The Howard Hughes Company, LLC f.k.a. The Howard Hughes Corporation, and Subsidiaries v. Commissioner

THE HOWARD HUGHES COMPANY, LLC, F.K.A. THE HOWARD

HUGHES CORPORATION, AND SUBSIDIARIES, PETITIONER v.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

HOWARD HUGHES PROPERTIES, INC., PETITIONER v.

COMMISSIONER OF INTERNAL REVENUE,

RESPONDENT

Docket Nos. 10539–11, 10565–11. Filed June 2, 2014.

Ps are in the residential land development business and

develop land in and adjacent to Las Vegas, Nevada. Ps sell

land to builders and, in some cases, individuals, who construct

and sell houses. Ps generally sell land through bulk sales, pad

sales, finished lot sales, and custom lot sales. In bulk sales,

Ps develop raw land into villages and sell an entire village to

a builder. Ps do not otherwise develop the sold village. In pad

sales, Ps develop villages into parcels and sell the parcels to

builders. Ps do not develop within the sold parcels. In finished

lot sales, Ps develop parcels into lots and sell whole parcels

of finished lots to builders. In custom lot sales, Ps sell indi-

vidual lots to individual purchasers or custom home builders,

who then construct homes. In all instances, Ps do not con-

struct residential dwelling units on the land they sell. During

the years at issue, Ps reported income from purchase and sale

agreements under the completed contract method of

accounting. R alleges Ps’ contracts are not home construction

contracts within the meaning of I.R.C. sec. 460(e). R further

contends the land sale contracts are not long-term construc-

tion contracts and are not eligible for the long-term percent-

age of completion method of accounting under I.R.C. sec. 460.

Held: Ps’ bulk sale and custom lot contracts are long-term

construction contracts. Held, further, Ps’ contracts are not

home construction contracts within the meaning of I.R.C. sec.

460(e), and Ps may not report gain and loss from these con-

tracts using the completed contract method of accounting.

355

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356 142 UNITED STATES TAX COURT REPORTS (355)

Stephen F. Gertzman, Kevin L. Kenworthy, Steven R.

Dixon, Mary W.B. Prosser, and Sat Nam S. Khalsa, for peti-

tioners.

Ronald S. Collins, Jr., Bernard J. Audet, Jr., and John R.

Gilbert, for respondent.

WHERRY, Judge: These cases, consolidated for trial,

briefing, and opinion, are before the Court on petitions for

redetermination of Federal income tax deficiencies.

Respondent determined deficiencies for the 2007 and 2008

tax years of petitioner the Howard Hughes Co., LLC (THHC)

(formerly the Howard Hughes Corp. & Subsidiaries (Old

THHC)), and deficiencies for the 2007 and 2008 tax years for

petitioner Howard Hughes Properties, Inc. (HHPI). The issue

for consideration concerns the proper method of accounting

for income from certain contracts. Respondent alleges that,

with respect to most of petitioners’ contracts, petitioners

must use the percentage of completion method of accounting

instead of the completed contract method of accounting. Peti-

tioners, however, contend that because their contracts qualify

as home construction contracts within the meaning of section

460(e)(6), they properly reported income on the completed

contract method. 1 Respondent further alleges that certain

other contracts are not long-term contracts or construction

contracts and that petitioners cannot account for the gain or

loss from these contracts under section 460.

FINDINGS OF FACT

The parties’ stipulation of facts and supplemental stipula-

tion of facts, both with accompanying exhibits, are incor-

porated herein by this reference. At the time petitioners filed

the petitions, their principal place of business was Dallas,

Texas. Their main business operations, however, are in Las

Vegas, Nevada.

Company Background

When Howard Hughes died in 1976, his portfolio of assets,

owned by Summa Corp., included land which was then out-

1 Unless otherwise noted, all section references are to the Internal Rev-

enue Code of 1986, as amended and in effect for the years at issue, and

all Rule references are to the Tax Court Rules of Practice and Procedure.

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 357

side the city of Las Vegas, Nevada. In the 1980s this land

was selected for development. The land was called

Summerlin, which was the maiden name of Mr. Hughes’

paternal grandmother. Summerlin was divided into three

geographic regions: Summerlin North, Summerlin South, and

Summerlin West.

In 1996 the Rouse Co. (Rouse), a publicly traded corpora-

tion based in Columbia, Maryland, acquired the assets of the

Hughes estate, including Howard Hughes Properties LP

(HHPLP), which owned Summerlin. Effective January 1,

1998, Rouse elected to be treated as a real estate investment

trust (REIT) in 1998. As part of this conversion Rouse orga-

nized HHPI, which in turn purchased the undeveloped acre-

age in Summerlin North and South from HHPLP. In

December 1997 HHPLP had distributed Summerlin West to

Old THHC. In 2004 General Growth Properties, Inc. (GGP),

a publicly traded REIT, acquired Rouse by merger. During

the tax years at issue, GGP was the general partner in a lim-

ited partnership, which, through another limited partner-

ship, the Rouse Co. LP, and a limited liability company,

Rouse LLC, owned HHPI and the Hughes Corp., which in

turn owned Old THHC.

In 2009 GGP and its affiliated entities filed for bankruptcy

under chapter 11 of the U.S. Bankruptcy Code. Effective

December 31, 2009, Old THHC converted from a corporation

to a Delaware limited liability company, which is petitioner

THHC in these cases. As part of the plan of reorganization

in 2010 GGP spun off the part of its business that owned

Summerlin. A newly formed entity, the Howard Hughes

Corp., an entity distinct from Old THHC, ended up owning,

as second- and third-tier subsidiaries, HHPI and THHC.

THHC owns Summerlin West, and HHPI owns Summerlin

North and Summerlin South to the extent that these prop-

erties have not yet been sold to third parties.

Summerlin

During the years at issue petitioners were in the residen-

tial land development business. They generated revenue pri-

marily by selling property to builders who would then con-

struct and sell homes. In some cases, they also sold property

to individual buyers who would then construct single-family

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358 142 UNITED STATES TAX COURT REPORTS (355)

residential homes. The land petitioners sold and still sell is

part of a large master-planned community known as

Summerlin.

Summerlin comprises approximately 22,500 acres on the

western rim of the Las Vegas Valley, about nine miles west

of downtown Las Vegas. As of the end of 2010 approximately

100,000 residents lived in 40,000 homes in Summerlin. At

completion, petitioners expect Summerlin to house approxi-

mately 220,000 residents. While Summerlin is largely resi-

dential, it is a fully integrated community, which means it

includes commercial, educational, and recreational facilities.

It contains about 1.7 million square feet of developed retail

space, 3.2 million square feet of developed office space, 3

hotels, and health and medical centers. It has 25 public and

private schools, 5 higher learning institutions, 9 golf courses,

parks, trails, and cultural facilities.

Summerlin North and Summerlin West are, as a result of

annexation, part of the city of Las Vegas, and Summerlin

South is in Clark County, Nevada. The first residential land

sales in Summerlin North took place around 1986, and by

the years at issue HHPI had fully developed Summerlin

North. The first land sales in Summerlin South took place in

1998, and the first land sales in Summerlin West took place

in 2000. Each of these three geographical regions is further

divided into villages, each of which averages about 500 acres.

Villages are further divided into parcels, or neighborhoods,

which contain the individual lots. These cases involve only

petitioners’ sales of land in Summerlin South and Summerlin

West.

Petitioners’ sales generally fell into one of four categories:

pad sales, finished lot sales, custom lot sales, and bulk

sales. 2 In a pad sale, petitioners, after dividing the village

into parcels, constructed all of the infrastructure in the vil-

lage up to a parcel boundary. Petitioners then sold the parcel

to a buyer, who was usually a homebuilder. The builder, with

petitioners’ approval, was responsible for all of the infra-

structure (such as streets and utilities) within the parcel and

subdividing the parcel into lots. In a finished lot sale, peti-

tioners also divided the village into parcels. They then fur-

2 The parties disagree over whether the bulk sales contracts are in sub-

stance different from the pad sales contracts. We resolve this issue infra.

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 359

ther constructed any additional needed parcel infrastructure,

divided the parcels into lots, and sold the neighborhoods to

a buyer, usually a homebuilder. In finished lot sales, peti-

tioners constructed all of the infrastructure up to the lot line.

In both the pad sales and the finished lot sales, petitioners

contracted with homebuilders through building development

agreements (BDAs). The BDAs were more than just simple

sales contracts that, for consideration, pass title. We discuss

the parties’ responsibilities infra. In doing so, we do not pur-

port to cover all of the details but simply address some

important aspects of the BDAs.

Custom lot sales were essentially the same as finished lot

sales except that petitioners sold the individual lots. The

buyers of these individual lots were individuals who were

contractually bound to build a residential dwelling unit. 3

The purchase sales contracts required the individuals to

agree that they would occupy the home for at least one year

or, if the home was sold before then to a third party, to pay

additional consideration of 10% of the third-party price.

Finally, in a bulk sale, petitioners sold an entire village to

a purchaser. The purchaser was responsible for subdividing

the village into parcels and lots and for constructing all of

the infrastructure improvements within the village.

Even though the builders were ultimately responsible for

building and selling homes to the end user—the home-

buyer—petitioners marketed to the homebuyers. Petitioners’

marketing strategy embodied the idea of the master-planned

community, and they viewed Summerlin as a brand that

evokes thoughts of an attractive lifestyle and community.

But petitioners did not bear the sole burden of the marketing

cost. In fact, their agreements with the builders required the

builders to pay into an advertising program promoting

Summerlin. The builders paid, upon the close of escrow of a

home sale, a fee equal to 1% of the purchase price.

