                                           SHEA HOMES, INC. AND SUBSIDIARIES, ET AL., 1 PETITIONERS
                                             v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
                                                Docket Nos. 29271–09, 1400–10,                    Filed February 12, 2014.
                                                             1401–10.

                                                   Corporation C and partnerships S and V develop large,
                                                planned residential communities. They develop the land and
                                                construct homes and common improvements, including amen-
                                                ities. For the years at issue they reported income from their
                                                contracts for the sale of homes using the completed contract
                                                method of accounting. Under their interpretation of this
                                                method of accounting, their contracts are complete when they
                                                meet the use and 95% test pursuant to sec. 1.460–1(c)(3)(A),
                                                Income Tax Regs., and incur 95% of the costs of the develop-
                                                ment. They contend that final completion and acceptance
                                                pursuant to sec. 1.460–1(c)(3)(B), Income Tax Regs., does not
                                                occur (after excluding secondary items, if any, pursuant to sec.
                                                1.460–1(c)(3)(B)(ii), Income Tax Regs.) until the last road is
                                                paved and the final bond is released. R seeks to place C, S,
                                                and V on his interpretation of the completed contract method.
                                                R contends that the subject matter of the contracts of C, S,
                                                and V consists only of the houses and the lots upon which the
                                                houses are built. Under R’s interpretation, the contract for
                                                each home meets the final completion and acceptance test
                                                upon the close of escrow for the sale of each home. R also
                                                alleges that contracts entered into and closed within the same
                                                taxable year are not long-term contracts under I.R.C. sec. 460.
                                                Held: The subject matter of the contracts consists of the home
                                                and the larger development, including amenities and other
                                                common improvements. Held, further, C, S, and V are per-
                                                mitted to report income and losses from sales of homes in
                                                their planned developments using their interpretation of the
                                                completed contract method of accounting.

                                       Gerald A. Kafka, Rita A. Cavanagh, Chad D. Nardiello,
                                     and Sean M. Akins, for petitioners.
                                       Melissa D. Lang, Allan E. Lang, David Rakonitz, and
                                     Nicholas D. Doukas, for respondent.
                                       WHERRY, Judge: These consolidated cases are before the
                                     Court on a petition for redetermination of deficiencies in
                                     income tax respondent determined for petitioner Shea
                                     Homes, Inc., and Subsidiaries’ 2004 and 2005 tax years; a
                                           1 Cases
                                               of the following petitioners are consolidated herewith: Shea
                                     Homes, LP, J F Shea, LP, f.k.a. J F Shea, LLC, Tax Matters Partner, dock-
                                     et No. 1400–10; and Vistancia, LLC, Shea Homes Southwest, Inc., Tax
                                     Matters Partner, docket No. 1401–10.

                                     60




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   61


                                     petition for review of notices of final partnership administra-
                                     tive adjustment respondent issued for the 2004, 2005, and
                                     2006 tax years of Shea Homes, LP; and a petition for review
                                     of notices of final partnership administrative adjustment
                                     respondent issued for the 2004 and 2005 tax years of
                                     Vistancia, LLC.
                                        The ultimate issue for decision in these cases is whether
                                     Shea Homes, Inc., and Subsidiaries, Shea Homes, LP, and
                                     Vistancia, LLC, properly reported income and loss from the
                                     sale of homes in their planned developments using the com-
                                     pleted contract method of accounting provided for in section
                                     460. 2 The resolution of this issue turns on the determination
                                     of whether the home sale contracts include the development
                                     amenities or are limited to the house and the lot on which
                                     it sits.

                                                                          FINDINGS OF FACT

                                       The parties’ stipulation of facts and the accompanying
                                     exhibits are incorporated herein by this reference.
                                     Petitioners
                                        Petitioner in docket No. 29271–09, Shea Homes, Inc. (SHI),
                                     and Subsidiaries, is an affiliated group of corporations with
                                     the common parent, SHI, organized under the laws of Dela-
                                     ware. At all relevant times SHI maintained its principal
                                     offices in Walnut, California. SHI used the accrual method as
                                     its overall method of accounting for the years at issue.
                                        The partnership in docket No. 1400–10, Shea Homes, Lim-
                                     ited Partnership (SHLP), is a limited partnership organized
                                     under the laws of California. J F Shea, LP, f.k.a. J F Shea,
                                     LLC (JFLP), is the tax matters partner of SHLP. 3 At all rel-
                                     evant times SHLP maintained its principal offices in Walnut,

                                           2 Unless
                                                  otherwise indicated, all section references are to the Internal
                                     Revenue Code of 1986 (Code), as amended and in effect for the taxable
                                     year at issue, and all Rule references are to the Tax Court Rules of Prac-
                                     tice and Procedure. All monetary amounts are rounded to the nearest dol-
                                     lar unless otherwise noted.
                                        3 Effective April 1, 2005, JFLP was converted from a Delaware limited

                                     liability company, known as J F Shea, LLC, to its current form as a lim-
                                     ited partnership.




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                                     62                  142 UNITED STATES TAX COURT REPORTS                                          (60)


                                     California. SHLP used the accrual method as its overall
                                     method of accounting for the years at issue.
                                        The partnership in docket No. 1401–10, Vistancia, LLC
                                     (Vistancia), is a limited liability company organized under
                                     the laws of Delaware. Shea Homes Southwest, Inc. (SHSI),
                                     is the tax matters partner of Vistancia. At all relevant times
                                     Vistancia maintained its principal offices in Scottsdale,
                                     Arizona. Vistancia used the accrual method as its overall
                                     method of accounting for the years at issue.
                                        During the tax years at issue, SHI, SHLP, and Vistancia
                                     deferred revenue, costs of sales, and income from the con-
                                     tracted-for sales of homes that closed in escrow as follows:

                                                           2002                2003           2004             2005            2006

                                     SHI:
                                      Revenue               ---                 ---        $81,066,693     $122,237,525         ---
                                      Cost of
                                       sales                ---              ---            64,005,169       80,638,808         ---
                                      Income                             $9,260,993         17,061,524       41,598,717
                                     Vistancia:
                                      Revenue               ---                 ---         92,348,246      310,218,513         ---
                                      Cost of
                                       sales                ---              ---            66,561,918      212,621,241         ---
                                      Income                ---           8,835,716         25,786,328       97,597,272         ---
                                     SHLP:
                                      Revenue               ---        289,761,283         563,962,237      944,999,695   $956,921,373
                                      Cost of
                                       sales                ---        235,477,059         417,368,568      678,173,038     739,981,843
                                      Income1            $182,000       54,284,224         146,593,669      266,826,659     216,939,529
                                        1 In 2002, SHLP deferred $3,149,537 of income. It then determined that it had erro-
                                     neously deferred $2,967,537 of that amount; and rather than file an amended return
                                     for 2002, it included the $2,967,537 in income on the 2003 return, which respondent
                                     accepted. The remaining $182,000 has apparently not yet been recognized. In addi-
                                     tion, the parties stipulated that the income calculation for the 2006 year contains a
                                     rounding error. The income calculation for the 2005 year also likely contains a round-
                                     ing error.

                                       For the tax years at issue, SHI, SHLP, and Vistancia
                                     deferred some income from the sales of homes in the tax
                                     years the contracts for those sales closed in escrow and then
                                     recognized part of that income for Federal income tax pur-
                                     poses in following years as follows:




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                      63


                                                                    Year             Deferred              Year        Amount
                                                                   deferred          income             recognized    recognized

                                                 SHI                2003             $9,260,993           2007        $9,260,993
                                                                    2004             17,061,524           2007        17,061,524
                                                                    2005             41,598,717           2007        41,598,717
                                                 Vistancia          2003              8,835,716           2009         8,835,716
                                                                    2004             25,786,328           2009        25,786,328
                                                                    2005           1 97,597,272           2009        97,597,272
                                                 SHLP               2002              3,149,537           2003         2,967,537
                                                                    2003           2 54,466,226           2004        35,127,818
                                                                                                          2005        18,234,951
                                                                                                          2006         1,103,457
                                                                    2004          3 146,593,669           2005        40,817,288
                                                                                                          2006       101,577,422
                                                                                                          2007         4,198,958
                                                                    2005           266,826,659            2006        60,556,813
                                                                                                          2007        48,350,567
                                                                                                          2008        33,374,188
                                                                                                          2009        21,215,992
                                                                    2006           216,939,529            2007        32,896,005
                                                                                                          2008        64,557,454
                                                                                                          2009        49,310,872
                                                                                                          2010        39,173,387
                                                   1 Paragraph 42(c) of the parties’ stipulation of facts reports the
                                                 amount deferred as $97,597,272. Paragraph 79 of the stipulation
                                                 reports the amount deferred as $97,597,273. This $1 discrepancy
                                                 may be the result of rounding.
                                                   2 This amount is derived from paragraph 79 of the parties’ stipu-
                                                 lation of facts and is in partial conflict with the $54,284,226
                                                 amount specified by paragraph 46(c) of the stipulation. This dis-
                                                 crepancy is the apparent result of the $182,000 of deferred but not
                                                 yet recognized income. See supra p. 62, table note 1.
                                                   3 Paragraph 48(c) of the parties’ stipulation of facts reports the
                                                 amount deferred as $146,593,669. Paragraph 79 of the stipulation
                                                 reports the amount deferred as $146,593,668. The $1 discrepancy
                                                 may be the result of rounding.


