Proposed Sec. 460 Regulations Provide Potential Tax Savings for Lot Developers and Condominium Builders
Section 460 and the current regulations in place offer guidance for taxpayers entering into transactions classified as long-term contracts. Proposed changes may give condominium builders and lot developers the chance to save taxes.
A long-term contract is defined as any contract for manufacture or construction if such contract is not to be completed within the taxable year entered into (generally the date at which the contract binds both the taxpayer and the customer under applicable law). The default method of tax accounting for long-term contracts is the percentage-of-completion method (“PCM”), which provides (with some exceptions) that a taxpayer must recognize income equal to the product of actual contract costs incurred at year-end over total expected contract costs, and the expected net income of the project. In many circumstances, income is recognized for tax purposes prior to any cash being received from the purchaser, potentially making it more difficult for the contractor to maintain debt obligations and manage cash flow.
There is an exception to the PCM requirement for those engaged in home construction contracts. A home construction contract is defined in the current regulations as a contract that the taxpayer expects to attribute 80 percent or more of total contract costs to the construction of dwelling units (contained in a building of 4 or fewer dwelling units), and improvements to real property directly related to and located on site of such dwelling units. Townhouses and rowhouses are considered separate buildings for purposes of applying the “4 or fewer” requirement. Contracts meeting this definition qualify for use of the more favorable completed-contract method (“CCM”) of accounting, which allows for deferral of income recognition until the year the contract is completed.
The proposed regulations present two major breakthroughs for lot developers and condominium builders.
First, the proposed regulations alter the definition of home construction contract so that it can meet the 80 percent test either by construction of dwelling units, or improvements to real property directly related to and located on the site of such dwelling units. This change affords lot developers the opportunity to classify some contracts as home construction contracts, thereby allowing use of the CCM. The proposed regulations also clarify that developers contracted to construct common improvements, e.g., sidewalks, sewers, roads, and clubhouses, can also treat their contracts as home construction contracts.
Second, although current regulations carve-out townhouses and rowhouses as separate buildings for purposes of the “4 or fewer” requirement, condominiums are left out. The proposed regulations explicitly include in the term townhouse and rowhouse an individual condominium unit. Therefore, builders of condominiums would have access to the CCM so long as all other requirements were met.
Another item of note is the possibility that taxpayers who are not otherwise eligible to adopt the CCM under current regulations would be required to follow formal application procedures to change their accounting method(s). This creates some complexity from a tax return compliance standpoint, but generally would not overshadow the benefits of using the more favorable CCM.
The changes currently remain in proposed form and little has developed during the last several months. Taxpayers should wait for further guidance on how to apply the proposed changes. One thing is certain: If enacted, these changes pose an enormous opportunity to use more favorable tax accounting approaches with respect to certain construction and development activities.
If you have questions about Section 460 and how your business may be affected, please contact Gary Master, Partner-in-Charge, Real Estate and Construction Services, or Thomas Earley, Partner, Tax Services.