3 The parties stipulated that the sales in all custom lot contracts were

made to ‘‘an individual purchaser’’. A review of the list of custom lot con-

tracts, however, reveals that some of the buyers appear to be builders (e.g.,

Executive Home Builder, Six Star Construction, Inc., and PMR Homes,

Inc.). This apparent discrepancy may result from the meaning of ‘‘indi-

vidual purchaser’’ but is irrelevant to our ultimate holding. For simplicity,

we will rely on the parties’ stipulation.

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360 142 UNITED STATES TAX COURT REPORTS (355)

We discuss infra the general process THHC and HHPI

undertake in their home development business. Much of the

trial was devoted to the details of the process, and we by no

means purport to address every step. Our intention is not to

discount those important steps not addressed but to provide

a general picture of how the development process worked.

Developing Summerlin—Entitlements

Petitioners were parties to master development agree-

ments with Las Vegas, Nevada, and Clark County, Nevada,

that govern the planned development of Summerlin West

and Summerlin South, respectively. These long-term, 30-year

agreements assure petitioners that they will be able to

develop the land in accordance with the agreements and

remove any necessity to negotiate development agreements

and entitlements village by village.

Summerlin West

Las Vegas, pursuant to powers delegated by the State of

Nevada by chapter 278 of the Nevada Revised Statutes,

adopted in April 1992 the City General Plan, which is a

master land use plan. HHPLP and Las Vegas signed a

development agreement (LVDA) in February 1997. The

LVDA was recorded in the Clark County, Nevada, Recorder’s

Office and was approved by the Las Vegas City Council.

Along with approvals and plans referenced within the agree-

ment, the LVDA governed land development in Summerlin

West. Las Vegas also amended its City General Plan to

incorporate the Summerlin West General Development Plan,

which conceptualized future development of Summerlin

West, and rezoned Summerlin West from a rural district to

a planned community district.

The Summerlin West Development Standards, attached to

the LVDA, set minimum requirements for development,

including ‘‘residential densities; building height and setbacks;

signage; landscaping; parking and open space requirements;

as well as procedures for site plan review and for modifying

the Planned Community Program.’’ The LVDA states that

development of Summerlin West will occur in phases called

villages. The owner has to prepare and submit for city

approval a Village Development Plan for each village. A vil-

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 361

lage traffic study and a village drainage study also had to

accompany the village development plan.

Initially, the LVDA permitted 20,250 residential units,

5.85 million square feet of office, retail, or industrial space

uses on 508 acres of land, golf courses featuring up to 90

holes of golf, and related facilities. Other uses described in

the Summerlin West General Development Plan were also

contemplated. The LVDA required HHPLP to maintain

medians but allowed HHPLP to assign that responsibility to

homeowners associations. HHPLP granted the city the right

to construct traffic signals, turn lanes, and similar improve-

ments as necessary. The LVDA also required HHPLP to

donate land to the city and construct a fire station on that

land and to donate up to five acres of land to the city for a

satellite government center. In addition, HHPLP was to

donate land to the city for a public park with sports and rec-

reational facilities and assume the cost of constructing a

sewer interceptor. With respect to traffic and transportation,

the LVDA required HHPLP to provide, or at least provide

adequate assurance that it would provide, standard improve-

ments in connection with each village. Standard improve-

ments were ‘‘mitigation measures and improvements

required for intersections and roadways immediately adja-

cent to the Planned Community.’’ HHPLP also agreed to

dedicate land needed for the right of way to the city for a

major arterial road, the Summerlin Parkway extension.

In November 2003 Old THHC, as the successor in interest

to HHPLP, and the city amended the LVDA to require Old

THHC to allocate a certain minimum amount of recreational

space per 1,000 residents, construct a neighborhood pool, and

design and construct a police substation with a helicopter

landing pad. The amended LVDA also increased the allowed

number of residential units from 20,250 to 30,000. Petitioner

THHC was and is, as successor in interest to Old THHC,

subject to the LVDA as amended.

Summerlin South

Clark County, Nevada, pursuant to the powers delegated

by the State of Nevada, adopted the Clark County Master

Plan in 1983. It and HHPLP also signed and recorded a

development agreement (CCDA) in February 1996 to govern

the development of Summerlin South. Before the CCDA,

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362 142 UNITED STATES TAX COURT REPORTS (355)

Clark County had amended its County Master Plan to

include the Land Use and Development Guide for

Summerlin’s Southern Comprehensive Planned Community

(Land Use and Development Guide). Clark County also

rezoned Summerlin South from a rural district to a planned

community district.

The CCDA provided that Summerlin South would be devel-

oped in accordance with the Summerlin Master Plans, which

consisted of the Land Use and Development Guide, a

Summerlin Master Parks and Public Facilities Plan, a

Summerlin Master Transportation Plan, and a Summerlin

Master Drainage Plan. As with the LVDA, the CCDA envi-

sioned development by phases called villages, and HHPLP

agreed to submit a Village Development Plan before begin-

ning development of a village. HHPLP also agreed to submit

with the Village Development Plan a traffic study, a drain-

age study, and a parks and public facilities plan.

Under the CCDA, Summerlin South could contain up to

18,000 residential dwelling units, 740 acres for nonresiden-

tial private uses, 90 holes of golf and related facilities, 3

hotels/casinos, and other land uses and facilities. The CCDA

obligated HHPLP to construct a fire station, donate up to 5

acres of land for a satellite government center, which may

include the fire station, and dedicate up to 20 acres of land

for a community sports park. The CCDA also obligated

HHPLP to submit the Master Parks and Public Facilities

Plan, which was to generally identify the location and

development timing of parks, trails, and public spaces sys-

tems. HHPLP also was to submit a Master Transportation

Study, provide the necessary improvements to mitigate the

development’s traffic impact, provide village access roads for

each village, and bear all public and private expenses, such

as roadway construction, lighting, drainage, signage, and

landscaping expenses related to Summerlin South’s internal

roadway network. The CCDA further required HHPLP to

prepare a technical drainage study and construct flood facili-

ties which were to be integrated where possible with the

trails and parks systems.

The parties, Clark County and HHPI, as successor in

interest to HHPLP, have amended the CCDA three times,

most recently in July 2005. The most recent amendment

increased the number of permissible residential dwelling

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 363

units to 32,600. In return, HHPI agreed, inter alia, at its

expense to purchase and provide a 100-foot aerial fire truck

with operating equipment; design, construct, and convey a

second fire station; and convey 2.5 acres of land to the county

for a third fire station. In addition, HHPI agreed to convey

25 acres or more of land to the county for recreational pur-

poses or 30 acres or more for a sports park to be designed

and constructed by HHPI, and a community center and out-

door aquatic center to be designed and constructed by HHPI.

Developing Summerlin—Covenant, Conditions, and Restric-

tions

Petitioners and their predecessors in interest recorded

Master Declarations, which govern use of the land by subse-

quent owners. These declarations, also known as covenants,

conditions, and restrictions (CC&Rs), not only imposed use

restrictions and protective covenants, but also created home-

owners associations. The Master Declarations served as the

governing documents for the homeowners associations. The

declarations applied to an initial set of properties within

Summerlin, but allowed petitioners to annex property,

thereby expanding the community subject to the declara-

tions.

The Master Declarations provided for the establishment of

village subassociations through new declarations. The sub-

association declarations supplemented the Master Declara-

tions. These subassociations were responsible for owning and

maintaining certain common elements and/or exclusive

amenities associated with a neighborhood and for enforcing

their own covenants, conditions, and restrictions. A neighbor-

hood, which could include a gated community, consists of

properties which share exclusive amenities or common areas.

The Summerlin South Master Declaration established the

Summerlin South Design Review Committee. This committee

had to approve ‘‘construction, alteration, grading, additions,

excavation, modification, decoration, redecoration or

reconstruction of an Improvement or removal of any tree in

any Phase of Development’’. The Summerlin West Master

Declaration established a similar review process. In both

cases, petitioners retained control over the review process

until such time as they no longer owned an interest in the

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364 142 UNITED STATES TAX COURT REPORTS (355)

respective Summerlin West and Summerlin South geographic

regions.

Developing Summerlin—Villages

Petitioners developed Summerlin in village phases starting

with the villages adjacent to existing development to take

advantage of the infrastructure. Subsequent villages could

likewise take advantage of the additional infrastructure cre-

ated by the adjacent villages.

Generally, the first step in petitioners’ development activi-

ties was to survey the property and create and file a parcel

map. The parcel map broke off a village-size piece for

development and sale by petitioners. Petitioners also had to

grant easements for utilities and drainage and dedicate

public streets. The parcel map reflected these easements and

dedications.

Often, Clark County or Las Vegas imposed obligations on

petitioners with respect to street grading, surfacing, and

alignment and provisions for drainage, water quality and

supply, sewerage, and particular lot designs. Before devel-

oping the land, petitioners prepared and filed a tentative

map. Along with this map, petitioners conducted technical

studies, such as traffic and drainage studies, and established

a village development plan, which is required by the LVDA

and the CCDA and established the specific zoning, uses, and

entitlements within the villages. Normally, the governing

agency required petitioners to design and construct the

improvements on the tentative map as a condition of

approval of the map. But in certain cases, petitioners

requested waivers. For instance, if a road was not imme-

diately necessary, petitioners could request a waiver delaying

construction until it was necessary. In addition, the tentative

maps did not show all of the improvements that petitioners

would construct on the parcels. For instance, they did not

show landscaping, wall, and dry utility improvements.

Petitioners also prepared improvement plans for the

improvements shown on the tentative maps. It took about

nine months to one year to prepare these plans and for the

governing agency to review and approve them.

Once the various governmental bodies approved the ten-

tative map, petitioners were required to also submit a final

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 365

subdivision map. In the case of pad sales, the builders also

had to prepare and submit tentative and final maps to fur-

ther subdivide the pad land into lots. The pad purchase con-

tracts governing pad sales also required the builders to first

submit these maps to petitioners for approval.

