In Technical Advice Memorandum (TAM) 201650014, the IRS advised a construction company that it qualifies to use the completed contract method of accounting (CCM) for its long-term construction contracts that require grading and soil compaction for the pad area necessary for the construction of house foundations. The IRS included a caveat that the memorandum is subject to modification or revocation if temporary or final regulations are adopted that are inconsistent with the conclusions in the TAM.

Facts

Taxpayer is an active participant in private sub-division housing projects. As part of these projects, Taxpayer enters into contracts with land developers that require land improvements necessary to build houses, including the grading and compacting of soil for the construction of homes.

Taxpayer's grading activities include rough grading of the sub-division and fine grading of the "pad" for the foundation of the house. State and county building codes require the testing of soil in a sub-division, in some cases on a lot-by-lot basis. Taxpayer performs grading and soil compaction of the pad area to required densities and depths in accordance with engineering surveys to comply with these requirements and also replaces soil as necessary. Taxpayer's work is covered by home warranties, and the taxpayer has paid claims related to its work on pad areas. Taxpayer represents that its contracts generally do not exceed four years in duration.

The IRS granted consent to Taxpayer to use CCM to account for its contracts that qualify as home construction contracts within the meaning of Section 460(e)(6)(A). On audit, the revenue agent examined several contracts that Taxpayer claimed were home construction contracts and concluded that none of Taxpayer's contracts qualify as home construction contracts.

Law and analysis

Section 460(f)(1) defines a long-term contract as "any contract for the manufacture, building, installation or construction of property if such contract is not completed within the [tax] year in which such contract is entered." Section 460(a) generally requires income from any long-term contract to be reported using PCM.

Section 460(e)(1) contains an exception to the required use of PCM under Section 460(a) and permits the use of CCM for any "home construction contract." Section 460(e)(6) defines a home construction contract as "any construction contract if 80% or more of the estimated total contract costs (as of the close of the tax year in which the contract was entered into) are reasonably expected to be attributable to (construction) activities with respect to: (i) dwelling units (as defined in Section 168(e)(2)(A)(ii)) contained in buildings containing four or fewer dwelling units (as so defined), and (ii) improvements to real property directly related to such dwelling units and located on the site of such dwelling units."

In the CCM, the IRS focused on the meaning of dwelling units under Section 460(e)(6)(A)(i) and concluded that, in these particular circumstances, the grading and soil compaction of the pad area necessary for the construction of foundations for houses are construction activities with respect to dwelling units as required under Section 460(e)(6)(A)(i). Taxpayer's work is regulated by state and local building codes and is the subject of home warranties. The IRS concluded that grading and soil compaction of the pad area necessary for the construction of the foundations are essential to support the houses and should be considered construction of a portion of the dwelling units.

Because Taxpayer is performing construction activities with respect to dwelling units, the contracts meet the 80% test of Section 460(e)(6). At least 80% of a contract's estimated costs would be attributable to the construction of dwelling units, because the regulations permit a taxpayer constructing all or a portion of a dwelling unit to consider the allocable share of common improvement costs as part of the costs of constructing the dwelling units. Substantially all of a contract's estimated costs would be qualifying costs for purposes of meeting the 80% test: costs for the construction of a portion of a dwelling unit; costs for the construction of improvements to real property on the site of such dwelling unit; and an allocable share of the costs of constructing common improvements.

The IRS also cited cases that have held that the cost of land preparation can be included in the basis of a building used in a trade or business or held for the production of income, making the costs depreciable. Courts and the IRS have ruled that, when land preparation is so closely associated with a specific depreciable structure that the land preparation would be retired, abandoned, or replaced contemporaneously with that depreciable structure, the cost of the land preparation is depreciable and may be part of the cost basis of the structure.

The cost of the pad is part of the cost basis of the house because it would probably need to be replaced if the building was torn down. Thus, the pad may be considered part of the dwelling unit. The IRS noted that rough grading of the lot or clearing trees would not qualify as construction of a dwelling unit because those are non-depreciable improvements to land. Installation of retaining walls and driveways for a rental building would qualify as the construction of depreciable improvements to land, but not ones that are part of the dwelling unit itself.

Implications

Following the IRS success in denying CCM to a land developer in the Howard Hughes Tax Court and Circuit Court decisions (see Tax Alerts 2014-1097 and 2015-2173), the TAM is very helpful in illustrating the level of construction activity needed to qualify for CCM. Of course, taxpayers that are not already using CCM will also have to consider the applicable requirements for a change in method of accounting.

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