains in check as a result of lenders historically being cautious to deploy capital, especially for new construction. That trend is changing as more lenders are looking to get in the game and private equity groups are flush with cash and aggressively looking for yield. While we expect to see supply growth increasing this year, new construction is not a near-term threat to recovery. New supply is not expected to be a concern until 2016. 

An increase in capital availability from existing lenders and new investors and lenders should continue for the near term. Existing lenders are becoming more comfortable with the stability of the industry and are increasingly more aggressive with financing terms. New lenders including Asian lenders are entering the market. Participants reported that new debt is being issued at between 65% and 70% loan-to-value and debt yield requirements are averaging between 7% and 9%. 

Cap rate compression should continue as availability of capital and a plethora of investors fuels competition for deals. New development will become increasingly more attractive to investors as cap rates for existing assets continue to compress and lenders become increasingly comfortable with lending for new construction. Many participants at the conference noted that cash-flowing assets are trading at or above replacement cost, further encouraging investors to consider development. 

Hotel profits should grow despite headwinds from the impact of the Affordable Care Act, legislation for increases in the minimum wage, and increases in interest rates. Additional costs loom for hotel owners from the implementation of new brand initiatives and large Property Improvement Plan (PIP) requirements. 

In conclusion, industry fundamentals are solid, supply growth is in check, and hotel profits should continue to grow through 2015. Happy New Year indeed.

EisnerAmper is an independent member of PKF North America.
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