The final map showed roads and easements that peti-

tioners intended to dedicate to the public. These easements

included those for wet utilities, such as sewer and water, and

dry utilities, such as electric, telecommunications, and gas.

Absent a Special Improvement District (SID), the approving

governmental body could require petitioners to enter agree-

ments whereby petitioners posted bonds to ensure completion

of the agreed-upon improvements. These improvements may

have included streets, alleys, curbs, gutters, sidewalks,

medians, streetlights, traffic signals, sewer systems, drainage

facilities, open space improvements, trails, parks, and land-

scaping. Petitioners obtained and posted bonds based on the

unit rate times required material as determined by the

agency that requires the bond. The agency commented on

and required modifications to or approved the bond, and it

exonerated petitioners only when the improvements were

fully constructed and inspected and the agency took owner-

ship.

Petitioners also used tax-exempt SIDs financing to finance

construction of some Summerlin infrastructure improve-

ments. In a project financed by SID bonds, petitioners did

not have to post performance bonds. These SID bonds

financed public improvements such as street, water, sewer,

and storm drainage improvements. Petitioners were entitled

to reimbursement from the money raised from the sale of the

SID bonds when they incurred the relevant construction

costs, subject to the approval of the relevant municipal

authority. Special assessments on the property within the

SID covered the scheduled bond payments. SID financing

was not available to cover dry utilities, landscaping, and

walls. Summerlin West and Summerlin South contain seven

SIDs. The total amount of the SID bonds was $183,685,000.

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366 142 UNITED STATES TAX COURT REPORTS (355)

Villages at Issue

Respondent’s determinations concern income from 107

BDAs 4 for the sale of land in 9 of petitioners’ villages. Those

villages are: Village 13 (Summerlin Centre), Village 14B (The

Gardens), Village 15B (Siena), Village 16 (The Mesa), Village

18 (The Ridges), Village 19 (Summerlin Centre West), Village

20 (The Vistas), Village 23A/B (The Paseos), and Village 26

(Reverence). All of the villages except Villages 15B, 19, and

26 contained land sold in pad sales. 5 Finished lot sales

occurred in Villages 16, 18, 19, 20, and 23.

Also at issue are 279 custom lot contract sales. All custom

lot contracts involved the sale of lots in Village 18. Of the

custom lot contracts, 94% were entered into and closed in the

same tax year. The remaining custom lot contracts closed in

the tax year following the one in which they were entered

into.

The parties have agreed that Villages 16, 18, 20, and 23

are generally representative of the villages at issue. The par-

ties have also agreed on a BDA that is representative of fin-

ished lot sales (Ladera BDA), a BDA that is representative

of pad sales (Lyon BDA), and two custom lot contracts,

Redhawk and Arrowhead, that are generally representative

of the custom lot contracts at issue.

In addition to the pad sales, the finished lot sales, and the

custom lot contracts, petitioners also sold villages 15B and 26

in bulk sales essentially equivalent to very large pad sales.

Within the boundaries of the property sold in a bulk sale,

petitioners do nothing. Rather, the purchaser is responsible

for all development. With respect to Village 26, known as

Reverence, the first half of the sale to Pulte Homes, Inc., now

4 The

parties provided a stipulated exhibit that purports to be a list of

BDAs at issue. This list of 130 BDAs includes 23 contracts for sales in Vil-

lage 14A. But the parties also stipulated that petitioners recognized the

gain on BDAs involving Village 14A in 2000. Other stipulated exhibits,

such as a map highlighting the villages at issue and the calculations at-

tached to the 30-day letters, also reveal that the contracts for sales of land

in Village 14A are not in issue. We disregard the contracts from Village

14A in arriving at the total number of BDAs at issue.

5 The parties disagreed over whether Villages 18 and 19 contained land

sold in pad sales. This dispute is immaterial to our ultimate holding, but

we find that the weight of the evidence suggests Village 18 contained land

sold in pad sales whereas Village 19 did not.

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 367

known as Pulte Group, Inc., occurred in December 2006, just

before the 2007 housing market collapse, and neither peti-

tioners nor the purchaser have done any work on this prop-

erty. In fact, the sale of Village 26 was to occur in two parts,

but the purchaser defaulted on the second half of the con-

tract. With bulk sales, petitioners still incurred regional costs

that benefit the two villages, such as costs for water lines,

regional drainage, and road extensions.

Common Improvements Generally

The BDAs, loan agreements, governmental laws, and other

legal obligations required petitioners to build common

improvements in Summerlin. These improvements included

rough grading, roadways, sidewalks, utility infrastructure

such as water, sewer, gas, electricity, and telephone, storm

water drainage, parks, trails, landscaping, entry features,

signs, and perimeter walls. Upon completion of a common

improvement, petitioners transferred ownership or granted

easements to the respective community association or, where

appropriate, the municipality. Generally, community associa-

tions received some roads, swimming pools, open spaces, and

medians, whereas the municipalities received police stations,

fire stations, other roads, traffic signals, and street lights.

Some of these improvements were necessary for construc-

tion of the dwelling units. The allocable costs attributable to

petitioners’ improvement construction activities exceeded

10% of the various total contract prices. Petitioners designed

all of the common improvements in an effort to make

Summerlin an attractive community. In addition, petitioners

monitored and maintained approval control over all construc-

tion in Summerlin, including construction of the dwelling

units.

Representative Contracts

Finished Lot Sale—Ladera BDA

With respect to the BDAs, the parties stipulated that these

contracts are construction contracts within the meaning of

section 460(e)(4). The Ladera BDA is a purchase and sale

agreement between HHPI and KB Home Nevada, Inc. (KB

Home), for finished lots in Village 16 in a neighborhood

called Ladera. The Ladera BDA called for the land sale to be

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368 142 UNITED STATES TAX COURT REPORTS (355)

completed in three phases. Village 16, known as The Mesa,

consisted of a mix of residential uses including single family

and multifamily units. The style of The Mesa drew its

inspiration from the mountains in the backdrop, and peti-

tioners required builders to use natural building materials,

such as stone, and to include at least two outdoor living

spaces per residence.

In addition to the purchase price, the Ladera BDA entitled

HHPI to certain participation payments as well as payments

tied to power company refunds. HHPI received a lot premium

participation payment equal to 50% of the lot premium less

a credit calculated by reference to any commission paid to an

unrelated broker. HHPI also received a payment equal to the

greater of 3% of the net sale price or HHPI’s percentage

share, 38% of the net sale price less the finished lot costs. 6

The power company refund payments stemmed from the fact

that HHPI paid the Nevada Power Co. to construct electric

feeder lines. As homeowners subscribed to electrical service,

the power company refunded all or part of the costs. HHPI

assigned the rights to the refunds to KB Home but then

required KB Home to make three lump-sum payments equal

to the estimated amount of the refund.

The Ladera BDA required HHPI to develop the parcel into

finished lots. HHPI constructed all of the infrastructure up

to the individual lot lines. Thus, wet and dry utilities were

‘‘stubbed’’ to the lot boundaries. HHPI was also responsible

for the streets and street improvements such as traffic sig-

nals, the driveway depressions, the perimeter and retaining

walls, entry monumentation, and landscaping. HHPI also

graded the parcel, including the lots. And HHPI agreed to

construct a community park with a swimming pool, for which

KB Home paid HHPI a community park fee of $2,000 per

residence.

Improvement plans governed the work HHPI had to per-

form as part of the contract. HHPI, through the engineering

firm G.C. Wallace, Inc. (GCW), created their plans, one for

each phase, for approval by Clark County, the public utili-

ties, and other agencies. The plans governed the curbs, gut-

6 As used in the contracts, net sale price means the gross sale price less

credit for any lot premium and any costs of amenities, such as swimming

pools. Finished lot costs is the purchase price KB Home paid for the lot.

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 369

ters, and other paving improvements, street signs,

streetlights, driveway depressions, and wet utilities, such as

sewer mains, manholes, water mains, fire hydrants, and

water and sewer service stubbed to each lot. Another set of

plans prepared by the utility companies governed the dry

utilities, such as telephone and gas. In addition, HHPI was

responsible for any improvement necessary for the issuance

of a building permit or certificate of occupancy and for land-

scaping, design, and construction of perimeter and screen

walls, entry monumentation, and community open space.

On the purchaser’s side, the Ladera BDA obligated KB

Home to build dwelling units subject to a development dec-

laration and a development plan. The BDA also annexed the

property to the Summerlin South Community Association,

making KB Home also subject to the CC&Rs of that associa-

tion. The development declaration, entered at the time of

closing of phase 1, contained a number of additional restric-

tions on KB Home. The declaration allowed KB Home to con-

struct only single-family homes in accordance with a develop-

ment plan. The declaration preserved HHPI’s control over

design of homes and landscaping by requiring that they con-

form to HHPI’s residential design criteria for The Mesa Vil-

lage and to the landscape standards. The design criteria gov-

erned everything from lot grading to home finishes.

The declaration required KB Home to create a develop-

ment plan. The development plan had to describe land-

scaping improvements as well as building improvements.

With respect to the plans for the homes, the declaration

required KB Home to create a concept plan, with floor plans

and sketches of the home exteriors visible from the street,

preliminary and final plot plans, which showed the location

of the home and other improvements on the lot, an architec-

tural materials sample board, which included samples of the

building materials to be used, and a marketing signage plan,

which contained details on all signage.

The development plan was subject to the approval of

HHPI. If HHPI or a governmental agency disproved or

rejected an item as not being in conformity with the develop-

ment plan, KB Home was obligated to correct the defect at

its own cost. In addition to requiring KB Home to construct

single-family homes in a certain manner, the Ladera BDA

also required KB Home to construct sidewalks, driveways,

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370 142 UNITED STATES TAX COURT REPORTS (355)

model homes, interior screen walls, curb scribes, and water

meters.

