House-pad work qualifies for completed contract accounting

Plain-English summary

A construction company performed subdivision work that included grading and compacting the soil pads on which house foundations would be built. The IRS concluded that this work was construction activity with respect to dwelling units because building codes governed it, home warranties covered it, and the prepared pads were essential to supporting the houses. Contracts requiring that pad work qualified for the home construction exception and could use the completed contract method. Rough lot grading and tree clearing did not qualify as dwelling-unit construction, while retaining walls and driveways could be depreciable land improvements without being part of the dwelling unit itself.

Ruling snapshot

• Question: Do contracts requiring grading and soil compaction of house foundation pads qualify for completed contract accounting?
• Outcome: advice given
• Key authorities: IRC §§ 460(e)(1)(A), 460(e)(4), 460(e)(6)(A); Treas. Reg. §§ 1.460-3(b)(2)(iii), 1.460-4

Full text (IRS public release)

                        INTERNAL REVENUE SERVICE
              NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                        August 25, 2016

Number: 201650014
Release Date: 12/9/2016
Third Party Communication: None
Date of Communication: Not Applicable

Index (UIL) No.: 460.00-00, 460.04-01
CASE-MIS No.: TAM-106726-16

Director

     Taxpayer's Name:                         ---------------------------------------
     Taxpayer's Address:                      -------------------------------------
                                              ------------------------------------
     Taxpayer's Identification No             -----------------
     Year(s) Involved:                        -------------------------------------
     Date of Conference:                      -----------------------------

LEGEND:

Taxpayer: ------------------------------------------
State A: --------------
Date 1--------------------------
Date 2: ----------------------
Date 3: ----------------------

ISSUE:

     Whether certain of Taxpayer’s contracts qualify for the completed contract

method of accounting.
TAM-106726-16 2

CONCLUSION:

   Those of Taxpayer’s long-term construction contracts requiring grading and soil

compaction of the pad area necessary for the construction of foundations for houses

qualify for the completed contract method of accounting.

FACTS:

   Taxpayer, a C Corporation, actively participates in private sub-division housing

projects in State A. It enters into contracts with both land developers and

owners/homebuilders. These contracts require Taxpayer to make a variety of heavy

construction improvements necessary for the development of a housing sub-division. In

particular, these contracts require some or all of: clearing land; grading and compacting

soil for construction of homes; installing lot improvements such as retaining walls and

driveways; and constructing common improvements for the development, such as

curbs, sidewalks, and gutters.

   Taxpayer’s grading activities include rough grading of the sub-division and fine

grading of the “pad” area of an individual lot where the foundation of a house will be

constructed. Further, state and county building codes in State A 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 that are completed in order to comply with these requirements. In

some cases, clay or organic soil must be replaced with more stable soil. The specific

grading and compaction of the pad area required are based on the structure that will be

built on the lot and environmental factors such as water runoff. Taxpayer’s work is
TAM-106726-16 3

covered by home warranties, and Taxpayer represents that it has paid claims related to

its work on pad areas. Taxpayer represents that its contracts generally do not exceed

four years in duration.

   For the tax year ending on Date 3, the Service granted consent to Taxpayer to

use the completed contract method of accounting (CCM) to account for its contracts

qualifying as home construction contracts within the meaning of § 460(e)(6)(A). Home

construction contracts are exempted from required use of the percentage-of-completion

method of accounting (PCM). I.R.C. § 460(e)(1)(A). Under PCM, contract price is

reported as contract costs are incurred, based on the proportion of incurred to estimated

total costs. § 460(b)(1)(A). A taxpayer can use an “exempt method,” including CCM, to

account for home construction contracts. Treas. Reg. § 1.460-4(c). Under CCM,

contract price and costs are reported upon contract completion. Treas. Reg. § 1.460-

4(d). In an audit of the tax year ending Date 2, the revenue agent examined several

contracts that Taxpayer claimed were home construction contracts and thus eligible for

CCM. Based on this review, the field office has requested revocation of the Date 1

letter of consent on the grounds that none of Taxpayer’s contracts qualify as home

construction contracts.

