In the previous year, the Large Business and International (LB&I) Division of the IRS introduced an updated Concept Unit to offer additional guidance for land developers and subcontractors who employ the completed contract method of accounting for long-term contracts.
Section 460 of the Internal Revenue Code (IRC): Long-Term Contracts
Overview: §460 of the IRC mandates the use of the percentage of completion method for accounting for long-term contracts. An exception is provided in Paragraph (e) for certain construction contracts, specifically home construction contracts under §460(e)(1)(A), which are exempt from reporting income using the percentage of completion method.
Section 460(e)(5)(A) defines a home construction contract as one in which 80% or more of the total estimated contract costs are reasonably expected to be attributable to activities completed in connection with dwelling units1 and improvements to real property directly to such dwelling units and located on the site of such dwelling units.
Key Tax Court Cases
- Shea Homes Inc. v. Commissioner (2014): The U.S. Tax Court found that a group of home development companies properly reported income and loss under the completed contract method of accounting. The court determined that the subject matter, including the house, lot, development, and common improvements and amenities, all constituted work to be performed in order to fulfill development promises on behalf of their buyers. For this reason, the court found that the completed contract method was used accurately and ruled against the IRS’ assertion that the costs attributable to common improvements are secondary items unrelated to the construction of a home.
- Howard Hughes Co., L.L.C. v. Commissioner (2015): The U.S. Tax Court determined that affiliated land and developing corporations’ “bulk sale” and “custom lot” contracts did not qualify as home construction contracts under §460(e)(1)(A) and that income and loss were required to be calculated using the percentage of completion method. The ruling found that these taxpayers were ineligible to use the completed contract method since none of the construction activities involved the building, construction, reconstruction, or rehabilitation of—or installation of an integral component to—real property improvements directly related to and located on the site of the dwelling units. The court ruled that certain developers must recognize income based on significant progress made on a project rather than when the project is completed and sold. The court affirmed that a contract qualifies as a home construction contract only if the work performed is directly related to or located on the site of dwelling units.
Following the guidance from these two cases, land developers are not permitted to use the completed contract method and must recognize gain over the life of a particular project, despite incurring large upfront development costs.
Additional IRS Guidance Following the Hughes Decision
In a Technical Advice Memorandum (TAM 201650014), the IRS permitted the use of the completed contract method for contracts consisting of grading and soil compaction on lots designated for home construction. The IRS reasoned that the grading and soil compaction was eligible for the completed contract method of accounting for long-term contracts under the home construction exception because the work was performed on a lot-by-lot basis, rather than treated as a common improvement.
In late 2024, the LB&I division issued additional guidance for developers and subcontractors engaged in the construction of improvements such as water lines, utilities, roads, sewers, and parks. This guidance generally indicates that contracts for these services may be required to utilize the percentage of completion method for these long-term contracts because they are not performed in direct connection with production of a dwelling unit.
It is important to note that taxpayers who project that their contracts will be completed within two years, or who have average annual gross receipts below a specified threshold for the preceding three taxable years, will not be mandated to use the percentage of completion method when accounting for long-term contracts according to the exceptions provided in Treasury Regulation §1.460-3(b). The gross receipts threshold is adjusted annually for inflation and stands at $31 million for tax year 2025.
How Forvis Mazars Can Help
It is generally preferable to utilize the completed contract method when accounting for long-term contracts, as this approach defers the recognition of income and expenses until the year in which the contract is completed. Nonetheless, the IRS has consistently maintained that this preferable treatment is intended exclusively for taxpayers engaged in home construction (see TAM 200552012).
A taxpayer who incorrectly applies the completed contract method in accounting for long-term contracts may be obligated to change their accounting method. A taxpayer also may be required to determine whether any adjustments are required under §481(a) to avoid omission or duplication of an item of income or expense. Revenue Procedure (Rev. Proc.) 2002-18 provides procedural guidance for taxpayers who initiate a voluntary (IRS-imposed) change in accounting method.
Taxpayers who initiate a voluntary method change should follow the voluntary change procedural guidance found in Rev. Proc. 2015-13. A voluntary change will require a Form 3115, Application for Change in Accounting Method, to be filed. However, voluntary changes may be performed on a cut-off basis and may not require adjustment under §481(a).
For developers or subcontractors interested in reviewing their specific fact pattern and accounting methods for long-term contracts, or seeking additional guidance on filing a method change, please consult with a professional at Forvis Mazars.
- 1Dwelling units have the same meaning within the use of §168(e)(2)(A)(ii) – a building containing four or fewer dwelling units. For purposes of §460(e)(5)(A)(1), each townhouse or rowhouse is to be treated as a separate building.