Pad Sale—Lyon BDA

The second purchase and sale agreement is an example of

a pad sale. This agreement was between Old THHC and Wil-

liam Lyon Homes, Inc. (Lyon), for the sale of Parcel M in Vil-

lage 20. As part of this agreement, THHC transferred fee

simple title to Lyon subject to a number of encumbrances,

including the Summerlin West Master Declaration, a supple-

mental declaration of annexation, a development declaration,

and the Summerlin West Development Agreement. The

agreement limited Lyon to constructing single-family homes.

The agreement also placed substantial restrictions on

Lyon’s use of the property. The supplemental declaration of

annexation subjected Parcel M to the CC&Rs in the

Summerlin West Master Declaration and imposed its own

restrictions, such as those governing satellite dishes and

signs. Similarly, the development declaration required Lyon

to submit a development plan for THHC’s approval before it

could begin any construction. The development declaration

also required improvements to conform to an architectural

concept plan, a preliminary plot plan, an architectural mate-

rials sample board, a final plot plan, a marketing signage

plan, and the Summerlin Design Standards. If any item did

not conform to the development plan or was otherwise defec-

tive, Lyon had to, at its own cost, correct the problem.

The agreement also required Lyon to build entry

monumentation and landscaping, a minipark, and pedestrian

access ways. The parties agreed to share costs of boundary

walls between the property and adjacent parcels if the par-

ties thought such walls were desirable.

THHC, as part of the agreement, agreed to perform all

other obligations, except those inuring solely and specifically

to the subject property or specifically under the LVDA nec-

essary for the purchaser’s project. THHC also agreed to con-

struct the roads bordering the parcel, Vista Run Drive and

Trail View Lane, and associated roads, curbs, gutters, and

street lighting. The agreement further required petitioners to

construct a perimeter boundary wall along the roads bor-

dering the property and to stub the wet and dry utilities to

the parcel.

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 371

Custom Lot Contracts

The parties provided two custom lot contracts for the sale

of property in Village 18 to individual purchasers through

custom lot contracts. Each custom lot contract involved the

sale of a lot(s) in one of seven neighborhoods in Village 18,

known as The Ridges. The two representative contracts were

for the sale of a lot in the Arrowhead neighborhood and for

the sale of a lot in the Redhawk neighborhood. These con-

tracts are representative of the other custom lot contracts at

issue in these cases.

Each contract sold a lot described in final maps recorded

with the Office of the County Recorder of Clark County,

Nevada. The contracts required the purchaser to build a

single-family home on the lot. In addition, the contracts

stated that HHPI must construct or have constructed certain

improvements and the individual lot purchaser is to be solely

responsible for other lot improvements. For instance, section

7 of the Arrowhead contract stated in part:

HHP’s Improvements. HHP has installed roads providing access to the

Lot, together with underground improvements for sanitary sewer,

potable water, telephone, natural gas and electric power. All such utility

improvements have been stubbed out to the Lot. It shall be Purchaser’s

responsibility to activate water service * * * prior to commencing

construction on the Lot. Purchaser is responsible for all utility connec-

tions from the property line to Purchaser’s Home and for making all nec-

essary arrangements with each of the public utilities for service. Pur-

chaser acknowledges that HHP is not improving the Lot and has not

agreed to improve the Lot for Purchaser except as provided in this Sec-

tion 7. Purchaser will be responsible for finish grading and preparation

of the building pad and acknowledges that HHP has not agreed to pro-

vide any grading of the Lot beyond its present condition.

Section 7 of the Redhawk contract was substantially similar,

but it implied that HHPI’s work was not yet completed at the

time of the purchase and sale agreement.

As part of the custom lot contract, HHPI explicitly stated

that it ‘‘made no representations or warranties concerning

zoning * * * or the future development of phases of Arrow-

head, The Ridges or the surrounding area or nearby prop-

erty’’. A similar provision was in the Redhawk contract. The

contracts also contained integration clauses. Paragraph 23 of

the representative contracts stated:

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372 142 UNITED STATES TAX COURT REPORTS (355)

This Agreement constitutes the entire agreement and understanding

between Purchaser and HHP with respect to the purchase of the Lot and

may not be amended, changed, modified or supplemented except by an

instrument in writing signed by both parties. This Agreement super-

sedes and revokes all prior written and oral understandings between

Purchaser and HHP with respect to the Lot.

But the purchasers also initialed a page of the custom lot

contracts that states: ‘‘ALL OF THE DOCUMENTS LISTED

BELOW ARE IMPORTANT TO THE PURCHASE OF THE

LOT, SHOULD BE READ BY THE PURCHASER AND, AT

THE CLOSE OF ESCROW, SHALL BE DEEMED TO HAVE

BEEN READ AND APPROVED BY PURCHASER. * * *

PURCHASER HEREBY ACKNOWLEDGES RECEIPT OF

COPIES’’ of those listed documents. Among the documents

that purchasers acknowledged receipt of and were deemed to

have read are CC&Rs, articles of incorporation, and bylaws

of the Summerlin South Community Association, copies of

the recorded subdivision map for the neighborhood in which

the lot was located, the neighborhood design criteria, and a

public offering statement. 7

The purchasers and the purchased lots were subject to the

various CC&Rs that govern Summerlin South, Village 18,

and the subassociation within Village 18, and they were

contractually required to conform their lot to the relevant

architectural declaration. The architectural declaration

required that all construction on the lot be approved by

HHPI. If HHPI delegated the approval power to a review

committee for The Ridges, then that committee must approve

the declaration. In addition, the CC&Rs for the Village 18

association granted access to homeowners to their lots by

way of one of two circular roadways accessible by two guard

houses and private gates, all of which were to be designed

and constructed by HHPI, including associated landscaping.

These improvements became common elements owned by the

community association as did other elements such as entry

7 The parties did not provide copies of the attachments to the two rep-

resentative custom lot contracts. Rather, they provided the attachments to

a different custom lot contract, which involved the sale of a lot in The

Azure community in Village 18. The parties have stipulated that these at-

tachments are generally representative of the exhibits attached to a con-

tract for the purchase and sale of a custom lot in Village 18.

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 373

features, recreational facilities, landscaped medians, and cul-

de-sacs.

The recorded subdivision maps identified the common

areas, including private roads such as Drifting Shadow Way

and Sun Glow Lane, which were granted to the relevant

community association. These maps also showed the location

of storm drain easements and flood control and drainage

channel right-of-ways. The neighborhood design criteria con-

tained maps showing the walls and fences HHPI had to con-

struct. The design criteria also contained a map that showed

a community and fitness center, which the parties stipulated

was available to residents of Village 18. The public offering

statements not only stated that the private roads, guard

houses, and landscaping improvements are to be owned by

the community association, but they also recited that HHPI

was responsible for utility connections to the lots and land-

scaping improvements in common lots.

Tax Reporting

For the years at issue, petitioners used the completed con-

tract method of accounting in computing gain or loss from

their contracts for sale of residential real property in

Summerlin West and South intended for residential

buildings planned to contain four or fewer residential units

per building. 8 Petitioners reported gain from BDAs, custom

lot contracts, and the bulk sale agreements when they

incurred 95% of the estimated costs allocable to each BDA,

custom lot contract, or bulk sale agreement.

Petitioners broke down estimated BDA costs into three cat-

egories: direct village costs, regional costs, and finished lot

costs. Direct village costs consisted of the cost for the

common improvements that benefit only the village that was

the subject matter of the contract. These costs included the

following cost categories: planning; engineering; inspection,

testing, and processing; rough grading; water/sewer storm

drain; street improvements; dry utilities; walls/fencing; land-

scaping; parks; deposits; other; and contingency. Regional

8 For

example, petitioners did not use the completed contract method of

accounting to account for gain or loss from the sale of property upon which

large multiunit apartment and commercial buildings were ultimately to be

built.

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374 142 UNITED STATES TAX COURT REPORTS (355)

costs consisted of common improvements that benefited more

than one village and included the following cost categories:

regional water, regional sewer, regional drainage, regional

roads, regional traffic signals, regional entry features,

regional annual costs, regional other costs, and townwide

arterial costs. Finished lot costs were the costs that benefit

only the neighborhood or parcel in which the finished lots

were located.

Petitioners used the engineering firm GCW to calculate

most cost estimates. For the actual construction cost cat-

egories, the ‘‘hard costs’’, GCW used a market price unit rate

for each improvement, which was based on its experience

with past bids as well as prevailing bond rates. The unit rate

generally reflected labor and materials cost for the relevant

improvement. The unit rate was applied differently to dif-

ferent improvements. For instance, GCW applied the unit

rate based on length for improvements such as curbs, sewer

lines, and sidewalks, on area for improvements such as

paving and some landscaping, and on number of units of a

designated improvements such as street lights and fire

hydrants. ‘‘Soft costs’’, or costs other than the actual

construction costs such as engineering, inspection, testing,

and processing, were calculated as a percentage of the hard

costs.

For regional water costs, GCW allocated the costs to vil-

lages according to the percentage of village acreage in the

relevant water zone. GCW assigned costs to each water zone

for water mains, pump stations, reservoirs, and inlet and

outlet pipes in the water zone. For regional sewer costs,

GCW allocated the cost among villages in proportion to their

acreage. These costs included costs for the sewer systems,

including pipes and mains, paving, manholes, flowmeters,

and traffic controls. Drainage, regional roads, regional entry

features, regional annual, regional other, and townwide arte-

rial costs were all also allocated in proportion to village acre-

age. Traffic signal costs, however, were allocated to the vil-

lage(s) adjacent to the street corners (for example, one-fourth

to each corner at a four-way intersection) of the relevant

signal and then prorated by acreage.

For the finished lot costs, petitioners and GCW used a for-

mula based on historical actual costs. This formula yielded

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 375

an estimated incremental cost of improvements of $40,000

per lot.

