Category: Accounting Periods & Methods;
Real Estate; Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer (TP) is a cash basis C corporation engaged in the business of real estate development. TP is developing a high-rise condominium project. Units in the project are pre-sold based on a sales contract (a representative sample of which is attached and incorporated by reference into this memorandum) which provides that the buyer will deposit with the seller 15% of the selling price as earnest money prior to start of construction, 15% at "stage 2" of construction, 20% at "stage three" of construction, 20% at "stage four" of construction, and the remaining 15% on closing. The buyer's performance under the contract is secured by an irrevocable letter of credit. In the event that the buyer does not close for any reason except seller non-performance, all payments are forfeited. The average annual gross receipts for TP and any related entities for the three year period preceding execution of the contract are less than $10 million. Construction of the condominium units requires 12 to 15 months. Given the length of construction time, it is likely that the sales of many units will straddle tax years; in essence, the contract will be entered into in one tax year and completed in the next tax year. The issue is whether TP must recognize the advance payments as income prior to closing. It appears that TP may have the opportunity to adopt the completed contract method of accounting as it existed prior to the Tax Reform Act of 1986 and thereby defer recognition of all project related income and expenses until closing. It is well settled that no income recognition results from a mere contract to sell real estate in the future. The sale occurs and income is recognized at the time title passes or when possession of the benefits and burdens of ownership pass to the buyer. Payments to the seller prior to actual consummation of the sale are treated as deposits against the purchase price and are accounted for in the year of the sale. See, for example, Revenue Ruling 69-93, 1969-1 C.B. 139. While the characterization of the present contract as a mere contract of sale versus something else is a question of fact, it seems quite clear to me that the terms of TP's contract differ so materially from those ordinarily seen in contracts of the type envisioned by Revenue Ruling 69-93, that the present contract must be viewed in some other light. The glaringly obvious difference between this contract and the typical sale contract is, of course, that the buyer is financing the project in its entirety from the outset. The buyer has assumed the most substantial burden of property ownership, the burden of paying for the property, prior to closing. Further, the contract does not require the seller to refund any monies for any reason after commencement of construction. In fact, the contract provides that if the buyer fails to close for any reason except title defects or the seller's failure to complete the building in accordance with its specifications, all the buyer's funds are forfeited to the seller as liquidated damages. Finally, the contract provides that the buyer may pledge the agreement as security for a loan against the to-be-completed property. In other words, the parties view this contract as a property interest that is sufficiently complete to be used as security for a substantial loan. In my view, these facts distinguish the current situation from the well established rule that payments prior to consummation of a sale are treated as mere deposits. The question becomes how to characterize the current arrangement if it is not a mere contract to sell. At its most basic level, TP's sale contract closely resembles a construction contract. First, the terms of the contract call for TP to construct or cause to be constructed the condominium units which are the object of the sales contract. The fact that TP has chosen to retain a construction firm to act as TP's agent for the actual construction seems to me irrelevant. Second, the contract allows the seller to back out of the deal unless 90% of the units are sold prior to the beginning of construction. The effect of this contract provision resembles the fact pattern present in many construction situations. In essence, the seller is producing this condominium project for a group of buyers without the commitment of whom the project would not be undertaken in the first instance. Finally, the contract calls for progress payments based on identifiable events in the construction of the building. This is an extremely common provision in construction contracts. If one accepts the premise the contract is a construction contract and not a mere executory contract of sale, then what are the tax consequences? The answers depend on whether the contract is treated under the long term contract accounting rules or not. IRC Section 460 controls tax accounting for most long term contracts. Under Sec. 460(f), a long-term contract is any contract for the manufacture, building, installation, or construction of property if the construction of such property is not completed in the year in which it is entered into. In essence, a contract merely has to span two tax years in order to be considered long term. If Section 460 applies, the taxpayer is required to use the percentage of completion method (PCM) under which, generally speaking, the taxpayer expenses contract costs as incurred. Income is recognized in proportion to the extent to which the project has been completed as measured by the ratio of actual costs incurred versus expected total costs to be incurred. §460(e)(1) exempts small contractors from the rule requiring use of PCM accounting. In order to qualify for the exception, the taxpayer must reasonably estimate the contract will be completed within two years of its commencement and the average gross receipts of the taxpayer for the three tax years ended prior to the commencement of the contract must not exceed $10 million. Note that §460(e)(2) aggregates all the taxpayer's trades or businesses and includes the gross receipts of various related parties. Based on our conversation, it appears that TP qualifies under the small contractor exception of §460(e)(1); however, the aggregation rules should be carefully scrutinized based on your knowledge of TP's circumstances. Assuming that the small contractor exception under §460 applies, TP has the opportunity to report income from the transaction under its normal method of accounting, the cash method. This would of course mean that TP would report all the advances as income when received. In the alternative, TP may be eligible to adopt, for regular tax purposes only and not for AMT, any one of the pre-§460 long-term contract methods including the completed contract method. See §451 and regulation 1.451-3. Under the completed contract method, recognition of all income and expenses under the contract would be delayed until completion of the contract, in essence until closing for each unit. It appears based on my limited knowledge of TP 's circumstances that TP is eligible to adopt the completed contract method of accounting. The rules for adoption and operation of the completed contract method of accounting are complex and require intimate knowledge of the taxpayer's facts. I do not have such knowledge. It is essential someone in possession of such knowledge carefully review the rules related to completed contract accounting before further advising TP in this regard. In addition to careful review of the general rules related
to completed contact accounting, one specific matter should receive
particular scrutiny. Completed contract is a method of accounting
which requires permission. If TP has already established some
other method of accounting for construction contracts, then completed
contract accounting will not be available without prior permission
of the commissioner. Such permission must be obtained within the
first 180 days of the tax year for which the new accounting method
is to be used. See §446 and related regulations. On the other
hand, if TP has never engaged in an activity of this type, completed
contract accounting should be available without permission. |
