                               142 T.C. No. 20



                      UNITED STATES TAX COURT



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 individual lots
   to individual purchasers or custom home builders, who then construct
   homes. In all instances, Ps do not construct 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
                                        -2-

      construction contracts within the meaning of I.R.C. sec. 460(e). R
      further contends the land sale contracts are not long-term construction
      contracts and are not eligible for the long-term percentage 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 contracts using the completed contract method of
      accounting.



      Stephen F. Gertzman, Kevin L. Kenworthy, Steven R. Dixon, Mary W.B.

Prosser, and Sat Nam S. Khalsa, for petitioners.

      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
                                         -3-

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. Petitioners, 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 stipulation of facts, both

with accompanying exhibits, are incorporated 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 outside the city of Las Vegas,

      1
       Unless otherwise noted, all section references are to the Internal Revenue
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.
                                        -4-

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 corporation 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 organized HHPI, which in turn purchased the

undeveloped acreage 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 limited partnership,

which, through another limited partnership, 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
                                         -5-

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 properties have not yet been sold to third parties.

Summerlin

      During the years at issue petitioners were in the residential land

development business. They generated revenue primarily by selling property to

builders who would then construct and sell homes. In some cases, they also sold

property to individual buyers who would then construct single-family 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 approximately 220,000

residents. While Summerlin is largely residential, it is a fully integrated

community, which means it includes commercial, educational, and recreational
                                           -6-

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 village

up to a parcel boundary. Petitioners then sold the parcel to a buyer, who was


       2
       The parties disagree over whether the bulk sales contracts are in substance
different from the pad sales contracts. We resolve this issue infra.
                                          -7-

usually a homebuilder. The builder, with petitioners’ approval, was responsible

for all of the infrastructure (such as streets and utilities) within the parcel and

subdividing the parcel into lots. In a finished lot sale, petitioners also divided the

village into parcels. They then further 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, petitioners 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 purport 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

      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 contracts, 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 “individual purchaser” but is
irrelevant to our ultimate holding. For simplicity, we will rely on the parties’
                                                                          (continued...)
                                         -8-

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 homebuyer--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.

      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


      3
        (...continued)
stipulation.
                                        -9-

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 agreements 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 LDVA 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 agreement, the

LVDA governed land development in Summerlin West. Las Vegas also amended

its City General Plan to incorporate the Summerlin West General Development
                                         - 10 -

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 village 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 improvements 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
                                        - 11 -

government center. In addition, HHPLP was to donate land to the city for a public

park with sports and recreational 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 improvements in connection with each village. Standard improvements

were “mitigation measures and improvements required for intersections and

roadways immediately adjacent 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
                                        - 12 -

signed and recorded a development agreement (CCDA) in February 1996 to

govern the development of Summerlin South. Before the CCDA, 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 developed 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 envisioned development by phases called villages,

and HHPLP agreed to submit a Village Development Plan before beginning

development of a village. HHPLP also agreed to submit with the Village

Development Plan a traffic study, a drainage 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 nonresidential 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
                                        - 13 -

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

systems. 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

facilities 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 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
                                         - 14 -

for recreational purposes or 30 acres or more for a sports park to be designed and

constructed by HHPI, and a community center and outdoor aquatic center to be

designed and constructed by HHPI.

Developing Summerlin--Covenant, Conditions, and Restrictions

      Petitioners and their predecessors in interest recorded Master Declarations,

which govern use of the land by subsequent owners. These declarations, also

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

restrictions and protective covenants, but also created homeowners 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 declarations.

      The Master Declarations provided for the establishment of village

subassociations through new declarations. The subassociation declarations

supplemented the Master Declarations. 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 neighborhood, which could include a gated community,

consists of properties which share exclusive amenities or common areas.
                                       - 15 -

      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 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

created by the adjacent villages.

      Generally, the first step in petitioners’ development activities 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.
                                       - 16 -

      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 developing

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 immediately 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 tentative map,

petitioners were required to also submit a final subdivision map. In the case of
                                        - 17 -

pad sales, the builders also had to prepare and submit tentative and final maps to

further subdivide the pad land into lots. The pad purchase contracts governing pad

sales also required the builders to first submit these maps to petitioners for

approval.

      The final map showed roads and easements that petitioners 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 agreements 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 landscaping. 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 ownership.

      Petitioners also used tax-exempt SIDs financing to finance construction of

some Summerlin infrastructure improvements. In a project financed by SID
                                        - 18 -

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.