Deficiencies

For the tax years at issue, petitioners reported income

from the sale of land within Summerlin using the completed

contract method of accounting. Under petitioners’ methods of

accounting, each BDA, custom lot contract, and bulk sale

agreement was a home construction contract, and they were

not completed within the meaning of section 460 until peti-

tioners incurred 95% of the direct and indirect costs allocable

to the agreement or contract.

Respondent issued notices of deficiency to both petitioners.

As part of his determinations, respondent changed peti-

tioners’ methods of accounting from the completed contract

method of accounting to the percentage of completion method

of accounting. Respondent adjusted petitioners’ income as fol-

lows:

Petitioner 2007 2008 Total

THHC $209,875,725 $19,399,420 $229,275,145

HHPI 156,303,168 37,192,046 193,495,214

The total additional cumulative taxable revenue THHC

would have recognized through its 2008 tax year under the

percentage of completion method of accounting is

$239,897,451. The difference between this number and the

total $229,275,145 adjustment in the notice of deficiency is

due to adjustments for (1) gain recognized in the 2003 tax

year pursuant to a prior audit, (2) overreported gain for non-

exempt development activities, and (3) underreported gain

for nonexempt development activities.

The total additional cumulative taxable revenue HHPI

would have recognized through the 2008 tax year under the

percentage of completion method of accounting is

$231,791,739. The difference between this number and the

total $193,495,214 adjustment in the notice of deficiency is

due to (1) gain recognized in the 2003 tax year pursuant to

a prior audit, (2) overreported gain for nonexempt develop-

ment activities, and (3) overreported gain for exempt develop-

ment activities.

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376 142 UNITED STATES TAX COURT REPORTS (355)

Respondent’s adjustments resulted in his determination of

the following deficiencies:

Petitioner 2007 2008

THHC $73,456,504 $6,789,797

HHPI 50,633,554 13,228,620

Petitioners timely petitioned this Court for redetermination,

and a trial was held in Las Vegas, Nevada.

OPINION

I. Burden of Proof

Generally, the Commissioner’s determination of a tax-

payer’s liability for an income tax deficiency is presumed cor-

rect, and the taxpayer bears the burden of proving that the

determination is improper. See Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933). If a taxpayer’s method

of accounting does not clearly reflect income, section 446(b)

allows the Commissioner to change the taxpayer’s method of

accounting to one that does clearly reflect income. The

Commissioner is granted broad discretion in determining

whether an accounting method clearly reflects income, and

that determination is entitled to more than the usual

presumption of correctness. Commissioner v. Hansen, 360

U.S. 446, 467 (1959); RECO Indus., Inc. v. Commissioner, 83

T.C. 912, 920 (1984). The question of whether a particular

accounting method clearly reflects income is a question of

fact. Sam W. Emerson Co. v. Commissioner, 37 T.C. 1063,

1067 (1962).

To prevail, the taxpayer must establish that the Commis-

sioner abused his discretion in changing the method of

accounting. Prabel v. Commissioner, 91 T.C. 1101, 1112

(1988), aff ’d, 882 F.2d 820 (3d Cir. 1989). But the Commis-

sioner may not change a taxpayer’s method of accounting

from an incorrect method to another incorrect method. Id.

Nor may the Commissioner change a taxpayer’s method of

accounting ‘‘[w]here a taxpayer’s method of accounting is

clearly an acceptable method’’ and clearly reflects income. Id.

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 377

II. Custom Lot Contracts and Bulk Sale Agreements as Long-

Term Contracts

First, we must determine whether petitioners’ contracts

are long-term contracts. The parties stipulated that the

BDAs are long-term construction contracts. The notices of

deficiency determined deficiencies as if all of petitioners’ con-

tracts were long-term contracts. On brief respondent has

departed from that determination and contends that the cus-

tom lot contracts and the bulk sale agreements are not long-

term contracts. Generally, the Court will not allow a party

to raise an issue on brief if consideration of that issue would

surprise and prejudice the opposing party. Chapman Glen

Ltd. v. Commissioner, 140 T.C. 294, 349 (2013). Because we

do not think that petitioners need additional evidence to

respond to the new issue and respondent has not carried the

issue, we address it below. See id. (looking to ‘‘the degree to

which the opposing party is surprised by the new issue and

the opposing party’s need for additional evidence to respond

to the new issue’’ to determine prejudice). As to new issues,

respondent bears the burden of proof. See Rule 142(a)(1).

A. Custom Lot Contracts

Respondent alleges that none of petitioners’ custom lot con-

tracts qualify even for accounting under the percentage of

completion method because they are not long-term contracts.

Initially, respondent contends that many of the contracts

were entered into and closed within the same tax year and

they therefore cannot be considered long term within the

meaning of section 460. Second, respondent contends that

because petitioners did not have a legal obligation to perform

the construction activities contemplated by the contracts, the

contracts are not construction contracts. Petitioners, on the

other hand, first assert that the contracts are complete, for

the purposes of section 460, when they incur at least 95% of

the total allocable contract costs attributable to the contract’s

subject matter. They also contend that their contracts are

construction contracts that impose legal obligations upon

them.

A long-term contract is ‘‘any contract for the manufacture,

building, installation, or construction of property if such con-

tract is not completed within the taxable year in which such

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378 142 UNITED STATES TAX COURT REPORTS (355)

contract is entered into.’’ Sec. 460(f)(1). The relevant regula-

tion provides that the date a contract is completed is the ear-

lier of

(A) Use of the subject matter of the contract by the customer for its

intended purpose (other than for testing) and at least 95 percent of the

total allocable contract costs attributable to the subject matter have been

incurred by the taxpayer; or

(B) Final completion and acceptance of the subject matter of the con-

tract.

[Sec. 1.460–1(c)(3)(i), Income Tax Regs.]

But taxpayers determine the contract completion date ‘‘with-

out regard to whether one or more secondary items have

been used or finally completed and accepted.’’ Sec. 1.460–

1(c)(3)(ii), Income Tax Regs. In addition, the regulation

directs taxpayers to ‘‘consider all relevant facts and cir-

cumstances’’ in determining whether final completion and

acceptance has occurred. Sec. 1.460–1(c)(3)(iv), Income Tax

Regs.

If the subject matter of the custom lot contracts is solely

the sale of the piece of land, then petitioners’ custom lot con-

tracts would be complete upon close of escrow. The custom

lot contracts do indeed provide for the sale of a piece of land,

but they also reference numerous other documents, including

CC&Rs, development plans, and subdivision maps. Under

Nevada law, ‘‘ ‘[w]ritings which are made a part of the con-

tract by annexation or reference will be so construed; but

where the reference to another writing is made for a par-

ticular and specified purpose, such other writing becomes a

part for such specified purpose only.’ ’’ Lincoln Welding

Works, Inc. v. Ramirez, 647 P.2d 381, 383 (Nev. 1982)

(quoting Orleans M. Co. v. Le Champ M. Co., 284 P. 307

(Nev. 1930)). However, if the reference ‘‘indicates an

intention to incorporate * * * [the documents] generally,

such reference becomes a part of the contract for all pur-

poses.’’ Id.

The custom lot contracts contain a page whereon the pur-

chaser(s) acknowledge receipt of copies of numerous docu-

ments, which are listed on the page. 9 We believe that this

9 As

previously noted, the page reads in part: ‘‘ALL OF THE DOCU-

MENTS LISTED BELOW ARE IMPORTANT TO THE PURCHASE OF

THE LOT, SHOULD BE READ BY THE PURCHASER AND, AT THE

CLOSE OF ESCROW, SHALL BE DEEMED TO HAVE BEEN READ

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 379

sentence incorporates the documents listed, and, because

there is no indication that the reference is for a specific pur-

pose, we incorporate these documents generally.

After reviewing the custom lot contracts, the documents

referenced therein, and the testimony regarding Summerlin

as a master-planned community marketed as such by peti-

tioners, we are convinced that the subject matter of the con-

tracts encompasses more than just the sale of the lot. The

costs incurred for a custom lot contract are not really dif-

ferent from the costs for the finished lot sales. At the time

of trial, petitioners still had to complete a water service line,

traffic signals, landscaping, and construction of a park.

Therefore, we agree that final completion and acceptance

does not necessarily occur at the close of escrow, but rather

occurs when final completion and acceptance of the subject

matter of the contracts, which includes improvements whose

costs are allocable to the custom lot contracts, occurs. Cf.

Shea Homes, Inc. & Subs. v. Commissioner, 142 T.C. 60, 104

(2014). Consequently, petitioners are entitled to account for

the gain or loss from these contracts on the appropriate long-

term method of accounting under section 460 to the extent

the contracts are not completed within the taxable year in

which they are entered into.

In so holding, we reject respondent’s contention that the

contracts impose upon petitioners no separate legal obliga-

tion to complete the required improvements. The regulations

provide that a contract is a long-term contract under section

460 ‘‘if the manufacture, building, installation, or construc-

tion of property is necessary for the taxpayer’s contractual

obligations to be fulfilled and if the manufacture, building,

installation, or construction of that property has not been

completed when the parties enter into the contract’’ and the

contract is not completed within the contracting year. Sec.

1.460–1(b)(1) and (2)(i), Income Tax Regs.; see also Foothill

Ranch Co. P’ship v. Commissioner, 110 T.C. 94, 98–99 (1998).

For contracts that provide for the provision of land, the

regulations also contain a de minimis rule, under which if

the allocable costs attributable to construction activities do

not exceed 10% of the total contract price, the contract is not

a construction contract under section 460. Sec. 1.460–

AND APPROVED BY PURCHASER.’’

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380 142 UNITED STATES TAX COURT REPORTS (355)

1(b)(2)(ii), Income Tax Regs. To calculate the allocable costs,

the regulation allows a taxpayer to ‘‘include a proportionate

share of the estimated cost of any common improvement that

benefits the subject matter of the contract if the taxpayer is

contractually obligated, or required by law, to construct the

common improvement.’’ Id. Petitioners’ allocable costs attrib-

utable to construction activities exceed the 10% threshold.