                                     Deficiencies and Adjustments to Income
                                       Respondent determined the following deficiencies with
                                     respect to the Federal income tax of SHI:

                                                                                                                   Additional
                                                Year                            Deficiency                       amended amount
                                                2004                            $5,971,533                           $3,241,348
                                                2005                            14,559,551                               ---

                                     The additional amended amount in the above table rep-
                                     resents the amount respondent asserted in an amendment to
                                     his answer. Respondent asserts that this additional tax due
                                     amount is necessary under section 481(a) to prevent its
                                     permanent exclusion from Federal income taxation because
                                     of respondent’s change in SHI’s method of accounting.




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                                     64                  142 UNITED STATES TAX COURT REPORTS                                      (60)


                                       Respondent also proposed the following adjustments to
                                     partnership income with respect to SHLP and Vistancia:

                                                                             Adjustments to                       Additional
                                                          Year          partnership income items               amended amounts

                                       SHLP               2003                    $54,284,226                       $182,000
                                                          2004                    111,465,850                           ---
                                                          2005                    266,826,659                           ---
                                                          2006                    216,939,529                           ---
                                       Vistancia          2004                     25,786,328                       8,835,716
                                                          2005                     97,597,272                           ---


                                     Again, the additional amended amounts of taxable income
                                     are the amounts respondent alleges, by way of amended
                                     answer, are necessary under section 481(a). We also note
                                     that the partnership adjustments to the Federal taxable
                                     income of SHLP and Vistancia would have ultimately
                                     resulted in additional taxable income to the partners and
                                     may have resulted in significant additional tax due at the
                                     partner level.
                                       Respondent calculated the above amounts by including in
                                     income amounts SHI, SHLP, and Vistancia deferred using
                                     the completed contract method of accounting as reported on
                                     schedules attached to their tax returns and as supported by
                                     their underlying work papers. These amounts do not reflect
                                     various computational, correlative adjustments. Petitioners,
                                     SHI, JFLP, and SHSI, timely petitioned this Court for
                                     review, and a trial was held in Washington, D.C.
                                     Company Background
                                       The Shea family has been in the home development busi-
                                     ness for more than 40 years. The home development business
                                     was operated through several entities, including SHI, SHLP,
                                     and Vistancia. During the years at issue the Shea family
                                     companies were one of the largest private homebuilders in
                                     the United States.
                                           Business Model
                                       SHI, SHLP, and Vistancia are builders/developers of
                                     planned communities, ranging in size from 100 homes to
                                     more than 1,000 homes in Colorado, California, and Arizona.
                                     During the years at issue they sold homes in 114 develop-
                                     ments. For the purposes of these cases, the parties have




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   65


                                     selected eight representative developments and have agreed
                                     that the Court’s findings of fact based on documents and
                                     information from these sample developments will be control-
                                     ling for all developments. 4
                                         The eight developments are each representative of a divi-
                                     sion. They are: (1) Trilogy at La Quinta; (2) Vistancia; (3)
                                     Parkside at Reunion; (4) Breakers at Pointe Marin; (5) Costa
                                     Azul; (6) Azure; (7) Country Lane; and (8) Sommerset at
                                     Morgan Hill. SHI, SHLP, and Vistancia conducted their
                                     home development business through divisions, organized on
                                     the basis of the geographic locations of their developments,
                                     except in the case of the Active Adults Division,
                                     which was based on the type of development. These divisions
                                     were as follows: (1) Active Adults Division; (2) Arizona Divi-
                                     sion; (3) Colorado Division; (4) Northern California Division;
                                     (5) Southern California Division; (6) San Diego Division; (7)
                                     Inland Empire Division; and (8) Sacramento Division.
                                         SHI, SHLP, and Vistancia pride themselves on providing
                                     their customers with more than just the ‘‘bricks and sticks’’
                                     of a home and emphasize the features and lifestyle of the
                                     community to potential buyers. For example, at the Reunion
                                     at Parkside community they advertised using the themes
                                     ‘‘live well, work well, play well’’ and ‘‘the pursuit of happi-
                                     ness’’.
                                         SHI, SHLP, and Vistancia purchased land in various
                                     stages from completely raw to finished lots in developed
                                     communities. Their business involved the analysis and
                                     acquisition of land for development and the construction and
                                     marketing of homes and the design and/or construction of
                                     developments and homes on the land they acquired. The
                                     costs incurred in their home construction business included,
                                     by partial example: (1) acquisition of land; (2) financing; (3)
                                     municipal and other regulatory approvals of entitlements; (4)
                                     construction of infrastructure; (5) construction of amenities;
                                     (6) construction of homes; (7) marketing; (8) bonding; (9) site
                                     supervision and overhead; and (10) taxes. Their primary
                                     source of revenue from the home development business was
                                     from the sale of houses.
                                       4 The agreement is subject to an exception where it is necessary for the

                                     Court to make specific findings pertaining to the adjustments at issue, cor-
                                     relative adjustments, or any other computational findings.




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                                     66                  142 UNITED STATES TAX COURT REPORTS                                      (60)


                                       We discuss infra the general process SHI, SHLP, and
                                     Vistancia used in their home development business. Much of
                                     the trial was dedicated to the details of the process, and we
                                     by no means list every single step. Our intention is not to
                                     discount those important steps not mentioned but to give a
                                     general idea of how the development process worked.
                                           Land Acquisition
                                       The initial step in the process is to acquire land on which
                                     to build the developments. Divisions of SHI, SHLP, and
                                     Vistancia are responsible for identifying parcels of land as
                                     candidates for development. After identification, the divisions
                                     evaluate multiple factors to ascertain whether that property
                                     constitutes a viable development opportunity. If a division
                                     determines that the land is viable for development, it pre-
                                     pares a Land Committee Report which summarizes the divi-
                                     sion’s evaluation of the factors used to evaluate that parcel.
                                     The Land Committee Report is then sent to the Land Com-
                                     mittee, comprising senior executives, including owners, for
                                     approval.
                                           Design of Developments
                                       The developments are typically designed by architects,
                                     engineers, and consultants engaged by SHI, SHLP, and
                                     Vistancia. The final design for the planned construction of
                                     the developments is presented on a map or plat called a
                                     Tract Map. The Tract Map is submitted for approval to the
                                     county or municipality in which the development will be
                                     located. SHI, SHLP, and Vistancia may be required, before
                                     or after formal submission, to revise the design of the
                                     development using input from the county or municipality.
                                           Performance Bonds
                                       SHI, SHLP, and Vistancia were required by State and
                                     municipal law to post bonds to secure their performance with
                                     respect to the completion of the common improvements in
                                     their developments. 5 The bonds required them to complete
                                       5 A surety bond is a promise to pay a party (the obligee) its loss up to

                                     a certain amount (the bond amount) if a second party (the obligor) fails
                                     to meet one or more obligations. A performance bond is a surety bond
                                     issued by an insurance company or bank (the surety) in favor of an obligee
                                     to guarantee satisfactory completion of a project by an obligor. In the real




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   67


                                     the obligations specified therein before the bonds are exoner-
                                     ated. When performance bonds are required, they are posted
                                     before or concurrent with the approval by and recording with
                                     a governmental authority of a map or plat with respect to the
                                     development. The amount of a performance bond depended
                                     on the State and municipal law and the nature, extent, and
                                     anticipated costs of the common improvements. The costs are
                                     estimated by the obligee with the assistance of experts.
                                        The obligor must purchase the bond by paying a premium
                                     to the surety. The surety prices the performance bond pre-
                                     mium according to the risk associated with the obligor, the
                                     amount of the performance bond, and the term of the
                                     performance bond. If an obligor fails to fulfill the conditions
                                     of the performance bond, then the obligee may file a claim
                                     with the surety by sending the surety a letter detailing the
                                     failure of the obligor to perform under the conditions of the
                                     performance bond. Upon receiving the claim from an obligee,
                                     the surety forwards the claim to the obligor, who is required
                                     to manage the claim process, including all associated costs.
                                     If a surety is required to pay any of the bond amount to the
                                     obligee, the surety is entitled to recover the amount paid
                                     from the obligor and/or any third-party guarantor pursuant
                                     to indemnifications the obligor generally must enter into
                                     with respect to each surety.
                                        The obligee must approve of the completion of the subject
                                     matter before the performance bond will be exonerated.
                                     Obtaining the approval of an obligee may involve negotiation
                                     between the parties as to whether the obligor has satisfied
                                     the terms of the performance bond. For example, municipali-
                                     ties may require an obligor to repave roads, fix curbs, install
                                     fire hydrants, or construct additional infrastructure common
                                     improvements before releasing the obligor. Homeowners
                                     associations may, as examples, require an obligor to repave
                                     nature trails, fix steps in common areas, or improve a club-
                                     house before releasing the obligor from a performance bond.
                                     The obligees identified in the performance bonds of SHI,
                                     SHLP, and Vistancia included the homeowners associations

                                     estate development context, a performance bond is a surety bond issued by
                                     a surety in favor of an obligee to guarantee satisfactory completion of,
                                     among other things, common improvements with respect to a development
                                     constructed by an obligor (the developer).




