Proposed Regs Expand Scope of Home Construction Contract Exemption
Tax accounting for long-term construction contracts can be complex. Regulations proposed by the IRS could help certain home construction contractors by expanding the types of contracts that can qualify for the home construction contract exemption from the percentage-of-completion method of accounting.
Under federal tax law, taxpayers generally must use the percentage-of-completion method to account for taxable income from a long-term contract. However, “home construction contracts” are exempted from this requirement. Instead, the tax code permits the use of other methods, such as the completed-contract method. Generally, with the completed-contract method, all contract income and contract related expenses are deferred until the taxable year the contract is completed, even though payments are received in years before completion.
Defining a Home Construction Contract
Under the tax code, a home construction contract is a construction contract in which 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 the building, construction, reconstruction, or rehabilitation of:
- Dwelling units contained in buildings containing four or fewer dwelling units
- Improvements to real property directly related to the dwelling units and located on the site of the dwelling units.
Townhouses, Row Houses, and Condos
Currently, each townhouse or row house in a complex is treated as a separate building (irrespective of the number of townhouses or row houses physically attached to each other) for purposes of the home construction contract definition. The IRS’s proposed regulations would also treat each individual condominium unit as a separate building. As a result, contractors working on larger condominium projects could qualify for the home construction contract exemption.
The IRS has previously taken the position that land sale contracts are not home construction contracts eligible for the completed contract method where the land developer isn’t performing the construction contract activities related to the dwelling units. As a result, land developers that subdivide, improve, and then sell lots have not been eligible.
The proposed regulations would expand the scope of the home construction contract exemption. Under the proposed regulations, a contract for the construction of common improvements would be considered a contract for the construction of improvements to real property directly related to and located on the site of the dwelling units, even if the contract is not for the construction of any dwelling unit.
Examples of common improvements include:
- Land clearing and grading
- Sidewalks and roads
- A clubhouse on the property
In general, a common improvement does not benefit only one particular dwelling unit or lot. However, under the proposed regulations, land clearing and grading would be considered common improvements even when performed on a particular lot.
The proposed rules mean that a land developer selling individual lots, as well as the land developer’s contractors and subcontractors, might have long-term construction contracts that qualify for the home construction contract exemption.
The proposed regulations may change by the time they reach their final form. We will keep you apprised of the progress of these proposals and alert you when they are finalized.
Small Construction Contracts
The tax law provides an additional exemption from the required use of the percentage-of-completion method for “small construction contracts.” Contracts can qualify if:
- The contract is originally estimated to be completed within two years of the contract start date and
- The contractor’s average annual taxable gross receipts for the three previous tax years did not exceed $10 million.
“…land developers that subdivide, improve, and then sell lots have not been eligible.”