Respondent appears to read this regulation as requiring a

taxpayer to have a legal obligation independent of any other

preexisting duty.

While we agree with respondent that work completed by

petitioners at the time the contracts are entered into cannot

transform a contract into a construction contract under sec-

tion 460, we disagree that the statute and the regulations

necessarily require that all construction activity obligations

be solely enforceable because of the contract. Respondent

believes that section 1.460–1(b)(2)(i), Income Tax Regs., codi-

fies the common law preexisting duty doctrine. Therefore, he

says that because petitioners are already obligated by statute

to complete various improvements, the obligations are not

contractual obligations.

The preexisting duty rule states that ‘‘a promise to do that

which the promisor is already legally obligated to do is

unenforceable.’’ Johnson v. Seacor Marine Corp., 404 F.3d

871, 875 (5th Cir. 2005). Nevada follows the preexisting duty

rule. Cnty. of Clark v. Bonanza No. 1, 615 P.2d 939, 944

(Nev. 1980). The Nevada Common-Interest Ownership Act

requires sellers, such as petitioners, to complete all improve-

ments depicted on any site plan or similar documents except

those labeled ‘‘NEED NOT BE BUILT’’, Nev. Rev. Stat. sec.

116.4119(1) (1991), and provides purchasers with a cause of

action, id. sec. 116.4117 (1997). 10

It is not clear that the preexisting duty rule applies in

these cases. The contracts between petitioners and the pur-

chasers are valid contracts with valid consideration inde-

pendent of the duties with respect to the development.

Second, while the Nevada statute does indeed seem to grant

10 We

note that Nev. Rev. Stat. sec. 116.4117 (1997) has been amended

numerous times since it was enacted in 1991. We refer to the statute as

amended and in effect for the years in which the contracts were entered

into.

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 381

purchasers a cause of action if petitioners fail to construct

improvements as shown on site plans or plats, the statute

explicitly provides: ‘‘The civil remedy provided by this section

is in addition to, and not exclusive of, any other available

remedy or penalty.’’ Id. sec. 116.4117(5). Therefore, it is

uncertain whether a Nevada court would apply the pre-

existing duty rule to petitioners’ contracts. See Johnson, 404

F.3d at 875 (‘‘[A]s long as the contracting parties gain some

legally enforceable right as a result of the contract which

they previously did not have, consideration is present[.]’’).

The public policy concerns that underpin the preexisting duty

rule do not seem to be present here. 11

In addition, we do not agree with respondent that section

1.460–1(b)(2), Income Tax Regs., codifies the preexisting duty

rule. The regulation clearly states that ‘‘how the parties

characterize their agreement (e.g., as a contract for the sale

of property) is not relevant’’ in determining the existence of

a section 460 construction contract. Sec. 1.460–1(b)(2)(i),

Income Tax Regs.; see also Koch Indus., Inc. & Subs. v.

United States, 603 F.3d 816, 822 (10th Cir. 2010) (citing the

regulation). As to the allocable costs attributable to common

improvements in the de minimis rule, the regulation does not

require that the obligation be solely contractual. Sec. 1.460–

1(b)(2)(ii), Income Tax Regs. Rather, the regulation allows a

taxpayer to include the allocable costs ‘‘if the taxpayer is

contractually obligated, or required by law, to construct the

common improvement.’’ Id. Nothing in the regulation

requires that the contract be the sole source of the obligation,

and, in fact, it indicates the opposite—that the obligation

may be noncontractual.

B. Bulk Sale Contracts

Respondent similarly contends that the bulk sale contracts

do not qualify as long-term construction contracts under sec-

tion 460. Specifically, respondent alleges that petitioners

have not established that they were obligated to construct

anything under these contracts. Respondent bases this posi-

11 In fact, the Nevada Common-Interest Ownership Act appears to en-

able parties other than those in contractual privity with the developer to

have standing to institute a lawsuit. See Nev. Rev. Stat. sec. 116.4117(2)

(allowing suit to be brought by a unit’s owner, not just the original pur-

chaser of the land from the developer).

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382 142 UNITED STATES TAX COURT REPORTS (355)

tion on his belief that the terms of the bulk sale contracts are

unknown and that petitioners failed to carry their burden of

proving that the contracts are entitled to a long-term con-

tract method of accounting.

We disagree that the bulk sale contracts are substantially

different from the pad sale BDAs. The parties stipulated that

the pad sale BDAs are construction contracts. The bulk sale

agreements are merely pad sale BDAs on a larger scale. The

record supports this conclusion. We heard credible testimony

from the vice president of finance for petitioners that the

bulk sale contracts were BDAs and that petitioners were

obligated to build the same types of common improvements

that benefited the property sold, such as regional water lines,

traffic signals, and detention basins. Thus, we hold that

these contracts too are construction contracts that may be

accounted for under section 460 as long-term contracts to the

extent consistent with this Opinion.

III. Completed Contract Method of Accounting

Because the Court has concluded that all of petitioners’

contracts are long-term construction contracts, we turn to the

question of whether the contracts are home construction con-

tracts. Section 460(a) provides generally that taxpayers must

determine taxable income from long-term contracts under the

percentage of completion method of accounting. Under this

method of accounting, taxpayers generally recognize gain or

loss throughout the duration of the contract. See sec. 1.460–

4(b), Income Tax Regs. (rules concerning percentage of

completion method). But in some instances taxpayers may

account for income from certain construction contracts under

other methods of accounting such as the completed contract

method. Sec. 460(e).

This section provides an exception to the percentage of

completion method of accounting for home construction con-

tracts and an exception for other construction contracts

where the taxpayers complete the contract within 24 months

and meet a gross receipts test. Sec. 460(e)(1)(A) and (B). The

parties have stipulated that most of petitioners’ contracts are

construction contracts as defined in section 460(e)(4). Peti-

tioners do not contend that they qualify for the second excep-

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 383

tion, so the question before us is whether petitioners’ con-

tracts qualify as home construction contracts.

Deferral of income tax, like exemptions and deductions, is

a matter of legislative grace, and exceptions to the normal

income recognition rules must be strictly construed. See, e.g.,

Bingler v. Johnson, 394 U.S. 741, 752 (1969) (‘‘[E]xemptions

from taxation are to be construed narrowly[.]’’); Estate of Bell

v. Commissioner, 928 F.2d 901, 903 (9th Cir. 1991) (‘‘The

deferral [of estate tax payment] benefits of section 6166 are

a ‘matter of legislative grace’ that is similar to the benefits

conferred by other statutory provisions dealing with deduc-

tions, exemptions and exclusions from tax. Thus, a strict and

narrow construction should be applied to the deferral benefit

provisions[.]’’), aff ’g 92 T.C. 714 (1989).

The parties disagree over whether contracts such as peti-

tioners’, where the seller does not build the house or any

improvements on the lot, qualify as home construction con-

tracts. Section 460(e)(6) defines a home construction contract

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 rowhouse shall be treated

as a separate building.

We refer to this definition as the 80% test. Paragraph (4)

referred to by section 460(e)(6)(A) provides: ‘‘For purposes of

this subsection, the term ‘construction contract’ means any

contract for the building, construction, reconstruction, or

rehabilitation of, or the installation of any integral compo-

nent to, or improvements of, real property.’’ Sec. 460(e)(4).

The statute defines dwelling unit by cross-reference as ‘‘a

house or apartment used to provide living accommodations in

a building or structure, but does not include a unit in a hotel,

motel, or other establishment more than one-half of the units

in which are used on a transient basis’’. Sec.

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384 142 UNITED STATES TAX COURT REPORTS (355)

168(e)(2)(A)(ii). 12 The parties do not dispute that pursuant to

the contracts, agreements, and government development

rules, the structures to be ultimately built upon the land

petitioners sell in the contracts at issue are dwelling units.

Importantly, however, petitioners did not build homes on

the land they sold, nor did qualifying dwelling units exist on

the sold land at the time of the sales. Petitioners have not

established that at the time of each sale qualifying dwelling

units would ever be built on the sold land. The bulk sale

agreement for Village 26 is especially troubling as no

construction had yet occurred years later and, because the

purchaser-builder defaulted on the contract, THHC still

owned half of the village. As far as we know, no qualifying

dwelling units will ever be built on these lands, 13 and

12 The relevant regulation largely follows the statute. It defines home

construction contracts as follows:

(i) In general.—A long-term construction contract is a home construc-

tion contract if a taxpayer (including a subcontractor working for a gen-

eral contractor) reasonably expects to attribute 80 percent or more of the

estimated total allocable contract costs (including the cost of land, mate-

rials, and services), determined as of the close of the contracting year,

to the construction of—

(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I), contained in

buildings containing 4 or fewer dwelling units (including buildings with

4 or fewer dwelling units that also have commercial units); and

(B) Improvements to real property directly related to, and located at

the site of, the dwelling units.

(ii) Townhouses and rowhouses.—Each townhouse or rowhouse is a

separate building.

(iii) Common improvements.—A taxpayer includes in the cost of the

dwelling units their allocable share of the cost that the taxpayer reason-

ably expects to incur for any common improvements (e.g., sewers, roads,

clubhouses) that benefit the dwelling units and that the taxpayer is con-

tractually obligated, or required by law, to construct within the tract or

tracts of land that contain the dwelling units.

[Sec. 1.460–3(b)(2), Income Tax Regs.]