LAW AND ANALYSIS:

   Section 460(a) generally requires use of PCM to account for long-term contracts,

as defined in § 460(f). Section 460(e)(1)(A), however, exempts “any home construction

contract” from the general rule. A taxpayer performing construction services pursuant to
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a “home construction contract” may report income from that construction activity using

CCM. Treas. Reg. § 1.460-4(c).

       Under § 460(e)(4), a construction contract is “any contract for the building,

construction, reconstruction, or rehabilitation of, or the installation of any integral

component to, or improvements of, real property.” Section 460(e)(6)(A) defines “home

construction contract” as any construction contract if 80 percent or more of the

estimated total contract costs 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 4 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.” We refer to this test as “the 80-percent test.”

       For purposes of § 460(e)(6)(A), a “dwelling unit” is defined at § 168(e)(2)(A)(ii) as

“a house or apartment used to provide living accommodations in a building or

structure.…” Section 1.48-1(e)(1) of the Income Tax Regulations defines a building as

“any structure or edifice enclosing a space within its walls, and usually covered by a roof

. . . .”

       For purposes of the 80-percent test, § 1.460-3(b)(2)(iii) of the regulations allows

taxpayers to include in the costs of dwelling units their allocable share of the costs of

common improvements that taxpayer is required to build, by contract or by law, on the

tract of land containing the dwelling units.

       The home construction contract exemption was recently interpreted in Howard

Hughes Co., L.L.C. v. Comm’r, 805 F.3d 175 (5th Cir. 2015). The Hughes court found
TAM-106726-16 5

that a land developer who incurred solely common improvement costs, but did not incur

costs for the construction of dwelling units or for improvements within the individual lots

on which dwelling units were to be situated, could not use CCM to account for its

contracts. Because of its construction activities within individual lots, Taxpayer’s case is

not governed by Howard Hughes Co. Rather, we are required to determine whether

Taxpayer performs construction activities with respect to dwelling units, within the

meaning of § 460(e)(6)(A)(i). If it does, those contracts requiring such work qualify for

CCM treatment. At least 80 percent of a contract’s estimated costs would be

attributable to the construction of dwelling units, because under the regulations a

taxpayer constructing all or a portion of a dwelling unit can consider the allocable share

of common improvement costs as part of the costs of constructing the dwelling units.

Substantially all of a contracts’ estimated costs would be qualifying costs for purposes

of meeting the 80-percent 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.

   We conclude that under the specific circumstances of this case, grading and soil

compaction of the pad area necessary for the construction of foundations for houses are

construction activities with respect to dwelling units per § 460(e)(6)(A)(i). Taxpayer’s

work is regulated by state and local building codes and is the subject of home

warranties. The grading and soil compaction of the pad area necessary for the

construction of the foundations are as essential to support of the houses as the
TAM-106726-16 6

foundations themselves and should be considered construction of a portion of the

dwelling units.

   Further support for this conclusion is found in authorities addressing the issue of

whether 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, and therefore depreciable.

Courts have found and the Service has ruled that when grading (that is, 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. Eastwood Mall, Inc. v. United States, 95-1 U.S. Tax Cas.

(CCH) P50,236 (N.D. Ohio 1995); Rev. Rul. 2001-60, 2001-2 C.B. 587; and Rev. Rul.

68-193, 1968-1 C.B. 79.

   In all likelihood, replacement of a rental house and its foundation would require

the contemporaneous physical destruction of the pad, so that the cost of the pad is part

of the cost basis of the rental house. For purposes of § 460(e)(6)(A), the pad therefore

may be considered part of the dwelling unit. Note 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.
TAM-106726-16 7

CAVEATS:

   Temporary or final regulations pertaining to one or more of the issues addressed

in this memorandum have not yet been adopted. Therefore, this memorandum will be

modified or revoked by the adoption of temporary or final regulations to the extent the

regulations are inconsistent with any conclusions in the memorandum. See § 13.03 of

Rev. Proc. 2016-2, 2016-1 I.R.B. 102 (or any successor). A technical advice

memorandum that modifies or revokes a letter ruling or another technical advice

memorandum generally is not applied retroactively if the taxpayer can demonstrate that

the criteria in § 13.02 of Rev. Proc. 2016-2 (or any successor), are satisfied. This

technical advice memorandum is not to have retroactive effect, because the criteria for

relief have been satisfied.

   A copy of this technical advice memorandum is to be given to the Taxpayer.

Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.