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                                     68                  142 UNITED STATES TAX COURT REPORTS                                      (60)


                                     formed with respect to their developments as well as the
                                     municipalities and States in which the developments are
                                     situated.
                                        A performance bond may be accompanied by a bond
                                     guaranteeing payment of labor and material costs incurred in
                                     the development. These bonds are referred to as ‘‘labor and
                                     material bonds’’ or ‘‘payment bonds’’. They are surety bonds
                                     that supplement a performance bond for labor and material
                                     costs with respect to the conditions in the performance bond.
                                     The obligor of a labor and material bond may pay an addi-
                                     tional premium to post the bond, or the premium may be
                                     included in the premium price of the associated performance
                                     bond. The amount, premium price, and process for exonera-
                                     tion of a labor and material bond or payment bond is similar
                                     to that used for a performance bond.
                                        SHI, SHLP, and Vistancia posted performance bonds, labor
                                     and material bonds, and additional surety bonds for all eight
                                     representative developments. For Trilogy at La Quinta, SHI
                                     posted 28 bonds ranging in amount from $24,625 to
                                     $3,726,220 with premiums between $163 and $12,000. 6 The
                                     obligees on these bonds were the city of La Quinta, the
                                     County of Riverside, the California State government, and
                                     the Trilogy at La Quinta Maintenance Association. These
                                     bonds were exonerated between January 30, 2007, and
                                     December 21, 2010, with one bond for $2 million still out-
                                     standing as of the date of the trial in these cases. 7
                                        For the Parkside at Reunion development, SHLP posted
                                     six bonds ranging in amount from $23,592 to $3,300,000 with
                                     premiums between $464 and $13,200. The obligees were
                                     Commerce City and the County of Douglas. 8 Two bonds are
                                           6 These
                                                figures and the ones discussed below are from bond reports pro-
                                     vided by petitioners and in evidence as stipulations and/or stipulated ex-
                                     hibits except in the case of Vistancia. The factual and documentary record
                                     concerning the bonds is spotty. The parties included original documents as
                                     to some of the bonds, but in other cases we rely solely on the bond reports.
                                     The parties did not provide a bond report for Vistancia, but they did pro-
                                     vide a number of bond documents.
                                       7 Likewise, the bonds noted infra as outstanding were outstanding as of

                                     the date of the trial.
                                       8 The bond for the benefit of Douglas County is confusing to the Court

                                     as it is presented as used in connection with the Parkside at Reunion de-
                                     velopment, but the Exhibit 187–P listing references Highlands Ranch.
                                     Parkside is in Adams County, whereas Highlands Ranch is in Douglas




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   69


                                     still outstanding. The other four bonds were exonerated
                                     between October 5, 2006, and March 19, 2009.
                                        For Breakers at Pointe Marin, SHLP posted 23 bonds
                                     ranging in amounts from $1,677 to $1,708,400. The bond
                                     report does not list the premiums paid, but other exhibits
                                     reflect a $100 premium per bond for the other earlier
                                     Breakers at Pointe Marin surety bonds of $1,677, $1,845,
                                     $2,348, $2,012, $3,689, and $2,348. The obligee on these
                                     surety bonds was Pointe Marin Association, the develop-
                                     ment’s homeowners association. Exhibits also show perform-
                                     ance bonds ranging from $58,635 to $82,151 with premiums
                                     ranging from $150 to $410. The obligee of these bonds was
                                     also the homeowners association. Obligees for the remaining
                                     bonds listed on the bond report were Novato Sanitary Dis-
                                     trict, North Marin Water District, and the city of Novato.
                                        As to Costa Azul, SHLP posted five bonds. SHLP posted a
                                     performance bond in the amount of $500,000, with a pre-
                                     mium of $2,500. The State of California was the obligee on
                                     this bond. SHLP also posted bonds in the amounts of
                                     $10,950, $9,816, and $7,164 with premiums of $110, $100,
                                     and a premium amount not disclosed by the trial record,
                                     respectively. The fifth bond was for $172,000. The record
                                     again does not reflect the premium, but the obligee was the
                                     County of Orange. These bonds were exonerated as early as
                                     January 9, 2009, and as late as July 19, 2010.
                                        For Azure, SHLP posted 22 bonds. These bonds included a
                                     $300,000 bond with a $1,050 premium. The obligee on this
                                     bond was the State of California. Of the remaining bonds, at
                                     least two were surety bonds for $20,824 and $1,885 issued
                                     with the development’s San Elijo Hills Community Home-
                                     owners Association as the obligee. The premiums for these
                                     bonds were $104 and $100, respectively. The remaining 19
                                     bonds ranged in amount from $1,105 to $98,500. The
                                     exoneration dates on all bonds ranged from January 19,
                                     2005, to July 1, 2008.
                                        With respect to Country Lane, SHLP posted only one bond.
                                     This bond was for $330,657, the obligee was the State of
                                     Arizona, and the exoneration date was November 1, 2004.

                                     County with the County of Arapahoe and/or the City and County of Denver
                                     in between. The explanation may involve utilities such as water or sewage
                                     treatment or an error in the exhibit.




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                                     70                  142 UNITED STATES TAX COURT REPORTS                                      (60)


                                        As for Sommerset at Morgan Hill, the bond report shows
                                     that SHLP posted five bonds. According to the report, these
                                     bonds ranged in amount from $52,750 to $570,800. The
                                     obligee on four of these bonds was the County of Riverside,
                                     and the obligee on the fifth bond was the County of San
                                     Bernardino. The report reflects that three of these bonds
                                     were exonerated on December 7, 2007. The parties also
                                     included an unsigned copy of a surety bond not included in
                                     the bond report reflecting a sixth bond for $300,000 with a
                                     premium of $1,050 and the State of California as the obligee.
                                        Finally, for Vistancia, the parties introduced evidence of
                                     three performance bonds. These bonds were for $134,358,
                                     $346,971, and $235,441 with premiums of $672, $1,735, and
                                     $1,177, respectively. The obligee on the $134,358 bond was
                                     the city of Peoria, Maricopa County, Arizona. The obligee on
                                     the other two was the development’s homeowners associa-
                                     tion.
                                           Budgeting
                                        SHI’s, SHLP’s, and Vistancia’s operating divisions pre-
                                     pared budgets for the direct and indirect costs relating to the
                                     construction of developments. They prepared the budgets on
                                     a development-wide basis by compiling a budget file, referred
                                     to as a Tract-Property Investment Evaluator file (Tract-PIE
                                     file). 9 They used this tool to monitor the anticipated and
                                     actual development costs and the projected and actual rev-
                                     enue from the sale of homes in the development. They also
                                     updated the development’s Tract-PIE file on an annual, semi-
                                     annual, or quarterly basis depending on the needs of the par-
                                     ticular development.
                                        The Tract-PIE data inputs included: incurred costs and
                                     revenue received with respect to the development (actuals);
                                     job cost reports containing estimated unincurred costs (job
                                     cost); 10 sales and marketing forecasts (sales and marketing);
                                     estimated construction costs per home model (direct construc-
                                        9 Tract-PIE is a commercial software tool used to forecast and monitor

                                     the costs and revenue associated with constructing a development.
                                        10 The job cost data input is the estimated, non-home-specific construc-

                                     tion costs, including estimated costs for the purchase of land, design of the
                                     development, construction of infrastructure and amenity common improve-
                                     ments, labor, fees, and property taxes.




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   71


                                     tion template); 11 estimated revenue from the sales of homes
                                     (sale price revenue); and inflation and appreciation assump-
                                     tions (inflation/appreciation). Respondent does not challenge
                                     the accuracy of the construction budgets.
                                        Estimates of revenue from home sales involved projections
                                     of the average price of sold homes, the sales absorption rate,
                                     the construction cycle, and price appreciation, among other
                                     variables. SHI, SHLP, and Vistancia came up with their
                                     anticipated revenue starting with a projection of the number
                                     of houses they intended to build in a development and how
                                     many different floor plans they intended to offer. The divi-
                                     sions estimated, using experience and sometimes the help of
                                     outside consultants, a sale price for each floor plan.
                                        The prices per floor plan were exclusive of any discount or
                                     premium for views, lot size, or other aesthetic draws or draw-
                                     backs. Rather SHI, SHLP, and Vistancia estimated each pre-
                                     mium and discount as a development-wide number; then
                                     they divided that number by the projected number of units
                                     to arrive at an average discount and premium per unit. SHI,
                                     SHLP, and Vistancia used the average price per home, plus
                                     the premium and less the discount, to come up with a gross
                                     revenue figure and, after considering forecasted sales pace,
                                     added on additional revenue for expected future price
                                     increases.
                                        Similarly, SHI, SHLP, and Vistancia generally estimated
                                     costs on a development-wide basis, although some costs are
                                     estimated on a per-unit basis and extrapolated to a develop-
                                     ment-wide basis (e.g., their initial pro forma for Azure esti-
                                     mated a permitting cost of $3,000 per house). But they could
                                     roughly estimate costs on an average per-unit basis by
                                     dividing the total amount of estimated costs by the estimated
                                     number of homes to be sold.
                                        The Land Committee Report discussed supra included an
                                     estimated budget of that development’s revenue and
                                     expenses. SHI, SHLP, and Vistancia also summarized esti-



                                       11 The direct construction template consists of the estimated costs on a

                                     per-square-foot basis to construct each home model sold in that develop-
                                     ment.




