[Federal Register Volume 73, Number 150 (Monday, August 4, 2008)]
[Proposed Rules]
[Pages 45180-45184]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-17830]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-120844-07]
RIN 1545-BG70


Rules for Home Construction Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and Notice of Public Hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations amending the 
regulations under Sec.  1.460 to provide guidance to taxpayers in the 
home construction industry regarding accounting for certain long-term 
construction contracts that qualify as home construction contracts 
under section 460(e)(6) of the Internal Revenue Code (Code) and to 
provide guidance to taxpayers with long-term contracts under section 
460(f) regarding certain changes in method of accounting for long-term 
contracts. This document also provides a notice of a public hearing on 
these proposed regulations.

DATES: Written comments must be received by November 3, 2008. Outlines 
of topics to be discussed at the public hearing scheduled for December 
5, 2008, at 10 a.m. must be received by November 13, 2008.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-120844-07), room 5203, 
Internal Revenue Service, POB 7604 Ben Franklin Station, Washington, DC 
20224. Submissions may be hand delivered Monday through Friday between 
the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-120844-07), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Federal eRulemaking Portal at 
www.regulations.gov (IRS REG-120844-07). The public hearing will be 
held in the auditorium, Internal Revenue Service Building, 1111 
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Brendan P. O'Hara, (202) 622-4920; concerning submission of comments, 
the hearing, or to be placed on the building access list to attend the 
hearing, Richard Hurst, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

    This document contains a proposed amendment to the Income Tax 
Regulations, 26 CFR part 1, under section 460 and Sec. Sec.  1.460-3, 
1.460-4, 1.460-5 and 1.460-6 of the Income Tax Regulations. In general, 
section 460(a) requires taxpayers to use the percentage of completion 
method (PCM) to account for taxable income from any long-term contract. 
Section 460(e) exempts home construction contracts from the general 
requirement to use the percentage of completion method of accounting. 
Section 460(e)(6) defines a home construction contract to be any 
construction contract if 80 percent or more of the total estimated 
contract costs are reasonably expected to be attributable to the 
construction of (i) dwelling units contained in buildings containing 4 
or fewer dwelling units, and (ii) improvements to real property 
directly related to such dwelling units and located on the site of such 
dwelling units. Section 460(e)(4) defines a construction contract to be 
any contract for the building, construction, reconstruction, or 
rehabilitation of, or the installation of any integral component to, or 
improvement of, real property.
    These proposed regulations expand the types of contracts eligible 
for the home construction contract exemption and amend the rules for 
how taxpayer-initiated changes in methods of accounting to comply with 
the regulations under section 460 may be implemented.

Definition of a Home Construction Contract

Improvements to Real Property

    The definition of a construction contract under section 460(e) 
includes many transactions involving land developers and construction 
service providers in the home construction industry. For example, a 
construction contract under section 460(e) includes a contract for the 
provision of land by the taxpayer if the estimated total allocable 
contract costs attributable to the taxpayer's construction activities 
(not including the cost of the land provided to the customer) are 10 
percent or more of the contract's total contract price.
    As noted, section 460(a) requires that the income from any long-
term contract be recognized using the percentage of completion method. 
However, taxpayers with contracts that meet the definition of a ``home 
construction contract'' are not required to use the percentage of 
completion method for those contracts and may use an exempt method. 
Exempt methods commonly used to account for home construction contracts 
include the completed contract method (CCM) and the accrual method.
    Under section 460, a home construction contract includes any 
construction contract if 80 percent of the total estimated contract 
costs are reasonably expected to be attributable to the construction of 
improvements to real property directly related to qualifying dwelling 
units and located on the site of such dwelling units. Commentators have 
suggested that many contracts entered into by land developers in the 
home construction industry should fall within the definition of a home 
construction contract.
    The proposed regulations expand the scope of the home construction 
contract exemption by providing that a contract for the construction of 
common improvements is considered a contract for the construction of 
improvements to real property directly related to the dwelling unit(s) 
and located on the site of such dwelling unit(s), even if the contract 
is not for the construction of any dwelling unit. Therefore, under the 
proposed regulations, a land developer that is selling individual lots 
(and its contractors and subcontractors) may have long-term 
construction contracts that qualify for the home construction contract 
exemption.