Villages at Issue

      Respondent’s determinations concern income from 107 BDAs4 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


      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 Village 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 attached 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.
                                        - 19 -

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 parties have also agreed on a BDA that

is representative of finished 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


      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.
                                          - 20 -

development. With respect to Village 26, known as Reverence, the first half of the

sale to Pulte Homes, Inc., now known as Pulte Group, Inc., occurred in December

2006, just before the 2007 housing market collapse, and neither petitioners nor the

purchaser have done any work on this property. In fact, the sale of Village 26 was

to occur in two parts, but the purchaser defaulted on the second half of the

contract. 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 associations received some roads, swimming pools, open

spaces, and medians, whereas the municipalities received police stations, fire

stations, other roads, traffic signals, and street lights.
                                       - 21 -

      Some of these improvements were necessary for construction 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 construction 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 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 petitioners required builders to use natural

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

per residence.
                                        - 22 -

      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 signals, the driveway

depressions, the perimeter and retaining walls, entry monumentation, and

landscaping. HHPI also graded the parcel, including the lots. And HHPI agreed

      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.
                                        - 23 -

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 perform 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 utilities,

and other agencies. The plans governed the curbs, gutters, 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 landscaping, 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 declaration 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 association. The

development declaration, entered at the time of closing of phase 1, contained a

number of additional restrictions on KB Home. The declaration allowed KB
                                       - 24 -

Home to construct only single-family homes in accordance with a development

plan. The declaration preserved HHPI’s control over design of homes and

landscaping by requiring that they conform to HHPI’s residential design criteria

for The Mesa Village and to the landscape standards. The design criteria

governed everything from lot grading to home finishes.

      The declaration required KB Home to create a development plan. The

development plan had to describe landscaping 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 architectural

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 development 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, model homes, interior screen walls, curb scribes, and water meters.
                                        - 25 -

      Pad Sale--Lyon BDA

      The second purchase and sale agreement is an example of a pad sale. This

agreement was between Old THHC and William Lyon Homes, Inc. (Lyon), for the

sale of Parcel M in Village 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 supplemental 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 materials 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 defective, Lyon had to, at its

own cost, correct the problem.
                                        - 26 -

      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 parties

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 necessary for the purchaser’s project. THHC also agreed to

construct 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

bordering the property and to stub the wet and dry utilities to the parcel.

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 contracts are representative of the other custom lot contracts

at issue in these cases.
                                       - 27 -

      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 connections from the property line to Purchaser’s Home and
      for making all necessary arrangements with each of the public utilities
      for service. Purchaser acknowledges that HHP is not improving the
      Lot and has not agreed to improve the Lot for Purchaser except as
      provided in this Section 7. Purchaser will be responsible for finish
      grading and preparation of the building pad and acknowledges that
      HHP has not agreed to provide 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
                                          - 28 -

phases of Arrowhead, The Ridges or the surrounding area or nearby property”. A

similar provision was in the Redhawk contract. The contracts also contained

integration clauses. Paragraph 23 of the representative contracts stated:

      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
      supersedes 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

      7
          The parties did not provide copies of the attachments to the two
                                                                         (continued...)
                                        - 29 -

      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 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


      7
        (...continued)
representative 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 attachments are
generally representative of the exhibits attached to a contract for the purchase and
sale of a custom lot in Village 18.
                                       - 30 -

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 contained maps showing the walls and

fences HHPI had to construct. 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 landscaping improvements in common lots.

Tax Reporting

      For the years at issue, petitioners used the completed contract 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.

      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.
                                        - 31 -

      Petitioners broke down estimated BDA costs into three categories: 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;

landscaping; parks; deposits; other; and contingency. Regional 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 categories, 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 different improvements. For instance, GCW applied the unit rate based on
                                       - 32 -

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 villages 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 arterial costs were all also allocated in proportion to

village acreage. Traffic signal costs, however, were allocated to the village(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 formula based on

historical actual costs. This formula yielded an estimated incremental cost of

improvements of $40,000 per lot.
                                        - 33 -

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 petitioners 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 petitioners’ methods of accounting from the

completed contract method of accounting to the percentage of completion method

of accounting. Respondent adjusted petitioners’ income as follows

           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
                                        - 34 -

gain for nonexempt 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

development activities, and (3) overreported gain for exempt development

activities.