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                                     mated costs and revenues on a so-called napkin, 12 which
                                     included information from the Land Committee. On these
                                     reports ‘‘direct expenses’’ represented the actual ‘‘bricks and
                                     sticks’’ costs of home construction in the development. The
                                     parties provided Land Committee Reports and napkins for
                                     only four of the developments.
                                           Construction of Developments
                                        SHI, SHLP, and Vistancia constructed their developments
                                     in a sequence of stages consisting of: grading land; initial
                                     construction of amenity and infrastructure common improve-
                                     ments; construction of homes; and construction and finaliza-
                                     tion of any remaining common improvements. The amount of
                                     time it took to grade the land and initially construct the
                                     amenities and common infrastructure varied with the size,
                                     surface and subsurface condition, and nature of the develop-
                                     ment. The grading process was particularly subject to risk
                                     because often soil conditions under the surface differ from
                                     what was originally anticipated. While SHI, SHLP, and
                                     Vistancia assigned a cost and a time line to the initial
                                     construction phase, that time and cost would vary with
                                     conditions. It took approximately three to five months to con-
                                     struct a single-family detached home and approximately six
                                     to eight months to construct multifamily attached homes. For
                                     large developments, they could perform the construction
                                     stages in phases.
                                           Homeowners Associations
                                        Each development had at least one homeowners associa-
                                     tion. These associations could include homeowners associa-
                                     tions, condominium associations, maintenance associations,
                                     master associations, and community associations. The struc-
                                     ture, activities, and obligations of an association were gov-
                                     erned by, inter alia, (i) the articles of incorporation, (ii)
                                     bylaws, and (iii) covenants, conditions, and restrictions docu-
                                     ments with respect to those associations.



                                        12 The napkin is so called because it is a quick pro forma estimate, as

                                     if one were quickly evaluating a project on a napkin.




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   73


                                           Pricing of Homes
                                       SHI, SHLP, and Vistancia charged a single price for their
                                     homes. This is the ‘‘total purchase price’’. They did not
                                     charge separate prices for the home, the lot, improvements
                                     to the lot, infrastructure and amenity common improve-
                                     ments, financing, fees, property taxes, labor and supervision,
                                     architectural and environmental design, bonding, or any
                                     other costs. They could increase the price of a home by
                                     charging a lot/homesite or elevation premium. Such a pre-
                                     mium was an additional charge for a home on a lot with pre-
                                     ferred qualities or a home with aesthetic, architectural, or
                                     design upgrades to the exterior. SHI, SHLP, and Vistancia
                                     could also increase the price of a home for additional options
                                     or upgrades to the home. All of these charges were included
                                     in the total price set forth in the purchase and sale agree-
                                     ment.
                                           Marketing
                                       SHI, SHLP, and Vistancia used multiple forms of mar-
                                     keting including: print (magazines, newspapers, flyers, and
                                     pamphlets); radio; television; the Internet; billboards; and
                                     word of mouth. For a prospective buyer visiting a develop-
                                     ment, their on-site marketing efforts included: driving tours;
                                     guided walking tours of a development’s amenities; models of
                                     amenities that remain under construction; movies; and walk-
                                     throughs of model homes presented in a community style.
                                       SHI, SHLP, and Vistancia started their marketing process
                                     well in advance of the opening of the community. For
                                     example, the Active Adults Division developed a preselling
                                     process called tsunami. This process included focus groups,
                                     lead-generating mailers, and design shows. These design
                                     shows, also known as charrettes, and focus groups invited
                                     potential consumers to contribute to the design of the
                                     community. The consumers would, before the first home was
                                     sold, get a sense of ownership in the community. Often
                                     participants in this presale process would be the first buyers
                                     once the development was opened for sale.
                                       After the presale process, the community was generally
                                     opened for sales. At this point SHI, SHLP, and Vistancia
                                     intended to have finished constructing the community center
                                     and the model gallery. They thereafter continued to advertise




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                                     74                  142 UNITED STATES TAX COURT REPORTS                                      (60)


                                     using the tools discussed above. For example, with respect to
                                     Parkside at Reunion they established a Web site,
                                     reunionco.com; ran newspaper ads; and used billboards. Gen-
                                     erally, this marketing process was geared towards selling the
                                     community and lifestyle, not just the homes.
                                        At Vistancia, the ‘‘marketing trail’’ began when consumers
                                     first drove into the community. Vistancia purposefully
                                     designed the development so that the consumer, to get to the
                                     tour center and sales office, had to drive past all of the major
                                     amenities. They designed the grading of the land to make
                                     sure the water feature for the 18th hole of the golf course
                                     was visible for the entire drive from the gatehouse. They also
                                     oriented waterfalls and other aesthetics towards the con-
                                     sumer to maximize visibility on the drive in. Essentially,
                                     prospective purchasers’ views during their initial drive into
                                     a community was intended to be a silent sales corridor.
                                        The sales staff at Vistancia greeted the consumers by their
                                     names, which had been radioed from the gatehouse to the
                                     tour center. At the tour center, the staff showed the con-
                                     sumers a short video, which emphasized the development’s
                                     friendships, lifestyle, and community. The potential buyers
                                     then toured the clubhouse and the golf club and all of the
                                     various amenities. This tour could take between three and
                                     five hours. Customers then returned to the tour center,
                                     where Vistancia’s sales staff explained the benefits of living
                                     in the community. They began their explanation of the bene-
                                     fits at the macro geographical area and the proximity to La
                                     Quinta and then moved on to the micro level of the Vistancia
                                     community. Finally, the potential customers entered the
                                     model gallery, which consisted of several model homes as
                                     well as cafes and an amphitheater. Vistancia showed the
                                     homes only at the end because the marketing approach and
                                     product encompassed much more than the home, and it tried
                                     to showcase features and amenities to sell ‘‘the dream’’ to set
                                     up the sale of the home.
                                           Financial Data Tracking
                                       SHI, SHLP, and Vistancia used Tract-PIE software to
                                     record, account for, and summarize incurred and budgeted
                                     data with respect to each development. The information
                                     Tract-PIE kept on file for each development included
                                     cashflow receipts and disbursements, income statement, bal-




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   75


                                     ance sheet, internal rate of return, financing data, book
                                     interest allocations, inflation projections, total units, units
                                     closed, and projected unit closings for both incurred and
                                     budgeted data during the duration of the development. The
                                     Tract-PIE software tracked costs by both indirect and direct
                                     costs. SHI, SHLP, and Vistancia updated the budgeted costs
                                     quarterly with information provided by the divisions.
                                       The software allowed a breakdown of direct costs into a
                                     number of categories. The land and acquisitions category rep-
                                     resented costs to purchase the development land. The profit
                                     and participation agreements category represented agree-
                                     ments in which the seller of the development land had the
                                     opportunity to share in the profits of the development. The
                                     forward planning category represented costs associated with
                                     civil engineering, design, and architecture for the develop-
                                     ment. Direct construction costs were the costs incurred in the
                                     vertical construction of the homes, and option deposits and
                                     option costs reflected costs incurred with respect to upgrades
                                     buyers could select. Model upgrade costs were costs with
                                     respect to the model homes. Commitment fees were costs
                                     associated with financing activities. Finally, the sales tax
                                     category represented the Arizona sales tax that jurisdiction
                                     imposed on the sale of a home.
                                       The indirect cost categories included property tax pay-
                                     ments, site development/land development/common area costs
                                     for infrastructure, and amenities within a development. The
                                     category for amenities and golf reflected costs for a develop-
                                     ment’s golf course(s). The permits and fees category recorded
                                     payments to municipal and State jurisdictions to permit con-
                                     structing of the development. A property tax payments cat-
                                     egory reflected payments made for tax on property not yet
                                     conveyed to third parties, either through sale or through
                                     transfer to the homeowners associations or municipalities.
                                       There were also indirect cost categories for rebates/credits,
                                     indirect construction costs, management fees, and miscella-
                                     neous costs. Petitioners received rebates and credits from
                                     their materials suppliers if they met certain purchase quotas.
                                     Indirect construction costs were costs associated with super-
                                     vision, cleanup, architectural review, and other similar
                                     activities with respect to construction. Management fees
                                     were fees paid in developments being built as a joint venture.




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                                     76                  142 UNITED STATES TAX COURT REPORTS                                      (60)


                                     Miscellaneous costs consisted of any other indirect cost not
                                     covered by the other categories.
                                        The Tract-PIE files allowed SHI, SHLP, and Vistancia to
                                     compare the indirect costs to the direct costs. For example,
                                     exhibits and testimony show that for the 2005 tax year, the
                                     indirect costs of Parkside at Reunion were approximately
                                     27% or more of the total budgeted costs. Similar or even
                                     larger percentages applied to other developments such as
                                     Vistancia and Trilogy at La Quinta, where SHI, SHLP, or
                                     Vistancia was responsible for converting raw land into a
                                     development rather than purchasing and developing just a
                                     portion of another developer’s project, where some indirect
                                     costs had already been incurred and were included in land
                                     costs.
                                        To monitor operational performance and income tax
                                     compliance, SHI, SHLP, and Vistancia divided the total
                                     incurred direct and indirect costs by the total budgeted direct
                                     and indirect costs. Their tax department made relevant
                                     adjustments to reflect what it considered to be the require-
                                     ments of section 460, such as capitalization computations
                                     and tax interest analyses. If the incurred costs were equal to
                                     or greater than 95% of the budgeted costs, then they reported
                                     income for that tax year from homes that had closed in
                                     escrow up to that date. If the incurred costs did not exceed
                                     95%, then they deferred any income from homes that closed
                                     in escrow that year.
                                        For Federal income tax purposes during 2002 and 2003,
                                     SHLP compared the total number of homes closed in a
                                     development to the number projected to be closed by the end
                                     of the development. SHI computed the 95% test by com-
                                     paring the development’s total incurred direct and indirect
                                     costs to the development’s total budgeted direct and indirect
                                     costs. For the 2003 and 2004 tax years, Vistancia did not
                                     mathematically determine whether either the 95% test or the
                                     final completion and acceptance test had been met, the rea-
                                     son being that Vistancia estimated there were no cir-
                                     cumstances under which the 95% test would be satisfied
                                     because such a small portion of the homes in the develop-
                                     ment had been completed.
                                        For all tax years after 2003, except as just noted, SHI,
                                     SHLP, and Vistancia used the Tract-PIE software and
                                     related documentation to compare the development’s