Townhouses, Rowhouses, and Condominiums

    Under section 460, a home construction contract also includes any 
construction contract if 80 percent of the total contract costs are 
reasonably expected to be attributable to the construction of dwelling 
units contained in buildings containing four or fewer dwelling units. 
Section 460(e)(6) states that each townhouse or rowhouse shall be 
treated as a separate building, regardless of the number of townhouses 
or rowhouses physically attached to each other. In certain 
circumstances, the terms condominium

[[Page 45181]]

and townhouse are used interchangeably to describe similar structures. 
Individual condominium units possess many of the characteristics 
generally associated with townhouses and rowhouses such as private 
ownership, shared portions of their structures, residential housing, 
and the economics of the underlying purchase transactions.
    The proposed regulations expand what is considered a townhouse or 
rowhouse, for purposes of the home construction contract exemption, to 
include an individual condominium unit. This will have the effect of 
allowing each condominium unit to be treated as a separate building for 
purposes of determining whether the underlying contract qualifies as a 
home construction contract.

Completed Contract Method

    Under the current regulations under section 460, the appropriate 
severing of a home construction contract requires a facts and 
circumstances analysis based upon certain factors that are neither 
specific nor always relevant to home construction contracts. Likewise, 
the date a home construction contract is considered completed and 
accepted is determined using a facts and circumstances analysis.
    The IRS and Treasury Department are aware of controversies related 
to the application of the existing facts and circumstances analyses for 
determining the appropriate severance and final completion and 
acceptance of home construction contracts accounted for using the 
completed contract method. Expanding the definition of a home 
construction contract as provided in these proposed regulations may 
heighten the significance of these issues. As a result, the IRS and 
Treasury Department expect to propose specific severing and completion 
rules for home construction contracts accounted for using the completed 
contract method. Taxpayers are encouraged to submit comments on the 
types of severing and completion rules that would result in the clear 
reflection of income for home construction contracts accounted for 
using the completed contract method. Specifically, the IRS and the 
Treasury Department request comments on the circumstances (if any) in 
which it would not be appropriate to require severing and completion of 
a home construction contract to be determined on a dwelling unit by 
dwelling unit or lot by lot basis or, when a contract is not for the 
sale of a dwelling unit or lot, on the basis of when the taxpayer 
receives payment(s) under the contract.

Method of Accounting

    Currently, the regulations under section 460 provide that a 
taxpayer that uses the percentage-of-completion method (PCM), the 
exempt-contract percentage-of-completion method (EPCM), or elects the 
10-percent method or special alternative minimum taxable income (AMTI) 
method, or that adopts or elects a cost allocation method of accounting 
(or changes to another method of accounting with the Commissioner's 
consent) must apply the method(s) consistently for all similarly 
classified contracts until the taxpayer obtains the Commissioner's 
consent under section 446 to change to another method of accounting. 
The regulations further provide that a taxpayer-initiated change in 
method of accounting will be permitted only on a cut-off basis (that 
is, for contracts entered into on or after the year of change), and 
thus, a section 481(a) adjustment will not be permitted nor required. 
The proposed regulations continue this cut-off method of implementation 
but only for taxpayer-initiated changes from a permissible PCM method 
to another permissible PCM method for long-term contracts for which PCM 
is required and for taxpayer-initiated changes from a cost allocation 
method of accounting that complies with the cost allocation rules of 
Sec.  1.460-5 to another cost allocation method of accounting that 
complies with the cost allocation rules of Sec.  1.460-5. Under the 
proposed regulations all other taxpayer-initiated changes in method of 
accounting under section 460 will be made with a section 481(a) 
adjustment.
    The proposed regulations provide that in determining the 
hypothetical underpayment or overpayment of tax for any year as part of 
the look-back computation, amounts reported as section 481(a) 
adjustments shall generally be taken into account in the tax year or 
years they are reported. For purposes of determining whether there is a 
hypothetical underpayment or overpayment of tax under the look-back 
computation, a taxpayer would use amounts reported under its old method 
for the years the old method was used and would use amounts reported 
under its new method for the years the new method was used, netted 
against the amount of any section 481(a) adjustments required to be 
taken into account. Thus, a look-back computation would not be required 
upon contract completion simply because the taxpayer has changed its 
method of accounting. However, a look-back computation would be 
required upon contract completion if actual costs or the contract price 
differ from the estimated amounts notwithstanding the fact a change in 
method of accounting occurred. For example, if a taxpayer using PCM 
changed its method of accounting for construction costs incurred in a 
contract reported under PCM, the section 460 look-back would be 
computed using the costs recognized prior to the year of change 
(reported under the taxpayer's old method of accounting) and the costs 
recognized in subsequent years using the new method of accounting, 
netted against any applicable section 481(a) adjustment. Similarly, for 
changes in methods of accounting where no costs were recognized under 
the old method of accounting (for example, a change in method of 
accounting from CCM to PCM), look-back would effectively only apply to 
years in which the taxpayer's new method of accounting was used to the 
extent that no costs were recognized prior to the year of change under 
the old method of accounting. This approach to the look-back 
computation is consistent with the underlying purpose of look-back as 
well as the general accounting method change procedures. Comments are 
specifically requested with respect to issues that taxpayers may 
foresee with respect to the rules provided in these proposed 
regulations for taking into account section 481(a) adjustments in the 
year reported for purposes of the look-back computation.

