In a coup for real estate developers, the Ninth Circuit affirmed the U.S. Tax Court’s approval of a real estate developer’s strategy to defer income in Shea Homes, Inc. v. Commissioner, 834 F.3d 1061 (9th Cir. 2016). The strategy appears fairly narrow, and will likely be the subject of future IRS challenges.
In certain instances, income under a long-term construction contract is reported when the contract is completed; the timing of income tax reporting for gain on lot sales in a real estate development therefore rests on when the sales contracts are “completed.” Before the Tax Court, the IRS argued that the “subject of the contract” to be completed was the individual lot being purchased, and that the contract was completed (and tax reported) when escrow closed. The taxpayer, in contrast, argued that the “subject of the contract” was the entire development—the home, the lot, the common areas and improvements, any restrictive covenants, and so on—because the purchasers were buying more than mere “bricks and sticks.” Under the taxpayer’s argument, the contract was completed only when the last road was paved and the last obligations of the taxpayer were completed. The Tax Court agreed with the taxpayer, finding that the real estate developer’s sales contracts were not completed until the development was substantially completed.
While this decision is significant for developers, the Ninth Circuit decision limits its usefulness for planning purposes because the decision was largely the result of the IRS’s ineffective litigation strategy. For example, the IRS did not argue that the narrower interpretation appearing in IRS regulations should be afforded deference (a fact that the Tax Court noted as being atypical), so the Tax Court explicitly declined to give the IRS’s interpretation any deference at all, effectively scuttling the IRS’s case. Further, the Ninth Circuit’s affirmation was based largely on procedural defects in the IRS’s appeal, which resulted in the Ninth Circuit’s reviewing the appeal with a more lenient hand than the IRS anticipated.
In short, the IRS is not likely to let taxpayers abuse this strategy in the future and will likely attempt to distinguish the Shea Homes decision at every opportunity. The takeaway for developers is that there may be a strategy to defer tax, but it will work only if the taxpayer takes significant steps to ensure conformity with the Shea Homes decision.