13 We note that in a case of an insolvent builder, a bankruptcy court may

direct the trustee of the bankruptcy estate to petition the local government

for rezoning. See In re Lloyd, 37 F.3d 271, 274 (7th Cir. 1994) (affirming

the bankruptcy court’s direction to the trustee to seek to rezone property

from agricultural to residential to allow the debtor a homestead exemp-

tion). We also note that the Summerlin West and the Summerlin South de-

velopment agreements with Las Vegas and Clark County have been

amended from time to time by the parties. Thus, contractual promises or

obligations of third parties alone are, at least in this factual context, insuf-

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 385

deferral of income from contracts that might not ever result

in qualifying dwelling units seems entirely inappropriate

under these circumstances. Cf. Shea Homes, Inc. & Subs. v.

Commissioner, 142 T.C. at 105–106 (permitting deferral of

income from contracts where the completed qualifying

dwelling units were, themselves, included in the property

being sold and giving rise to the asserted taxable income).

Petitioners close the contracts and receive revenue without

needing to build a single home. In Shea Homes, the tax-

payers closed their contracts only after a certificate of occu-

pancy had been issued and simultaneously with the pur-

chasers’ taking possession of their house. Id. at 79. Peti-

tioners are under no contractual obligation to build homes as

their contracts are merely for the sale of land, developed to

varying degrees, to builders or individual customers who may

eventually build homes on that land.

In respondent’s mind, the definitions foreclose petitioners

from using the completed contract method of accounting.

Only the section 460(e)(4) costs directly associated with

building the actual house or improvements thereto qualify for

purposes of meeting the 80% test. Petitioners assert that

construction activity costs count in meeting the 80% test

even though they do not build the four walls or roof of a

dwelling unit. Under their interpretation, the ‘‘allocable

costs’’ include the costs of required infrastructure and

common improvements attributable to the dwelling units.

Even if true, this point, without more, would not be deter-

minative of their right to use section 460(e).

The starting point for interpreting a statute or a regulation

is its plain and ordinary meaning unless such an interpreta-

tion ‘‘would produce absurd or unreasonable results’’. Union

Carbide Corp. v. Commissioner, 110 T.C. 375, 384 (1998).

Undefined words take their ‘‘ordinary, contemporary,

ficient to ensure that qualifying dwelling units will in fact be constructed

on the sold land. When it comes to yet-to-be completed common improve-

ments, presumably bonds are posted, whereas the purchasers of the land

do not post or purchase bonds promising construction of homes. We cannot

therefore conclude that governmental zoning and entitlement agreements

and land sale contracts alone are enough to meet petitioners’ evidentiary

burden of establishing that the qualifying dwelling units requirement of

sec. 460(e)(6)(A) is or will be met.

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386 142 UNITED STATES TAX COURT REPORTS (355)

common meaning’’. Hewlett-Packard Co. & Consol. Subs. v.

Commissioner, 139 T.C. 255, 264 (2012).

A. Costs Attributable to Dwelling Units

Section 460(e)(6) defines a home construction contract, as

of the end of the taxable year when the contract was entered

into, by reference to the estimated total contract costs attrib-

utable to construction activity ‘‘with respect to’’ (i) dwelling

units and (ii) improvements to real property directly related

to the units and located on the site of the dwelling units. The

regulations clarify that the allocable contract costs to be

included in the 80% test must be attributable to the

construction of the units and the improvements thereto. Sec.

1.460–3(b)(2)(i), Income Tax Regs. 14

What does the statute mean when it says ‘‘attributable to’’

construction activities ‘‘with respect to’’ dwelling units and

improvements directly related to real property? Sec.

460(e)(6)(A). Respondent asserts that only costs incurred in

the actual construction of the dwelling units or their related

real property improvements count. Respondent contends that

the home construction contract exception requires the tax-

payer to build dwelling units or to build improvements to

real property directly related to and located on the site of

such dwelling units.

Petitioners claim the statute contemplates a broader defi-

nition of home construction costs. Under their interpretation,

they believe that their costs benefit dwelling units and real

property improvements related to and located on the site of

such dwelling units. Because the costs benefit dwelling units,

petitioners contend that the costs are therefore attributable

to the dwelling units and that these costs should count

towards meeting the 80% test. Under petitioners’ view,

because all of their development costs are attributable to

construction activity with respect to dwelling units and real

property improvements related to and located on the site of

14 Petitioners do not challenge the regulations, and accordingly we give

them their due deference. See sec. 460(h); Mayo Found. for Med. Educ. &

Research v. United States, 562 U.S. 44, 55–56 (2011) (applying to regula-

tions the test announced in Chevron, U.S.A. Inc. v. Natural Res. Def. Coun-

cil, Inc., 467 U.S. 837, 842–843 (1984)); cf. Shea Homes, Inc. & Subs. v.

Commissioner, 142 T.C.60, 98 n.18 (2014).

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 387

those dwelling units, section 460(e) is applicable even though

they do not construct the dwelling units.

Petitioners assert that because the costs are allocable to

the contracts and because the costs benefit the property sold

to the homebuilders and ultimately to individual buyers, the

costs are attributable to construction activities with respect

to the dwelling units or real property improvements. This

conclusion follows, according to petitioners, because the

statute does not confine the availability of the completed con-

tract method of accounting to those taxpayers who build the

dwelling units’ ‘‘sticks and bricks’’ and/or real property

improvements related to and located on the dwelling units’

lots.

Petitioners’ interpretation of the statute would make any

construction cost tangentially related to a dwelling unit or

real property improvement related to and located on the site

of the dwelling unit a cost to be counted in determining

whether a contract is a home construction contract. Without

petitioners’ development work, the pads and lots would be

mere patches of land in a desert. Petitioners’ work may

indeed be necessary for the ultimate home to feasibly be built

and occupied.

But these correlations do not mean that those costs are

necessarily incurred ‘‘with respect to’’ qualifying dwelling

units. ‘‘With respect to’’ implies a stronger proximate causa-

tion than petitioners’ interpretation permits. The preposi-

tional phrase ‘‘with respect to’’ can mean ‘‘as regards: insofar

as concerns: with reference to’’. Webster’s Third New Inter-

national Dictionary 1934 (2002). So the construction activi-

ties that count towards meeting the 80% test are defined by

reference to the dwelling unit. The phrase does not imply a

correlation as loose as proposed by petitioners, nor does it

encompass real property improvement activities that are

merely related to land which at some indeterminate future

time may perhaps become the site of a qualified dwelling

unit(s). Consequently, petitioners have failed to establish

that such construction costs are incurred with respect to

qualifying dwelling units.

At most the statute is ambiguous, and we look to section

1.460–3(b)(2)(i), Income Tax Regs., which clarifies the

statute. ‘‘Attribute’’ as used in the regulation means ‘‘to

explain as caused or brought about by: regard as occurring

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388 142 UNITED STATES TAX COURT REPORTS (355)

in consequence of or on account of ’’. Webster’s Third New

International Dictionary 142. The word implies causation,

and as used in the regulation, the plain meaning of

‘‘attribute to’’ is ‘‘caused by’’. 15 None of these costs, in our

view, are attributable to the construction of the dwelling

units, because petitioners do not intend to build such units

and neither the units nor the real property improvements

related to and located on the site of the dwelling units have

yet been built. The regulation is reasonable, and we conclude

it forecloses petitioners’ interpretation. See Chevron U.S.A.,

Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 842–843

(1984).

Congress added the exception for home construction con-

tracts in 1988. Technical and Miscellaneous Revenue Act of

1988 (TAMRA), Pub. L. No. 100–647, sec. 5041, 102 Stat. at

3673. Senator Dennis DeConcini and Representative Richard

T. Schulze were concerned that homebuilders would have to

recognize income not yet received and that costs would no

longer match revenues. 134 Cong. Rec. 20722–20723 (Aug. 5,

1988) (Sen. DeConcini); 134 Cong. Rec. 29962–29963 (Oct.

12, 1988) (Sen. DeConcini); 134 Cong. Rec. 20202 (Aug. 3,

1988) (Rep. Schulze). While the conference report is ulti-

mately silent as to why the exception was added in its final

form, it is clear that the intended beneficiaries of this relief

measure were taxpayers involved in ‘‘the building, construc-

tion, reconstruction, or rehabilitation of ’’ a home and not

land developers who do not build homes, even if essential

development work paves the way for, and thus facilitates,

home construction. TAMRA sec. 5041. 16

15 Cf. Lawinger v. Commissioner, 103 T.C. 428, 435 (1994) (discussing

the definition of ‘‘attributable to’’ in the context of sec. 117(m) of the Inter-

nal Revenue Code of 1954 and sec. 108(g)(2)(B) of the Internal Revenue

Code of 1986).

16 The Congressional Record reveals that Chairman Rostenkowski of the

House Ways and Means Committee, when moving to suspend the rules so

that the House could adopt the Conference Committee Report on H.R.

4333, stated that the conference report exempted ‘‘single family home-

builders from the provision’’ that restricted the completed contract method

of accounting. 134 Cong. Rec. 33112 (Oct. 21, 1988). Likewise, Representa-

tive Archer, the ranking House conference committee member, stated in

support of the conference report: ‘‘I was particularly pleased that we

changed the ‘completed contract method of accounting’ provisions under

current law to exempt single family residential construction—thereby

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 389

That Congress changed the wording of section 460(e)(4)

from ‘‘reasonably expected to be attributable to the building,

construction, reconstruction, or rehabilitation of ’’ to ‘‘reason-

ably expected to be attributable to activities referred to in

paragraph (4)’’ only confirms our view. Omnibus Budget Rec-

onciliation Act of 1989, Pub. L. No. 101–239, sec.

7815(e)(1)(A) and (B), 103 Stat. at 2419. This change added

‘‘the installation of any integral component to, or improve-

ments of, real property’’ to the list of construction activity.

Id. The purpose of this change was to ensure that costs

incurred in installing integral components such as heating or

air conditioning systems were qualifying costs. H.R. Rept.