Proposed Effective/Applicability Date

    These regulations are proposed to apply to taxable years beginning 
on or after the date the final regulations are published in the Federal 
Register. The final regulations will provide rules applicable to 
taxpayers that seek to change a method of accounting to comply with the 
rules contained in the final regulations. Taxpayers may not change or 
otherwise use a method of accounting in reliance upon the rules 
contained in these new proposed regulations until the rules are 
published as final regulations in the Federal Register.

Special Analyses

    It has been determined that this proposed regulation is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply, and because the regulations do not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Code,

[[Page 45182]]

this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small businesses.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
with eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The IRS and Treasury Department request comments on the 
clarity of the proposed regulations and how they may be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for December 5, 2008, beginning 
at 10 a.m., in the auditorium of the Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (signed original and eight (8) copies) 
by November 13, 2008. A period of 10 minutes will be allotted to each 
person for making comments. An agenda showing the scheduling of the 
speakers will be prepared after the deadline for receiving outlines has 
passed. Copies of the agenda will be available free of charge at the 
hearing.

Drafting Information

    The principal author of these regulations is Brendan P. O'Hara, 
Office of Associate Chief Counsel (Income Tax and Accounting). However, 
other personnel from the IRS and Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.460-3 is amended by:
    1. Revising paragraph (b)(1)(ii).
    2. Redesignating paragraphs (b)(2)(ii), (b)(2)(iii) and (b)(2)(iv) 
as paragraphs (b)(2)(iii), (b)(2)(iv) and (b)(2)(v), respectively, and 
revising them.
    3. Adding a new paragraph (b)(2)(ii).
    The revisions and addition read as follows:


Sec.  1.460-3  Long-term construction contracts.

* * * * *
    (b) * * *
    (1) * * *
    (ii) Construction contract, other than a home construction 
contract, that a taxpayer estimates (when entering into the contract) 
will be completed within 2 years of the contract commencement date, 
provided the taxpayer satisfies the $10,000,000 gross receipts test 
described in paragraph (b)(3) of this section.
    (2) * * *
    (ii) Land improvements. For purposes of paragraph (b)(2)(i)(B) of 
this section, improvements to real property directly related to, and 
located on the site of, the dwelling units consist of improvements to 
land on which dwelling units (as described in paragraph (b)(2)(i)(A) of 
this section) are constructed, and common improvements as defined in 
paragraph (b)(2)(iv) of this section. A long-term construction contract 
is a home construction contract if a taxpayer (including a 
subcontractor working for a general contractor) meets the 80% test in 
paragraph (b)(2)(i) of this section as applied to either paragraph 
(b)(2)(i)(A) of this section or paragraph (b)(2)(i)(B) of this section, 
or both paragraphs (b)(2)(i)(A) and (b)(2)(i)(B) of this section, 
collectively.
    (iii) Townhouses and rowhouses. For purposes of determining whether 
a long-term construction contract is a home construction contract under 
paragraph (b)(2) of this section, each townhouse or rowhouse is a 
separate building. For this purpose, the term townhouse and rowhouse 
includes an individual condominium unit.
    (iv) Common improvements--(A) In general. A taxpayer includes in 
the cost of a dwelling unit or land its allocable share of the cost 
that the taxpayer incurs for any common improvements that benefit the 
dwelling unit or land.
    (B) Definition. For purposes of this section, a common improvement 
is an improvement that the taxpayer is contractually obligated, or 
required by law, to construct within the tract or tracts of land 
containing the dwelling units (or the land on which dwelling units are 
to be constructed) and that benefits the dwelling units (or the land on 
which dwelling units are to be constructed). In general, a common 
improvement does not solely benefit any particular dwelling unit or any 
particular lot on which a dwelling unit is constructed. However, land 
clearing and grading are common improvements, even when performed on a 
particular lot. Other examples of common improvements are sidewalks, 
sewers, roads and clubhouses.
    (v) Mixed use costs. If a contract involves the construction of 
both commercial units and dwelling units, a taxpayer must allocate the 
costs among the commercial units and dwelling units using a reasonable 
method or combination of reasonable methods. In general, the 
reasonableness of an allocation method will be based on facts and 
circumstances. Examples of methods that may be reasonable are specific 
identification, square footage, or fair market value.
* * * * *
    Par. 3. Section 1.460-4 is amended by:
    1. Revising the third sentence in paragraph (c)(1).
    2. Redesignating paragraph (g) as paragraph (g)(1) and revising 
newly redesignated paragraph (g)(1).
    3. Adding a paragraph (g)(2).
    4. Revising Example 5. of paragraph (h).
    The revisions and additions read as follows:


