A construction contract requiring grading and soil compaction of the area for building foundations for houses was found to qualify for completed contract treatment in Technical Advice Memorandum 201650014.
Under IRC §460, the general rule is that long term construction contracts must be reported under the percentage of completion method (PCM) for tax purposes. However, under IRC §460(e)(1)(A) a home construction contract does not require the use of PCM and the contractor may instead use the completed contract method of accounting.
A home construction contract for these purposes is defined at §460(e)(6)(A) as follows:
(A) Home construction contract
The term "home construction contract" means any construction contract if 80 percent or more of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to activities referred to in paragraph (4) 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.
For purposes of clause (i), each townhouse or row house shall be treated as a separate building.
In this case the contractor was performing the following activities:
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 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.
The ruling determined that under these specific facts the contractor’s contracts were “home construction contracts” allowing the use of the completed contractor method.
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 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.
The ruling went on to describe what would not count as a home construction contract as well.
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.
The memorandum also notes why this case is not governed by the results of the Howard Hughes Co., L.L.C. v. Commissioner, 805 F.3d 175 (5th Cir. 2015) case. As the memorandum reasons:
The Hughes court found 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.