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   77


                                     incurred direct and indirect costs to the development’s total
                                     budgeted direct and indirect costs for the purposes of deter-
                                     mining whether to report income for Federal income tax pur-
                                     poses under their interpretation of the completed contract
                                     method of accounting.
                                     Description of the Eight Representative Developments
                                           Trilogy at La Quinta
                                        The Trilogy at La Quinta development was a gated
                                     community with security and landscaping features located in
                                     Riverside County, within the city limits of La Quinta, Cali-
                                     fornia. The Trilogy development was constructed in eight
                                     phases, with 1,238 total lots and residences situated on
                                     approximately 536 acres. Construction began in or about
                                     July 2000. The Trilogy development included a 30,000-
                                     square-foot clubhouse with a ballroom, a center for higher
                                     learning, a studio for creative arts, a cafe, a kitchen, a
                                     catering kitchen, a grand living room, offices, mail offices,
                                     locker rooms, studios, an indoor pool, an outdoor pool,
                                     cabanas, an indoor running track, a fitness center, a medita-
                                     tion garden, and a spa. It also had outdoor walking, running
                                     and bike paths, tennis courts, and outdoor recreation areas.
                                           Vistancia
                                        The Vistancia development was in Peoria, Arizona, and
                                     included three subdivisions: Vistancia Village, Blackstone,
                                     and Trilogy. As originally designed, the plan was to include
                                     18 phases, situated on approximately 7,100 acres. Construc-
                                     tion of the Vistancia development began in or about January
                                     2002. The Vistancia development included a 3.5-mile trail
                                     system, a restaurant, a spa, pools, a basketball gymnasium,
                                     a multipurpose building, a tennis court, parks, open spaces
                                     for wildlife, playgrounds, and a country club.
                                           Parkside at Reunion
                                       The Parkside development was in Commerce City, Colo-
                                     rado. It was a subdivision of a larger development named
                                     Reunion. Construction of the Reunion development began in
                                     or about May 2001 and continued through December 2011 in
                                     four phases, with 1,875 total lots and 1,425 total residences
                                     on approximately 980 acres. The Reunion development




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                                     78                  142 UNITED STATES TAX COURT REPORTS                                      (60)


                                     included a 21,000-square-foot recreation center featuring an
                                     indoor gymnasium, a fitness center, aerobics, meeting, and
                                     locker rooms, an outdoor pool with interactive water features,
                                     a 52-acre central park that includes multiuse athletic fields,
                                     trails, playgrounds, picnic facilities, and an amphitheater, 10
                                     miles of walking, running and biking trails, 8 acres of lakes,
                                     150 acres of parks, and 170 acres of open space.
                                           Breakers at Pointe Marin
                                        The Breakers at Pointe Marin development was in Novato,
                                     California. It was a subdivision of a larger development
                                     called Pointe Marin. The homes in the Breakers at Pointe
                                     Marin were constructed in 10 phases, with 106 total lots
                                     situated on approximately 25 acres, beginning in or about
                                     May 2004. The Pointe Marin development included walking,
                                     running, and bike paths as well as open spaces for wildlife.
                                           Costa Azul
                                       The Costa Azul development was a gated community with
                                     security features located in Newport Beach, California. This
                                     development was a subdivision of a larger development called
                                     Pacific Ridge. It consisted of 42 total lots, situated on
                                     approximately 22 acres. The homes in Costa Azul were con-
                                     structed in eight phases beginning in or about April 2004.
                                     The development included a recreation center, tot lots, a
                                     swimming pool, a spa, locker rooms, a park, and walking,
                                     running, and biking trails and paths, including open spaces
                                     for wildlife.
                                           Azure
                                       The Azure development was in San Marcos, California. It
                                     was a subdivision of a larger development called San Elijo
                                     Hills. The homes in the Azure development were constructed
                                     in four phases beginning in or about November 2003. It con-
                                     tained 92 total lots, situated on approximately 30 acres. The
                                     Azure development included a park, a pet run area, a skating
                                     area, a swimming pool, and a daycare facility.
                                           Country Lane
                                       The Country Lane development was in Gilbert, Arizona. It
                                     was a subdivision of a development called Neely Commons.
                                     The homes in the Country Lane development were con-




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   79


                                     structed in a single phase, with 193 total lots, situated on
                                     approximately 25 acres, beginning in or about July 2002. The
                                     Country Lane development included a park, landscaped
                                     pedestrian areas, a soccer field, a tot lot, ramadas, and a
                                     half-court basketball facility.
                                           Sommerset at Morgan Hill
                                       The Sommerset at Morgan Hill development was in
                                     Temecula, California. It was a subdivision of a larger
                                     development called Morgan Hill. The homes in the
                                     Sommerset at Morgan Hill development were constructed
                                     beginning in or about March 2004 in seven phases with 70
                                     total lots, situated on approximately 17 acres. The develop-
                                     ment included a community center, a clubhouse, tennis
                                     courts, swimming pools, spas, a tot lot, and walking, running,
                                     and biking paths.
                                     Documentation
                                           Purchase and Sale Agreement
                                       SHI, SHLP, and Vistancia entered into sales contracts
                                     with prospective homebuyers. The purchase and sale agree-
                                     ment identified the buyer and the seller. It provided that the
                                     buyer agreed to purchase the property and the seller agreed
                                     to sell the property. When the buyer and the seller entered
                                     into a contract for the purchase of a home, the buyer had to
                                     remit an earnest money deposit. Once the contract had been
                                     executed the parties were obligated to perform. Before the
                                     buyer and seller could close escrow on a home, SHI, SHLP,
                                     and Vistancia were required to either construct all common
                                     improvement areas for the development (or phase) or post a
                                     bond as discussed supra. Therefore, in some instances the
                                     buyers were required to pay the full contract price before all
                                     of the common improvements and amenities promised for
                                     that development were completed.
                                       Before escrow could close, SHI, SHLP, and Vistancia had
                                     to obtain a certificate of occupancy from the local government
                                     having jurisdiction over the home. Once the funds and the
                                     closing documents were in escrow, and in proper order and
                                     duly executed, the deed transferring the property to the
                                     buyer was recorded. An average of four to six months passed
                                     between the time the buyer and the seller entered into the




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                                     contract for the purchase of a home and the time when
                                     escrow closed. At closing, SHI, SHLP, and Vistancia had
                                     expended all costs required to construct the dwelling unit
                                     and the improvements to the lot on which it sat.
                                        For the two representative developments in Arizona,
                                     Country Lane and Vistancia, the purchase contracts and the
                                     closing and escrow instructions included a statement dis-
                                     closing the purchaser’s right to receive and read a copy of the
                                     development’s public report before signing the purchase
                                     agreement. The documents also included an initialed and
                                     signed acknowledgment, by the purchaser(s), of the receipt of
                                     a copy of the development’s public report and of the oppor-
                                     tunity to read it. The purchaser(s) also signed a receipt docu-
                                     menting that he/she acknowledged the public report, identi-
                                     fied by a registration number and a date, and the informa-
                                     tion contained therein, which constituted a part of the pur-
                                     chase contract and closing and escrow instruction docu-
                                     mentation.
                                        For the five representative developments in California,
                                     Trilogy at La Quinta, Breakers at Pointe Marin, Costa Azul,
                                     Azure, and Sommerset at Morgan Hill, the purchase con-
                                     tracts and the closing and escrow instructions included Cali-
                                     fornia DRE Form RE614E, Receipt For Public Report Or
                                     California Permit, as evidence of the purchasers’ receipt of
                                     the public report. This document stated:
                                           The Laws and Regulations of the Real Estate Commissioner require that
                                           you as a prospective purchaser * * * be afforded an opportunity to read
                                           the public report * * * for this subdivision before you make any written
                                           offer to purchase * * * a subdivision interest or before any money or
                                           other consideration toward purchase * * * of a subdivision interest is
                                           accepted from you.

                                     The document further admonished prospective purchasers:
                                     ‘‘DO NOT SIGN THIS RECEIPT UNTIL YOU HAVE
                                     RECEIVED A COPY OF THE PUBLIC REPORT * * * AND
                                     HAVE READ IT.’’ The document further required the signa-
                                     ture(s) of the purchaser(s) confirming that he/she had read
                                     the public report, identified by registration number and date
                                     of issuance.