Sec.  1.460-4  Methods of accounting for long-term contracts.

* * * * *
    (c) * * *
    (1) * * * Permissible exempt contract methods are the PCM, the EPCM 
described in paragraph (c)(2) of this section, the CCM described in 
paragraph (d) of this section, the accrual method, and any other 
permissible method. * * *
* * * * *
    (g) Method of accounting--(1) In general. A taxpayer must apply its 
method(s) of accounting for long-term contracts consistently for all 
similarly classified long-term contracts until the taxpayer obtains the 
Commissioner's

[[Page 45183]]

consent under section 446(e) to change to another method of accounting.
    (2) Taxpayer-initiated change in method of accounting--(i) Change 
to PCM for long-term contracts for which PCM is required. A taxpayer-
initiated change in method of accounting for long-term contracts (or 
portion thereof) for which income must be determined using the PCM 
described in paragraph (b) of this section and the costs allocation 
rules described in Sec.  1.460-5(b) or (c) (required PCM contracts) 
from a method of accounting that does not comply with paragraph (b) of 
this section and Sec.  1.460-5(b) or (c) to a method that complies with 
paragraph (b) of this section and Sec.  1.460-5(b) or (c) must be 
applied to all required PCM contracts entered into before the year of 
change and not reported as completed as of the beginning of the year of 
change. Accordingly, a section 481(a) adjustment will be required.
    (ii) Change from a permissible PCM method to another permissible 
PCM method for long-term contracts for which PCM is required. A 
taxpayer initiated change in method of accounting for required PCM 
contracts, as defined in paragraph (g)(2)(i) of this section (or a 
portion thereof), from a method of accounting that complies with 
paragraph (b) of this section and Sec.  1.460-5(b) or (c) to another 
method of accounting that complies with paragraph (b) of this section 
and Sec.  1.460-5(b) or (c) must be made on a cut-off basis and applied 
only to contracts entered into during and after the year of change. 
Accordingly, a section 481(a) adjustment will be neither permitted nor 
required.
    (iii) Change to an exempt contract method for home construction 
contracts. A taxpayer-initiated change in method of accounting for home 
construction contracts, as defined in Sec.  1.460-3(b)(2), to a 
permissible exempt contract method, as described in paragraph (c)(1) of 
this section, must be applied to all home construction contracts 
entered into before the year of change and not reported as completed as 
of the beginning of the year of change. Accordingly, a section 481(a) 
adjustment will be required.
    (iv) Change to an exempt contract method for exempt contracts other 
than home construction contracts. A taxpayer-initiated change in method 
of accounting for long-term contracts (or portion thereof) not 
described in paragraphs (g)(2)(i), (ii) and (iii) of this section to a 
permissible exempt contract method as described in paragraph (c)(1) of 
this section must be applied to all contracts that are eligible to use 
the exempt contract method entered into before the year of change and 
not reported as completed as of the beginning of the year of change. 
Accordingly, a section 481(a) adjustment will be required.
    (h) * * *
* * * * *
    Example 5. PCM--contract terminated. C, whose taxable year ends 
December 31, determines the income from long-term contracts using 
the PCM. During 2001, C buys land and begins constructing a building 
that will contain 50 apartment units on that land. C enters into a 
contract to sell the building to B for $2,400,000. B gives C a 
$50,000 deposit toward the purchase price. By the end of 2001, C has 
incurred $500,000 of allocable contract costs on the building and 
estimates that the total allocable contract costs on the building 
will be $1,500,000. Thus, for 2001, C reports gross receipts of 
$800,000 ($500,000/$1,500,000 x $2,400,000), current-year costs of 
$500,000, and gross income of $300,000 ($800,000-$500,000). In 2002, 
after C has incurred an additional $250,000 of allocable contract 
costs on the building, B files for bankruptcy protection and 
defaults on the contract with C, who is permitted to keep B's 
$50,000 deposit as liquidated damages. In 2002, C reverses the 
transaction with B under paragraph (b)(7) of this section and 
reports a loss of $300,000 ($500,000-$800,000). In addition, C 
obtains an adjusted basis in the building sold to B of $700,000 
($500,000 (current-year costs deducted in 2001)-$50,000 (B's 
forfeited deposit) + $250,000 (current-year costs incurred in 2002). 
C may not apply the look-back method to this contract in 2002.
* * * * *
    Par. 4. Section 1.460-5 is amended by:
    1. Adding a new sentence to the end of paragraph (c)(2).
    2. Revising paragraph (g).
    The revision and addition read as follows:


