The Internal Revenue Service has proposed rules that would free some rural builders from the onerous requirement of using the percentage-of-completion method (PCM) when accounting for income from long-term contracts. The newly proposed rules would expand the types of contracts that qualify as Home Construction Contracts.
Everyone reports income and expenses on their tax return using the method of accounting best suited to their operation –- and one that is acceptable to the IRS. An accounting method must clearly show the building operation’s income, treat all income and expenses the same from year to year and be appropriate to the builder’s business.
Choosing the right method is important because it will affect when income is reported and expenses are deducted.
The majority of construction-related businesses use two tax accounting methods, one for their long-term contracts and one overall method for everything else. Generally, construction businesses use the Accrual Method for their overall method of accounting.
Here’s one methodUnder the accrual method of accounting:
A builder of homes built for speculation deducts the costs from income only after the spec home is sold.
A custom home built on land owned by the contractor or builder is a construction contract because the home must be built to fulfill the contract with the buyer. As with spec homes, costs are accumulated, and deduction postponed until the contract is completed.
A custom home built on land owned by the buyer is a construction contract because the home must be built to fulfill the contract with the buyer. Title to the work is transferred as work is performed. Homebuilders usually receive advance payments and may use the accrual method of accounting, percentage completion method, or the completed contract method.
A developer acquires land, obtains approval, secures construction financing and begins construction of residential developments in stages or phases. The developer assigns all the direct job costs and an allocated portion of the indirect costs such as streets, curbs, sidewalks, sewers, etc., to each lot in the development. All of these costs must be matched with the sales price of each lot as it is sold.
A long-term contract is defined as any contract that spans a year end. A contract started on December 26 but not completed until January 23 is a long-term contract. Long-term contracts are then broken down into general construction or home construction contracts.
Home construction contracts are contracts for buildings that have four or fewer residential units. Eighty percent or more of the estimated total contract costs must be for the construction, improvement or rehabilitation of these units. If a contract is not a home construction contract, it is a general construction contract.
The completion methodBuilders who have jobs that extend over the year end may want to choose the percentage of completion or completed contract method. While generally more advantageous than the accrual method, be aware that current tax rules also permit the use of so-called “exempt” accounting methods, such as the completed contract method (CCM) or the accrual method, for so-called “home construction contracts.”
The percentage of completion method only affects how income is computed and reported for tax purposes. With this method, income from long-term contracts is reported as work progresses.
On the plus side, PCM is the most accurate way to measure income. It evens out the reporting of income over the life of the contract. Losses are recognized, based on the percentage of the contract completed and it is the method preferred by most banks and bonding companies. The main disadvantage is its complexity and the fact that it accelerates income compared to other methods.
Using the completed contract method, all income from the contract is reported and all related job costs are deducted in the year when the project is completed and accepted by the customer. The advantage of CCM is that it normally achieves the maximum deferral of taxes.
On the downside, with CCM, the books and records do not show clear information on operations. Income can be bunched into a year when a number of jobs have been completed, and losses on contracts are not deductible until the contracts are completed. Plus, CCM can only be used by small contractors.
The IRS viewpointNow, the IRS has proposed guidance for the home construction industry on accounting for long-term contracts that qualify as home construction contracts. Guidance has also been proposed for taxpayers with long-term contracts regarding accounting method changes.
Under the newly proposed regulations, a contract for the construction of common improvements will be a contract for the construction of improvements to real property directly related to and located on the site of the dwelling units — even if the contract is not for dwelling unit construction.
Thus, a land developer who sells individual lots (and his or her contractors or sub-contractors) might have long-term construction contracts that qualify for the “home construction contract” exemption. The proposed regulations also permit an individual condominium unit to be considered a “townhouse” or “row house” under the exemption, so that each condominium unit can be treated as a separate building in determining whether the underlying contract qualifies.
As the rules now stand, a builder using the PCM or exempt-contract PCM, or electing the 10-percent method or special alternative minimum taxable income methods, or who adopts or elects a cost allocation accounting method must apply the method consistently for all similarly classified contracts — until consent is obtained from the IRS allowing a change in accounting methods.
A builder-initiated accounting method change is allowed only on a cut-off basis, i.e., only for contracts entered into on or after the year of change, making adjustments unnecessary.
The proposed rules continue a cut-off method only for taxpayer-initiated changes: (1) from a permissible PCM method to another permissible PCM method for long-term contracts requiring PCM, and (2) from a cost allocation method to another complying cost allocation method. All other builder-initiated changes will require adjustments.
What might changeThe proposed rules will also expand the types of contracts eligible for the home construction contract exemption by:
Providing that a contract of common improvements is considered a contract for the construction of improvements to real property directly related to the dwelling unit(s) and located on the site of such dwelling unit(s), even if the contract is not for the construction of any dwelling unit.
Changing the definition of townhouse or row house to include individual condominium units. That is, each townhouse or row house can be treated as a separate building, regardless of the number of townhouses or row houses physically attached to each other.
This change would have the effect of allowing each condominium unit to be treated as a separate building for purposes of determining whether the underlying contract qualifies as a home construction contract.
When all is said and done, a look-back computation would not be required upon completion of the contract simply because the taxpayer has changed his or her accounting method.
A look-back computation would, however, be required if actual costs or the contract price differ from the estimated amounts notwithstanding that an accounting method change occurred.
While accounting, particularly tax accounting, is rarely pleasant, the increased flexibility permitted builders under the newly proposed rules and rule changes may make the accounting process more rewarding, at least for those builders engaged in home construction.
Mark Battersby, a tax and financial consultant, lecturer and writer, has 30-plus years experience with small business issues. Contact him at (610) 789-2480 or MEBatt12@Earthlink.netFrom Rural Builder Magazine