       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.
                                       - 35 -

                                     OPINION

I.    Burden of Proof

      Generally, the Commissioner’s determination of a taxpayer’s liability for an

income tax deficiency is presumed correct, 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 Commissioner 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 Commissioner

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
                                        - 36 -

method of accounting “[w]here a taxpayer’s method of accounting is clearly an

acceptable method” and clearly reflects income. Id.

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’ contracts were long-term contracts. On brief respondent has departed

from that determination and contends that the custom 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).
                                        - 37 -

      A.     Custom Lot Contracts

      Respondent alleges that none of petitioners’ custom lot contracts 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 contract is not completed within

the taxable year in which such contract is entered into.” Sec. 460(f)(1). The

relevant regulation provides that the date a contract is completed is the earlier 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
                                        - 38 -

      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 contract.

Sec. 1.460-1(c)(3)(i), Income Tax Regs. But taxpayers determine the contract

completion date “without 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 circumstances” 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 contracts 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 contract by annexation or reference will be so construed; but

where the reference to another writing is made for a particular 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
                                          - 39 -

reference “indicates an intention to incorporate * * * [the documents] generally,

such reference becomes a part of the contract for all purposes.” Id.

      The custom lot contracts contain a page whereon the purchaser(s)

acknowledge receipt of copies of numerous documents, which are listed on the

page.9 We believe that this sentence incorporates the documents listed, and,

because there is no indication that the reference is for a specific purpose, 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 petitioners, we are convinced that the subject matter of the contracts

encompasses more than just the sale of the lot. The costs incurred for a custom lot

contract are not really different 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

      9
     As previously noted, the page reads in part: “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.”
                                        - 40 -

includes improvements whose costs are allocable to the custom lot contracts,

occurs. Cf. Shea Homes, Inc. & Subs. v. Commissioner, 142 T.C. ___, ___ (slip

op. at 73) (Feb. 12, 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 obligation 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 construction 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), (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
                                        - 41 -

not a construction contract under section 460. Sec. 1.460-1(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 attributable 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 section 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., codifies 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
                                        - 42 -

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 improvements 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 purchasers are valid contracts with valid

consideration independent of the duties with respect to the development. Second,

while the Nevada statute does indeed seem to grant 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

preexisting 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




      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.
                                        - 43 -

present[.]”). The public policy concerns that underpin the pre-existing 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.

      11
         In fact, the Nevada Common-Interest Ownership Act appears to enable
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 purchaser of the land from the
developer).
                                        - 44 -

      B.     Bulk Sale Contracts

      Respondent similarly contends that the bulk sale contracts do not qualify as

long-term construction contracts under section 460. Specifically, respondent

alleges that petitioners have not established that they were obligated to construct

anything under these contracts. Respondent bases this position 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 contract

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.
                                        - 45 -

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 contracts. 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 contracts 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). Petitioners do not contend that they qualify for the second

exception, so the question before us is whether petitioners’ contracts qualify as

home construction contracts.
                                        - 46 -

      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 deductions,

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 petitioners’, where the

seller does not build the house or any improvements on the lot, qualify as home

construction contracts. 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
                                        - 47 -

                   (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 component

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

      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
      construction contract if a taxpayer (including a subcontractor working
      for a general contractor) reasonably expects to attribute 80 percent or
      more of the estimated total allocable contract costs (including the cost
      of land, materials, 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),
                                                                       (continued...)
                                         - 48 -

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

      12
       (...continued)
      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
      reasonably expects to incur for any common improvements (e.g.,
      sewers, roads, clubhouses) that benefit the dwelling units and that the
      taxpayer is contractually 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.
                                       - 49 -

village. As far as we know, no qualifying dwelling units will ever be built on

these lands,13 and deferral of income from contracts that might not ever result in

qualifying dwelling units seem entirely inappropriate under these circumstances.

Cf. Shea Homes, Inc. & Subs. v. Commissioner, 142 T.C. at ___ (slip op. at 75-76)

(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 taxpayers

closed their contracts only after a certificate of occupancy had been issued and

simultaneously with the purchaser’s taking possession of their house. Id. at ___


      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 exemption). We also
note that the Summerlin West and the Summerlin South development 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, insufficient to ensure that qualifying dwelling units
will in fact be constructed on the sold land. When it comes to yet-to-be completed
common improvements, 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.
                                        - 50 -

(slip op. at 33). Petitioners 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 determinative

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 interpretation “would produce absurd or

unreasonable results”. Union Carbide Corp. v. Commissioner, 110 T.C. 375, 384

(1998). Undefined words take their “ordinary, contemporary, common meaning”.