Sec.  1.460-5  Cost allocation rules.

* * * * *
    (c) * * *
    (2) * * * Further, this election is not available if a taxpayer is 
changing from a cost allocation method other than as prescribed in 
paragraph (b) of this section, in which case the taxpayer must follow 
the procedures under Sec.  1.446-1(e) for obtaining the Commissioner's 
consent for the change in method of accounting.
* * * * *
    (g) Method of accounting. A taxpayer that adopts, elects, or 
otherwise changes to a cost allocation method of accounting (or changes 
to another cost allocation method of accounting with the Commissioner's 
consent) must apply that method consistently for all similarly 
classified contracts, until the taxpayer obtains the Commissioner's 
consent under section 446 to change to another cost allocation method. 
A taxpayer-initiated change in cost allocation method from a method 
that does not comply with the cost allocation rules of this section to 
a method that complies with the cost allocation rules of this section 
must be applied to all long-term contracts to which the rules of this 
section apply, including contracts entered into before the year of 
change and not reported as completed as of the beginning of the year of 
change. Accordingly, a section 481(a) adjustment is required. Any other 
taxpayer-initiated change in cost allocation method to a method 
permitted under the rules of this section must be made on a cut-off 
basis and applied only to contracts entered into during and after the 
year of change, in which case a section 481(a) adjustment will be 
neither permitted nor required.
    Par. 5. Section 1.460-6 is amended by:
    1. Adding paragraph (c)(3)(vii).
    2. Redesignating paragraph (d)(2)(iv) as paragraph (d)(2)(v).
    3. Adding a new paragraph (d)(2)(iv).
    The additions and revision read as follows:


Sec.  1.460-6  Look-back method.

* * * * *
    (c) * * *
    (3) * * *
    (vii) Section 481(a) adjustments. For purposes of determining the 
hypothetical underpayment or overpayment of tax for any year, amounts 
reported as section 481(a) adjustments shall be taken into account in 
the tax year or years they are reported. However, any portion of a 
section 481(a) adjustment not yet reported as of the tax year in which 
the contract is completed shall be taken into account in the tax year 
the contract is completed for purposes of determining the hypothetical 
underpayment or overpayment of tax.
* * * * *
    (d) * * *
    (2) * * *
    (iv) Section 481(a) adjustments. For purposes of determining the 
hypothetical underpayment or overpayment of tax for any year under the 
simplified marginal impact method, amounts reported as section 481(a) 
adjustments shall be taken into account in the tax year or years they 
are reported. However, any portion of a section 481(a) adjustment not 
yet reported as of the tax year in which the contract is completed 
shall be taken into account in the tax year the contract is completed 
for purposes of determining

[[Page 45184]]

the hypothetical underpayment or overpayment of tax.
* * * * *

Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
 [FR Doc. E8-17830 Filed 8-1-08; 8:45 am]
BILLING CODE 4830-01-P