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   81


                                           Public Reports
                                       The purpose of a public report is to disclose to a home-
                                     buyer the rights and obligations imposed on or granted to the
                                     homebuyer as well as the seller with respect to a certain
                                     development.
                                           Arizona
                                        In Arizona the public report stated that the Department of
                                     Real Estate requires the developer to provide each purchaser
                                     with a copy of the public report and to obtain a signed
                                     receipt. It noted that the purchase contract is rescindable by
                                     the purchaser if the developer fails to obtain a public report
                                     before offering the subdivided lots for sale or if the developer
                                     fails to provide the purchaser with a copy of the report. The
                                     public report also noted the designation of the portions of the
                                     development that are common areas, specifically stating for
                                     one of the developments that the portions that are common
                                     areas ‘‘ARE TO BE CONVEYED TO THE COUNTY LANE
                                     COMMUNITY ASSOCIATION, IN EACH CASE FOR THE
                                     USE AND ENJOYMENT OF SUCH ASSOCIATION AS
                                     MORE FULLY SET FORTH IN THE DECLARATION OF
                                     COVENANTS,         CONDITIONS         AND      RESTRICTIONS
                                     APPLICABLE TO SUCH ASSOCIATION’’.
                                        The public reports for the two Arizona developments also
                                     cited the locations of the development maps, which identified
                                     the developments’ common areas and improvements. The
                                     reports indicated the dates the developer anticipated comple-
                                     tion of the common area improvements and facilities as well
                                     as providing assurances that the common improvements
                                     would be completed. Specifically, for example, the Country
                                     Lane development reports stated: ‘‘Escrows will not close
                                     until the Town of Gilbert has issued its Occupancy Clearance
                                     and all Subdivision improvements have been completed. A
                                     bond has been secured to assure the completion of the land-
                                     scaping in the common area tracts. A bond for the completion
                                     of the additional landscaped pedestrian areas has been
                                     secured as assurance of their completion.’’
                                           California
                                       The public reports for the five developments in California
                                     stated that a purchaser(s) must acknowledge by signature




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                                     that he/she has received and read the public report for the
                                     development. The public reports stated, under a section titled
                                     ‘‘INTEREST TO BE CONVEYED’’, that each purchaser
                                     would receive fee title to a lot, membership in the home-
                                     owners association, and rights to use the common areas. The
                                     public reports also provided the developers’ estimate of when
                                     common areas and improvements would be completed and
                                     stated that escrows would not close until either the common
                                     areas and facilities had been completed or bonds had been
                                     posted. However, four of the five reports also stated that
                                     there was no assurance the project would be completed or
                                     developed as proposed. Therefore, while the public reports
                                     warned the purchasers that there was no assurance that the
                                     project would be completed or developed as proposed, the
                                     phase of the development that the public report discussed
                                     was assured. SHI, SHLP, and Vistancia had to complete or
                                     post bonds ensuring completion of common improvements.
                                        The public reports for the five California developments
                                     included a provision that before closing escrow, the developer
                                     was required to provide the purchaser with copies of the
                                     homeowners association articles of incorporation, including
                                     bylaws and covenants, conditions, and restrictions and that
                                     those documents should be read and included numerous
                                     provisions that substantially affected the purchasers’ rights.
                                           Covenants, Conditions, and Restrictions
                                       The developments were governed by a declaration of cov-
                                     enants, conditions, and restrictions (CC&Rs). The CC&Rs
                                     were reviewed and approved by the State’s department of
                                     real estate and local government agencies where that
                                     development was located and, in California and Colorado,
                                     were recorded. 13
                                       SHI, SHLP, and Vistancia provided each purchaser, at or
                                     before execution of a purchase agreement, with a copy of the
                                     declaration of CC&Rs in connection with the sales of homes
                                     in that development. These CC&Rs provided rights and
                                     restrictions with respect to the use and enjoyment of the pur-
                                     chased property. CC&Rs applied to the purchaser of property
                                       13 California and Colorado require a developer to file the CC&Rs with

                                     the clerk and recorder’s office of the county in which the development was
                                     located.




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   83


                                     within the development and to all future interest holders of
                                     property in the development. The CC&Rs included a legal
                                     description of the land subject to the CC&Rs, including both
                                     residential lots and common areas, and all of the property
                                     within the eight representative developments was held or
                                     conveyed subject to the terms of their respective CC&Rs. The
                                     purchasers of each home affirmed receipt of a copy of the
                                     CC&Rs by signing acknowledgments in the purchase and
                                     sale agreement or other related documents.
                                        The CC&Rs provided the authority for the homeowners
                                     association to administer the CC&Rs and manage the
                                     development, including the authority to assess members and
                                     to own and maintain common improvements. Under the
                                     CC&Rs each homeowner in the development automatically
                                     became a member of the development’s homeowners associa-
                                     tion and remained a member until he/she no longer held an
                                     ownership interest. The CC&Rs also authorized the respec-
                                     tive homeowners associations to enforce collection action,
                                     including filing a lien and the commencement of a foreclosure
                                     action against any member that failed to satisfy an assess-
                                     ment. Both the homeowners associations and their individual
                                     members could enforce the CC&Rs.
                                        For seven of the eight representative developments, the
                                     CC&Rs required SHI, SHLP, and Vistancia to transfer title
                                     to the common improvements to the developments’ respective
                                     homeowners associations. For Parkside at Reunion, the
                                     common improvements were not conveyed to the homeowners
                                     association. Rather, the purchasers obtained a tenancy in
                                     common interest with all other development owners in these
                                     common improvements. The CC&Rs specified this ownership
                                     interest.
                                           Maps and Plats
                                        The public reports referred to the tract maps on file with
                                     the local government. These tract maps represented the final
                                     design for the planned development. Generally, SHI, SHLP,
                                     and Vistancia prepared tentative versions of these maps
                                     first. The tentative map dictated grading, lots, streets, parks,
                                     easements, and other similar features. Often the local
                                     government required some modifications and also attached
                                     conditions and requirements before it would accept a tract
                                     map.




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                                        Approval of a final tract map often resulted in additional
                                     conditions, such as requiring the developer to pay for
                                     grading, curbs, gutters, sidewalk paving, streets, and utili-
                                     ties, which met that jurisdiction’s standards. The local
                                     governments did not just restrict conditions to the areas
                                     within the developments themselves. They could also condi-
                                     tion the approval upon widening arterial roads at the bound-
                                     aries of the developments, the building of schools, or
                                     installing offsite traffic lights. SHI, SHLP, and Vistancia
                                     could negotiate with respect to the scope, standards, and
                                     nature of the conditions to some degree, but the govern-
                                     mental authority retained the ultimate approval control over
                                     the maps. During the entitlement process, SHI, SHLP, and
                                     Vistancia often employed consultants. The governments also
                                     sometimes employed consultants in this process, and on occa-
                                     sion, SHI, SHLP, and Vistancia would cover the cost of these
                                     government consultants.
                                        SHI, SHLP, and Vistancia would also enter into agree-
                                     ments with the local governmental agencies. SHI, SHLP, and
                                     Vistancia had two options. They could build everything
                                     required by the map, or alternatively, they could enter into
                                     a subdivision improvement agreement with the governmental
                                     authority. These agreements required them to post bonds for
                                     improvements not yet built. If all of these steps were satis-
                                     factorily completed, then the governmental authority was
                                     obligated to record the map.
                                                                                  OPINION

                                     I. Burden of Proof
                                       Generally, the Commissioner’s determination of a tax-
                                     payer’s liability for an income tax deficiency is presumed cor-
                                     rect, and the taxpayer bears the burden of proving that the
                                     determination is improper. See Rule 142(a); Welch v.
                                     Helvering, 290 U.S. 111, 115 (1933). But 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




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   85


                                     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 factual ques-
                                     tion. Sam W. Emerson Co. v. Commissioner, 37 T.C. 1063,
                                     1067 (1962).
                                        To prevail, the taxpayer must establish that the Commis-
                                     sioner abused his discretion in changing the method of
                                     accounting. Prabel v. Commissioner, 91 T.C. 1101, 1112
                                     (1988), aff ’d, 882 F.2d 820 (3d Cir. 1989). But the Commis-
                                     sioner may not change a taxpayer’s method of accounting
                                     from an incorrect method to another incorrect method. Id.
                                     Nor may the Commissioner change a taxpayer’s method of
                                     accounting ‘‘[w]here a taxpayer’s method of accounting is
                                     clearly an acceptable method’’ and clearly reflects income. Id.
                                        On brief petitioners renewed pretrial motions to shift the
                                     burden of proof to respondent. Petitioners contend that
                                     respondent’s determinations are excessive and arbitrary and
                                     thus justify the burden shift. See Estate of Mitchell v.
                                     Commissioner, 250 F.3d 696, 702 (9th Cir. 2001), aff ’g in
                                     part, vacating in part and remanding T.C. Memo. 1997–461.
                                     Specifically, petitioners allege, citing Golden State Litho v.
                                     Commissioner, T.C. Memo. 1998–184, that respondent has
                                     not identified the correct method of accounting on which he
                                     seeks to place SHI, SHLP, and Vistancia. We disagree.
                                     Respondent is seeking to place SHI, SHLP, and Vistancia on
                                     his interpretation of the completed contract method, dis-
                                     cussed in more detail below. Thus the burden of proof does
                                     not shift in these cases.
                                     II. Legal Framework
                                           A. Long-Term Contracts Generally
                                       Section 460 governs how taxpayers report income from
                                     long-term contracts. It generally provides that taxpayers who
                                     receive income from long-term contracts must account for
                                     that income through the percentage of completion method.
                                     Sec. 460(a). This method essentially requires a taxpayer to
                                     recognize income and expenses throughout the duration of a
                                     contract. Sec. 460(b); Tutor-Saliba Corp. v. Commissioner,
                                     115 T.C. 1, 4 (2000). But, by an amendment, the statute
                                     excepts, inter alia, home construction contracts. Sec.
                                     460(e)(1)(A), (6)(A) (as amended by the Technical and Mis-