Hewlett-Packard Co. & Consol. Subs. v. Commissioner, 139 T.C. 255, 264 (2012).
                                        - 51 -

      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 attributable 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




      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. __, __, 131 S. Ct. 704, 713 (2011) (applying to regulations
the test announced in Chevron, U.S.A. Inc. v. Natural Res. Def. Council, Inc., 467
U.S. 837, 842-843 (1984)); cf. Shea Homes, Inc. & Subs. v. Commissioner, 142
T.C. ___, ___ (slip op. at 64 n.18) (Feb. 12, 2014).
                                        - 52 -

exception requires the taxpayer 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 definition 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

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 contract method of accounting to those taxpayers who build the
                                       - 53 -

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 causation than petitioners’ interpretation permits. The prepositional

phrase “with respect to” can mean “as regards: insofar as concerns: with reference

to”. Webster’s Third New International Dictionary 1934 (2002). So the

construction activities 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,
                                        - 54 -

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 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 contracts 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

      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 Internal Revenue
Code of 1954 and sec. 108(g)(2)(B) of the Internal Revenue Code of 1986).
                                        - 55 -

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 ultimately 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, construction,

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

      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 “reasonably expected to be attributable to activities referred to

in paragraph (4)” only confirms our view. Omnibus Budget and Reconciliation


      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 homebuilders from the provision” that
restricted the completed contract method of accounting. 134 Cong. Rec. 33112
(Oct. 21, 1988). Likewise, Representative 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
reducing the cost of homes.” Id.
                                        - 56 -

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 improvements

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 contracts 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. Petitioners urge


      17
       We cite the Joint Committee on Taxation’s report for its persuasive merit.
See United States v. Woods, 571 U.S. ___, ___, 134 S. Ct. 557, 568 (2013).
                                        - 57 -

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, Inc. & Subs., and we address such concerns infra.

      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

individual 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

development, 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 construction contract. Sec. 460(e)(6)(A)(i). Such a
                                        - 58 -

building would necessarily 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 Dictionary 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 presence 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 ambiguity through regulatory gap-filling. And

we are required to defer to an agency’s permissible interpretation of an ambiguous

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 completed

contract method of accounting for home construction contracts. He rightly
                                        - 59 -

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 regulation 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

improvement 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

      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. * * * [Emphasis added.]

H.R. Conf. Rept. No. 100-1104 (Vol. II), at 118 (1988), 1988-3 C.B. 473, 608.
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 construction contract for
a building with four or fewer dwelling units could qualify as a home construction
contract. Congress did not intend the plural to expand the definition of “site” from
the geographic limitations of the immediate lot to the geographic boundaries, and
even beyond, of the whole development.
                                        - 60 -

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.

      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 allocable 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’ contracts and agreements do not qualify
                                       - 61 -

as home construction contracts.19 Recently, we held that availability to

homebuilders of the completed contract method of accounting is “generously

broad and reflects a deliberate choice by Congress that home construction

      19
         We also do not think that respondent’s current position is inconsistent with
the Internal Revenue Service (IRS) material petitioners cite. For instance, 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 rehabilitating a home or installing integral components.
Id. As mentioned supra, when Congress changed sec. 460(e)(6) to reference para.
(4), thereby including “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
systems to potentially qualify their construction contracts as home construction
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), indicating that the IRS believes the
home construction exception is only available to the party who actually builds or
produces a dwelling unit. Consequently, 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 adopted, 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 located on the site of, the
dwelling units” by including costs of common improvements 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.
                                        - 62 -

contracts should be treated differently”, but only as to homebuilders. Shea Homes,

Inc. & Subs. v. Commissioner, 142 T.C. at ___ (slip op. at 78-79). 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 ___, slip op. at 78. Petitioners were not

homebuilders, and their contracts were not home construction 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,

included the home, the lot on which the home sat, and the common improvements

and amenities. Therefore, we held that in testing contract completion, the

taxpayers were entitled to apply the use and 95% completion test by using the

contract costs, after including the allocable share of the costs of the common

improvements and amenities of the development or development phase which

included the dwelling unit(s).
                                        - 63 -

      In reaching this conclusion, we looked in part at the definition of home

construction contract to inform our understanding of the regulation’s use of

“subject matter” of the contract. We concluded that section 460(e)(6)(A) defined a

home construction contract, and that “the regulations expand this definition to

allow taxpayers to include ‘the allocable share of the cost that the taxpayer

reasonably expects to incur for any common improvement.’” Shea Homes, Inc. &

Subs. v. Commissioner, 142 T.C. at ___ (slip op. at 70) (quoting section 1.460-

3(b)(2)(iii), Income Tax Regs.). We believed that the fact that the regulations

expanded the universe of costs to be considered when deciding whether a contract

qualified as a home construction contract was “at minimum instructive” when

deciding when that contract is subsequently completed.