No. 101–247, at 1411 (1989), 1989 U.S.C.C.A.N. 1906, 2881;

Staff of J. Comm. on Taxation, Description of Technical

Corrections Proposed to the Technical and Miscellaneous

Revenue Act of 1988, The Revenue Act of 1987, and Certain

Other Pension-Related Tax Legislation 4 (J. Comm. Print

1989). 17 Congress intended to extend this relief provision

only to taxpayers who have some direct dwelling construction

costs, as defined in section 460(e)(4).

In summary, the terms ‘‘with respect to’’, sec. 460(e)(6)(A),

or ‘‘attribute * * * to’’, sec. 1.460–3(b)(2)(i), Income Tax

Regs., do not qualify contracts as home construction con-

tracts when petitioners do not construct the home, prove that

a qualifying dwelling unit was built, or, in the case of pad

and bulk sales, even develop the immediate neighborhood.

We do not agree with petitioners’ assertion that the term

‘‘dwelling units’’ encompasses more than the home. Peti-

tioners urge us not to confine ‘‘dwelling unit’’ to the structure

built on the lot and would instead have that term encompass

all the relevant infrastructure that makes the unit suitable

for habitation. The regulations clarify this point by providing

a separate relief provision for such common improvements.

Sec. 1.460–3(b)(2)(B)(iii), Income Tax Regs. We recognize the

potential tension with our Opinion in Shea Homes, and we

address such concerns infra.

reducing the cost of homes.’’ Id.

17 We cite the Joint Committee on Taxation’s report for its persuasive

merit. See United States v. Woods, 571 U.S. ll, ll, 134 S. Ct. 557, 568

(2013).

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390 142 UNITED STATES TAX COURT REPORTS (355)

B. Section 406(e)(6)(A)(ii) Real Property Improvements

We disagree with petitioners that the statute allows their

construction activity costs to qualify because they are related

to and located on the site of the dwelling units. ‘‘Site’’,

according to petitioners, means Summerlin, not the indi-

vidual lot on which a house is later built. Petitioners reason

that because the statute uses the plural of dwelling unit—‘‘on

the site of such dwelling units’’—but does not use the plural

of ‘‘site’’, then the statute necessarily envisions a develop-

ment, like Summerlin, containing multiple dwelling units

and requires that a site be more than the lot upon which the

dwelling unit is built. Be that as it may, this argument is not

controlling here because it ignores the fact that the statute

allows a construction contract for a building with four or

fewer dwelling units to still be considered a home construc-

tion contract. Sec. 460(e)(6)(A)(i). Such a building would nec-

essarily consist of dwelling units (plural), but would sit on a

single site.

Petitioners read the preposition ‘‘on’’ in the phrase ‘‘on the

site’’ to connote proximity. Indeed, ‘‘on’’ can be used to

indicate contiguity. Webster’s Third New International Dic-

tionary 1574 (‘‘location closely adjoining something’’). But

‘‘on’’ is also used ‘‘to indicate position over and in contact

with that which supports from beneath’’. Id. By using the

phrase ‘‘at the site’’ in the regulations, respondent did not

necessarily interpret ‘‘on’’ to indicate proximity rather than

the narrower usage. While ‘‘at’’ can be used ‘‘to indicate pres-

ence in, on, or near’’, id. at 136, we do not think that in

choosing the word ‘‘at’’, as opposed to a phrase like ‘‘on or

nearby’’, the regulation intended to interpret ‘‘on the site’’

broadly.

Even if we were to view the statute as ambiguous in its

use of ‘‘on the site of ’’, the Secretary has resolved any ambi-

guity through regulatory gap-filling. And we are required to

defer to an agency’s permissible interpretation of an ambig-

uous statute. Chevron U.S.A., Inc., 467 U.S. at 842–843.

The Secretary believed that the statutory phrase might

prevent taxpayers from counting the costs of common

improvements towards the 80% test, and as a result many

large homebuilders might be unable to qualify for the com-

pleted contract method of accounting for home construction

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 391

contracts. He rightly ameliorated this problem by adopting

section 1.460–3(b)(2)(B)(iii), Income Tax Regs., which allows

taxpayers to count such costs as part of the cost of building

dwelling units for the purposes of the 80% test. The regula-

tion reflects a permissible—inescapable in our minds—

construction of the statute, and we defer to that construction.

See id. 18

The costs petitioners incur are, if anything, common

improvement costs as defined in section 1.460–3(b)(2)(iii),

Income Tax Regs. The regulations make clear that taxpayers

may include the allocable share of these common improve-

ment costs in the cost of the dwelling units. Id. But we agree

with respondent that the taxpayer must at some point incur

some construction cost with respect to the dwelling unit to

include these costs in the dwelling unit cost. We do not

believe that section 1.460–3(b)(2)(i) and (iii), Income Tax

Regs., allows a taxpayer with zero direct construction costs

with respect to dwelling units to simply add common

improvement costs for the purposes of the 80% test. Rather,

the regulation states that the taxpayer may ‘‘include’’ such

costs. Sec. 1.460–3(b)(2)(iii), Income Tax Regs. The regulation

allows the taxpayer to include only the share of the common

improvement costs allocable to the dwelling unit. Id. If the

taxpayer does not construct or intend to construct qualified

dwelling units, there is no allocable share of common

improvement costs.

18 In

addition, the legislative history supports our interpretation of ‘‘site’’

as limited to the site of the home. The conference committee report states:

[A] contract is a home construction contract if 80 percent or more of the

estimated total costs to be incurred under the contract are reasonably

expected to be attributable to the building, construction, reconstruction,

or rehabilitation of, or improvements to real property directly related to

and located on the site of, dwelling units in a building with four or fewer

dwelling units. * * * [H.R. Conf. Rept. No. 100–1104 (Vol. II), at 118

(1988), 1988–3 C.B. 473, 608; emphasis added.]

This sentence clearly shows that Congress used ‘‘dwelling units’’ in the

plural as opposed to the singular in sec. 460(e)(6)(A)(ii) because a construc-

tion contract for a building with four or fewer dwelling units could qualify

as a home construction contract. Congress did not intend the plural to ex-

pand the definition of ‘‘site’’ from the geographic limitations of the imme-

diate lot to the geographic boundaries, and even beyond, of the whole de-

velopment.

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392 142 UNITED STATES TAX COURT REPORTS (355)

Petitioners have no dwelling unit costs in which to include

the common improvement costs. The costs petitioners incur

are not the actual homes’ structural, physical construction

costs. Nor are they costs for improvements ‘‘located on’’ or

‘‘located at’’ the site of the homes. Therefore, petitioners may

not include these costs in testing whether 80% of their allo-

cable contract costs are attributable to the dwelling units and

real property improvements directly related to and located on

the site of the yet to be constructed dwelling units.

After reviewing the plain and ordinary meaning of the

statute and the regulation, we conclude that petitioners’ con-

tracts and agreements do not qualify as home construction

contracts. 19 Recently, we held that availability to home-

19 We

also do not think that respondent’s current position is inconsistent

with the Internal Revenue Service (IRS) material petitioners cite. For in-

stance, the IRS Non-Docketed Service Advice Review they referenced does

not say that a home construction contract need not involve the building of

a home. 2003 IRS Non-Docketed Service Advice Review 20006 (Jan. 18,

2003). Rather this document states that the activities enumerated by sec.

460(e)(4) encompass more than just building a house, such as rehabili-

tating a home or installing integral components. Id. As mentioned supra,

when Congress changed sec. 460(e)(6) to reference para. (4), thereby in-

cluding ‘‘the installation of any integral component to, or improvement of,

real property’’ in the qualifying costs of sec. 460(e)(6), it intended to allow

taxpayers who build components such as air conditioning and heating sys-

tems to potentially qualify their construction contracts as home construc-

tion contracts. Omnibus Budget Reconciliation Act of 1989, Pub. L. No.

101–239, sec. 7815(e)(1)(A), 103 Stat. at 2419; H.R. Rept. No. 101–247, at

1411 (1989), 1989 U.S.C.C.A.N. 1906, 2881. For an explication of the IRS’

current position, see Tech. Adv. Mem. 200552012 (Dec. 30, 2005), indi-

cating that the IRS believes the home construction exception is only avail-

able to the party who actually builds or produces a dwelling unit. Con-

sequently, a land developer who did not build any dwelling unit(s) could

not qualify.

We recognize that the proposed regulations, which would redesignate

sec. 1.460–3(b)(2)(iii), Income Tax Regs., as sec. 1.460–3(b)(2)(iv), if adopt-

ed, would expand the scope of the qualifying costs. Proposed Income Tax

Regs., 73 Fed. Reg. 45182 (Aug. 4, 2008). These regulations would modify

the definition of ‘‘improvements to real property directly related to, and lo-

cated on the site of, the dwelling units’’ by including costs of common im-

provements within that definition even if the contract does not provide for

the construction of any dwelling unit(s). Id. Not only does the preamble to

the proposed regulations explicitly caution taxpayers not to rely on these

regulations, id. at 45181, but by negative inference they add credence to

our view that petitioners’ position is unsupported by the wording of the

current statute and regulation.

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(355) HOWARD HUGHES CO., LLC v. COMMISSIONER 393

builders of the completed contract method of accounting is

‘‘generously broad and reflects a deliberate choice by Con-

gress that home construction contracts should be treated dif-

ferently’’, but only as to homebuilders. Shea Homes, Inc. &

Subs. v. Commissioner, 142 T.C. at 107–108. As for other

construction contracts, ‘‘[t]he completed contract method of

accounting is a narrow exception to the legislated rule that

most long-term contracts must now be accounted for under

the percentage of completion method of accounting’’, which

should be strictly construed. Id. at 107. Petitioners were not

homebuilders, and their contracts were not home construc-

tion contracts. Petitioners cannot account for gain or loss

from these contracts using the completed contract method of

accounting.

C. Shea Homes

In Shea Homes, we held that the subject matter of the

home construction contracts of the taxpayers, developers who

both developed land and built homes

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