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                                     cellaneous Revenue Act of 1988, Pub. L. No. 100–647, sec.
                                     5041(b)(1), 102 Stat. at 3673).
                                        Section 460(f)(1) defines a long-term contract as ‘‘any con-
                                     tract for the manufacture, building, installation, or construc-
                                     tion of property if such contract is not completed within the
                                     taxable year in which such contract is entered into.’’ The
                                     statute does not define completion, which is to be determined
                                     on a contract-by-contract basis, sec. 1.460–1(f), Income Tax
                                     Regs., but the regulations provide that a contract is com-
                                     pleted when it first meets one of two tests, sec. 1.460–
                                     1(c)(3)(i), Income Tax Regs. These tests are commonly known
                                     as the use and 95% completion test, and the final completion
                                     and acceptance test.
                                        Under the first test, the contract is completed upon ‘‘[u]se
                                     of the subject matter of the contract by the customer for its
                                     intended purpose (other than for testing) and at least 95 per-
                                     cent of the total allocable contract costs attributable to the
                                     subject matter have been incurred by the taxpayer’’. Sec.
                                     1.460–1(c)(3)(i)(A), Income Tax Regs. Under the second test,
                                     the contract is completed upon ‘‘[f]inal completion and accept-
                                     ance of the subject matter of the contract.’’ Sec. 1.460–
                                     1(c)(3)(i)(B), Income Tax Regs. As for this latter test, ‘‘to
                                     determine whether final completion and acceptance of the
                                     subject matter of a contract have occurred, a taxpayer must
                                     consider all relevant facts and circumstances.’’ Sec. 1.460–
                                     1(c)(3)(iv), Income Tax Regs.
                                        A further wrinkle to determining when a taxpayer com-
                                     pletes a contract is the role of secondary items. Taxpayers
                                     are to apply the tests to determine when a contract is com-
                                     pleted under the completed contract method ‘‘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 applying the 95% completion test, taxpayers
                                     ‘‘must separate the portion of the gross contract price and the
                                     allocable contract costs attributable to the incomplete sec-
                                     ondary item(s) from the completed contract’’. Id.
                                           B. Home Construction Contracts
                                       A taxpayer may account for income from home construction
                                     contracts under the completed contract method. Sec. 460(e).
                                     That is because section 460(e) provides that the percentage




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   87


                                     of completion method will not apply to ‘‘any home construc-
                                     tion contract’’. 14 A ‘‘home construction contract’’ is
                                           any construction contract if 80 percent 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 * * * contained in buildings containing 4 or fewer
                                           dwelling units * * *, and
                                             (ii) improvements to real property directly related to such dwelling
                                           units and located on the site of such dwelling units.
                                             [Sec. 460(e)(6)(A).]

                                     The ‘‘activities referred to in paragraph (4)’’ are ‘‘building,
                                     construction, reconstruction, or rehabilitation of, or the
                                     installation of any integral component to, or improvements
                                     of, real property.’’ Sec. 460(e)(4).
                                        As the statute is written and depending on the meaning of
                                     the word ‘‘site’’, taxpayers such as SHI, SHLP, and Vistancia
                                     can have trouble meeting the 80% requirement of section
                                     460(e)(6)(A). This occurs because a significant portion of the
                                     contract costs may be attributable to items not ‘‘located on
                                     the site of such dwelling units’’, such as development infra-
                                     structure. The regulations, however, instruct a taxpayer to
                                     ‘‘include[] 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 tax-
                                     payer is contractually obligated, or required by law, to con-
                                     struct within the tract or tracts of land that contain the
                                     dwelling units.’’ Sec. 1.460–3(b)(2)(iii), Income Tax Regs.
                                        Thus, at least for the purpose of determining whether the
                                     contract qualifies as a home construction contract under sec-
                                     tion 460(e), the taxpayer includes, for the 80% test, costs
                                     attributable to common improvements in the manner dic-
                                     tated by the regulations. Petitioners and respondent dis-
                                     agree, however, as to whether this regulation affects the
                                     tests in section 1.460–1(c)(3)(A) and (B), Income Tax Regs.,
                                       14 Sec. 460(e) also contains an exception for certain other construction

                                     contracts provided that the taxpayer meets a gross receipts test and antici-
                                     pates the contract will be completed within two years of contract com-
                                     mencement. Sec. 460(e)(1)(B). This section also gives a more generous per-
                                     centage of completion method of accounting for residential construction
                                     contracts which are not home construction contracts. Sec. 460(e)(5).




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                                     88                   142 UNITED STATES TAX COURT REPORTS                                      (60)


                                     that determine when the taxpayer completes the contract for
                                     the purposes of deciding whether it is a long-term contract.
                                     III. Analysis
                                        We must decide whether SHI, SHLP, and Vistancia prop-
                                     erly reported their income from the sales of homes in their
                                     developments using the completed contract method.
                                     Respondent contends that only the contracts that closed in
                                     tax years different from the taxable years they were entered
                                     into qualify as long-term contracts. Under respondent’s
                                     interpretation of the completed contract method, SHI, SHLP,
                                     and Vistancia must report income from these long-term con-
                                     tracts for the years in which the contracts closed in escrow.
                                     Respondent takes this position because, in his view, the sub-
                                     ject matter of the contract is the home and the lot upon
                                     which it sits. Consequently, each contract is completed,
                                     within the meaning of section 460, in the year in which
                                     escrow closes. That year is when respondent contends final
                                     completion and acceptance occurs. 15 For the other contracts,
                                     respondent would require SHI, SHLP, and Vistancia to
                                     account for the income under their normal method of
                                     accounting.
                                        Petitioners are of the opinion that the subject matter of the
                                     contracts is broader and encompasses the entire development
                                     or, in some instances of larger developments, the develop-
                                     ment phase of which the home is a part. In support, peti-
                                     tioners contend that a contract comprises all documents pro-
                                     vided to the buyer, any documents expressly referenced
                                     therein or incorporated therein by law, and easements,
                                     restrictions, and other documents recorded as encumbrances
                                     on a home purchaser’s title. Petitioners assert that these
                                     documents collectively set forth the rights and obligations of
                                     the buyer and seller. Therefore, they contend that, other
                                           15 It
                                            has been 25 years since sec. 460(e)(1)(A) and (6)(A) was enacted by
                                     the Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100–
                                     647, sec. 5041, 102 Stat. at 3673, and apparently development builders,
                                     such as SHI, SHLP, and Vistancia, may have used this method since 1988.
                                     The earliest tax year at issue in these cases is 2003. That delay in enforce-
                                     ment is immaterial to our consideration as the Commissioner is not bound
                                     by his failure to enforce the law in an earlier year. United States v. Woods,
                                     571 U.S. ll, ll, 134 S. Ct. 557, 567 n.5 (2013); Coors v. Commissioner,
                                     60 T.C. 368, 395 (1973), aff ’d, 519 F.2d 1280 (10th Cir. 1975).




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   89


                                     than secondary items if any, the final completion and accept-
                                     ance does not occur until, as to the phase or the develop-
                                     ment, the final road is paved and the final bond is released.
                                     Under their interpretation, the use and 95% completion test
                                     is met first when SHI, SHLP, and Vistancia incur 95% of the
                                     phase’s or development’s costs. Petitioners contend that
                                     because the 80% test for a home construction contract
                                     includes the allocable share of the costs of common improve-
                                     ments, the 95% test also must include these costs.
                                        Respondent also urges an alternative theory. According to
                                     this theory, if we hold that the subject matter of the con-
                                     tracts is broader than the house and the lot, we must apply
                                     the 95% completion test without regard to the costs attrib-
                                     utable to common improvements because they are secondary
                                     items. Petitioners, however, contend that these common
                                     improvements are part of the primary subject matter of the
                                     contract, not secondary items, and that they may include
                                     such allocable costs in applying the 95% test.
                                        The initial question is what documents are part of the con-
                                     tracts. Under respondent’s interpretation, the subject matter
                                     of the contracts is the lot and the house which the buyer(s)
                                     purchase. To support this contention, respondent points to
                                     the purchase and sale agreement as being the sole contract
                                     document. He urges us to find that State law and the
                                     wording of the contract necessarily restrict the contract to
                                     only this document. Petitioners, however, contend that the
                                     scope of the contracts exceeds the mere ‘‘bricks and sticks’’
                                     and encompasses the development as a whole. In this vein,
                                     petitioners assert that, for the purposes of section 460, the
                                     contract consists of the purchase and sale agreements as well
                                     as all documents referenced or incorporated therein. This
                                     would encompass public reports, CC&Rs, publicly recorded
                                     plats and maps, public resolutions or conditions of approval,
                                     and homeowners association documents.
                                           A. What Constitutes the Contract
                                           1. Integration Clauses
                                       Respondent claims that because each of the respective pur-
                                     chase and sale agreements contains an integration clause,
                                     the purchase and sale agreements constitute the entire con-
                                     tract. Each purchase and sale agreement states that the