      But at no point in Shea Homes did we say that a home construction contract

could consist solely of common improvement costs. The starting point in Shea

Homes was that the taxpayers’ contracts were for the construction of qualifying

dwelling units. Those taxpayers developed land and built homes, and so when

testing whether their contracts were home construction contracts, they were

permitted by the regulations to add to the costs of the dwelling units they

constructed their common improvement costs. And, when testing the contract
                                        - 64 -

completion date, they looked to when they incurred 95% of the costs of the subject

matter of the contract.

      Our Opinion today draws a bright line. A taxpayer’s contract can qualify as

a home construction contract only if the taxpayer builds, constructs, reconstructs,

rehabilitates, or installs integral components to dwelling units or real property

improvements directly related to and located on the site of such dwelling units. It

is not enough for the taxpayer to merely pave the road leading to the home, though

that may be necessary to the ultimate sale and use of a home. If we allow

taxpayers who have construction costs that merely benefit a home that may or may

not be built, to use the completed contract method of accounting, then there is no

telling how attenuated the costs may be and how long deferral of income may last.

We cautioned in a footnote in Shea Homes, Inc. & Subs. v. Commissioner, 142

T.C. at ___ n.24 (slip op. at 82), that there is a temporal component to the home

construction contract exception and contract completion.20 We think it consistent

      20
         The regulations caution that “taxpayers may not delay the completion of a
contract for the principal purpose of deferring federal income tax.” Sec. 1.460-
1(c)(3)(iv)(A), Income Tax Regs. In these cases, petitioners would often build
infrastructure as needed. For instance, the costs of a road or a water line that is
anticipated to benefit a village may upon request, see supra p. 16, not be incurred
for many years. This may lead to a situation where the contract completion date
could be substantially delayed. We do not suggest that developers intentionally
build ghost towns by building out infrastructure in excess of demand, but we
                                                                        (continued...)
                                         - 65 -

with congressional intent that a line should be drawn here so as to exclude

petitioners’ contracts, when we cannot conclude that qualifying dwelling units will

ever be built.

      Of course, the contract does not necessarily have to be for the actual sale of

a home. The regulations make clear that a subcontractor’s contract may qualify as

a home construction contract. For instance, a subcontractor who does the

electrical work inside the home may have a home construction contract.

Petitioners attempt to characterize their relationship with the homebuilders as a

general contract or subcontractor relationship. In an interesting and innovative

twist, petitioners try to characterize themselves as the subcontractor in the

relationship, as if the builders are subcontracting out all of this infrastructure and

extra-home development work to petitioners. But this is not the relationship the

parties have chosen. See Commissioner v. Nat’l Alfalfa Dehydrating & Milling

Co., 417 U.S. 134, 149 (1974) (“[W]hile a taxpayer is free to organize his affairs

as he so chooses, nevertheless, once having done so, he must accept the tax


      20
        (...continued)
suggest that such costs would not necessarily be a proper part of a home
construction contract. This is especially important for contracts qualifying for the
completed contract method of accounting where such a delay coupled with just-in-
time, as-needed improvements construction indeterminately defer recognition of
income.
                                        - 66 -

consequences of his choice, whether contemplated or not, and may not enjoy the

benefit of some other route he might have chosen to follow but did not.” (Citations

omitted.)).

IV.   Conclusion

      Petitioners’ contracts are not home construction contracts within the

meaning of section 460(e). Petitioners may not account for these contracts using

the completed contract method of accounting. The custom lot contracts and the

bulk sale agreements are, however, long-term construction contracts for which

petitioners, if those contracts are entered into in a year before their completion,

may use a permissible method of accounting for long-term contracts, such as the

percentage of completion method.

      The Court has considered all of the parties’ contentions, arguments,

requests, and statements. To the extent not discussed herein, the Court concludes

that they are moot, irrelevant, or without merit.


                                                 Decisions will be entered for

                                        respondent.