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                                     agreement is the sole and entire agreement between the
                                     buyer and the seller. Courts have given integration clauses
                                     significant weight when interpreting contracts. See, e.g.,
                                     Betaco, Inc. v. Cessna Aircraft Co., 103 F.3d 1281, 1283 (7th
                                     Cir. 1996). California caselaw explains that ‘‘ ‘[t]he crucial
                                     issue in determining whether there has been an integration
                                     is whether the parties intended their writing to serve as the
                                     exclusive embodiment of their agreement.’ ’’ Grey v. Am.
                                     Mgmt. Servs., 139 Cal. Rptr. 3d 210, 213 (Ct. App. 2012)
                                     (quoting Masterson v. Sine, 65 Cal. Rptr. 545, 547 (1968)). An
                                     Arizona court explained: ‘‘A completely integrated contract is
                                     a contract adopted by the parties as a complete and exclusive
                                     statement of the terms of the contract.’’ Anderson v. Preferred
                                     Stock Food Mkts., Inc., 854 P.2d 1194, 1197 (Ariz. Ct. App.
                                     1993).
                                        While we agree with respondent that the purchase and
                                     sale agreements do contain integration clauses, we do not
                                     conclude that the purchase and sale agreement alone serves
                                     as the exclusive embodiment of the entire agreement between
                                     the parties. Buyers of homes from SHI, SHLP, and Vistancia
                                     are consciously purchasing more than the ‘‘bricks and sticks’’
                                     of the home. The purchase and sale agreement specifically
                                     includes a checklist ensuring that the purchaser receives the
                                     related documents.
                                        For the two representative developments in Arizona,
                                     Country Lane and Vistancia, the purchase contracts and the
                                     closing and escrow instructions include a statement dis-
                                     closing the purchaser’s right to receive and read a copy of the
                                     development’s public report before signing the purchase
                                     agreement. Included is an attached acknowledgment, sig-
                                     nified by the purchaser’s initials and signature, of the receipt
                                     and opportunity to read a copy of the development’s public
                                     report.
                                        For the five representative developments in California, the
                                     purchase contracts and the closing and escrow instructions
                                     include California DRE Form RE614E as evidence of the pur-
                                     chaser’s receipt of the public report. The document also con-
                                     tains the signature of the purchaser confirming that he/she
                                     has read the public report, identified by registration number
                                     and date of issuance.
                                        At trial petitioners emphasized that it is not just the house
                                     but the lifestyle that SHI, SHLP, and Vistancia advertise




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                                     and sell to their purchasers. For the representative develop-
                                     ments SHI, SHLP, and Vistancia budgeted and incurred
                                     significant indirect costs when compared to the direct costs
                                     of building the homes. Purchasers of homes in their develop-
                                     ments were conscious of the elaborate amenities and would
                                     have understood that the price they paid for a home included
                                     the amenities of the development. If a purchaser did not
                                     want to live in one of the planned developments with its
                                     accompanying amenities, it is likely he or she could have
                                     paid much less for an otherwise comparable dwelling outside
                                     of a development and with no seller-provided amenities. 16
                                        Further evidence that SHI, SHLP, and Vistancia were obli-
                                     gated to their lot purchasers for much more than the pur-
                                     chase and sale agreement sans amenities is the hefty
                                     performance bonds that were required by State and munic-
                                     ipal law in order to secure their performance with respect to
                                     the completion of the common improvements in each develop-
                                     ment. In order for the performance bonds to be exonerated
                                     the obligees had to approve the completion of the amenity
                                     subject matter. Homeowners associations for each of the rep-
                                     resentative developments as well as the municipalities and
                                     States in which the developments were situated were identi-
                                     fied as obligees in the performance bonds. Purchasers auto-
                                     matically became members in the homeowners associations,
                                     and thus each purchaser had certain rights as to enforce-
                                     ment of the bonds vis-a-vis the homeowners association.
                                        SHI, SHLP, and Vistancia were also required by State law
                                     in California and Arizona to provide a purchaser with a copy
                                     of the public report which discloses to the homebuyer the
                                     obligations imposed on the homebuyer as well as SHI, SHLP,
                                     and Vistancia with respect to the development. SHI, SHLP,
                                     and Vistancia were required to obtain a signed acknowledg-
                                     ment from the purchaser that he or she had received the
                                     public report, and in Arizona the public report states that the
                                     purchase contract is rescindable if the developer fails to pro-
                                     vide the purchaser with a copy of the report. The public
                                       16 Indirect costs in, for example, Parkside at Reunion, could amount to

                                     over one-fourth of the total development costs. Other raw land develop-
                                     ments, such as Trilogy at La Quinta and Vistancia, had similarly large in-
                                     direct costs. To believe that the consumer homebuyers did not view the
                                     fruits of these expenditures as an integral aspect of their home purchase
                                     decision strains credibility.




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                                     reports for the two Arizona developments also cite the loca-
                                     tions of the development maps, which identify the develop-
                                     ments’ common areas and improvements. The reports
                                     indicate the dates the developer anticipates completion of the
                                     common area improvements and facilities as well as pro-
                                     viding assurances that the common improvements will be
                                     completed.
                                        The public reports for the five developments in California
                                     state that each purchaser will receive fee title to a lot, mem-
                                     bership in the homeowners association, and right to use of
                                     the common areas. Each report also provides the developer’s
                                     estimate of when common areas and improvements will be
                                     complete and states that either escrows will not close until
                                     completion of the common areas and facilities or bonds have
                                     been posted.
                                        Evidence of the home purchasers’ extra-purchase and sale
                                     agreement obligations are found in the CC&Rs. SHI, SHLP,
                                     and Vistancia provided all purchasers with copies of the dec-
                                     laration of CC&Rs for the developments in connection with
                                     the sales of homes in their developments, which provided the
                                     rights and restrictions with respect to the property pur-
                                     chased. They provided the purchasers with copies of the
                                     CC&Rs at or before the time of execution of the purchase and
                                     sale agreements, and the purchasers affirmed receipt of the
                                     CC&Rs by signing acknowledgments in the purchase and
                                     sale agreements or other related documents.
                                        We disagree with respondent’s conclusion that the integra-
                                     tion clause of the purchase and sale agreements necessarily
                                     excludes these documents. Rather, we agree with petitioners
                                     that in construing the contracts under section 460, these
                                     documents should be and in fact are incorporated into the
                                     construction purchase and sale contracts. Not only are these
                                     documents exchanged or acknowledged during the signing by
                                     the parties, but the purchase and sale agreements reference
                                     these documents.
                                        We concur with respondent that mere reference to another
                                     document does not mandate incorporation of that document
                                     into the contract. See, e.g., United Cal. Bank v. Prudential
                                     Ins. Co. of Am., 681 P.2d 390, 411 (Ariz. Ct. App. 1983). Yet,
                                     the Arizona court of appeals subsequently stated that
                                     ‘‘substantially contemporaneous instruments will be read
                                     together to determine the nature of the transaction between




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                   93


                                     the parties.’’ Pearll v. Williams, 704 P.2d 1348, 1351 (Ariz.
                                     Ct. App. 1985). While no specific wording is required to incor-
                                     porate another document, the incorporating reference must
                                     be clear and unequivocal and ‘‘must be called to the attention
                                     of the other party, he must consent thereto, and the terms
                                     of the incorporated document must be known or easily avail-
                                     able to the contracting parties’’. United Cal. Bank, 681 P.2d
                                     at 420. Here, the homebuyers acknowledge that they have
                                     received and read the public reports as well as the CC&Rs.
                                     Not only is the reference called to the purchasers’ attention,
                                     but they consent, and the document is provided to them by
                                     SHI, SHLP, or Vistancia. We believe, therefore, that the pur-
                                     chase and sale agreements incorporate the other referenced
                                     documents, such as the public reports, the CC&Rs, the home-
                                     owners association documents, and even the publicly
                                     recorded maps and conditions of approval.
                                        California courts have rules similar to Arizona’s regarding
                                     incorporation by reference. See Avery v. Integrated
                                     Healthcare Holdings, Inc., 159 Cal. Rptr. 3d 444, 457 (Ct.
                                     App. 2013) (‘‘ ‘For the terms of another document to be incor-
                                     porated into the document executed by the parties the ref-
                                     erence must be clear and unequivocal, the reference must be
                                     called to the attention of the other party and he must con-
                                     sent thereto, and the terms of the incorporated document
                                     must be known or easily available to the contracting par-
                                     ties.’ ’’ (quoting Wolschlager v. Fid. Nat’l Tit. Ins. Co., 4 Cal.
                                     Rptr. 3d 179, 184 (Ct. App. 2003))). Thus, we believe simi-
                                     larly that the contracts for sale of homes in California incor-
                                     porated the referenced documents.
                                        In Colorado, a public report is not required. But home-
                                     buyers still acknowledged receipt of homeowners association
                                     documents, which included maps and legal descriptions of
                                     the development, contiguous area reports, which included
                                     maps, and a list of easements. And Colorado courts take a
                                     view similar to those of California and Arizona on incorpora-
                                     tion by reference. See Taubman Cherry Creek Shopping Ctr.,
                                     LLC v. Neiman-Marcus Grp., Inc., 251 P.3d 1091, 1095 (Colo.
                                     App. 2010) (‘‘Pursuant to general contract law, for an incor-
                                     poration by reference to be effective, ‘it must be clear that
                                     the parties to the agreement had knowledge of and assented
                                     to the incorporated terms.’ ’’ (quoting 11 Samuel Williston &
                                     Richard A. Lord, Contracts, sec. 30.25, at 234 (4th ed.




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                                     1999))). We think it clear that the purchase and sale agree-
                                     ments in Colorado also incorporated the referenced docu-
                                     ments.
                                        Respondent, however, also cites Treo @ Kettner Home-
                                     owners Ass’n v. Superior Court, 83 Cal. Rptr. 3d 318 (Ct.
                                     App. 2008), as standing for the proposition that CC&Rs
                                     cannot be considered contracts. But Treo held only that the
                                     ‘‘developer-written requirement in an association’s CC&R’s
                                     that all disputes between owners and the developer and dis-
                                     putes between the association and the developer be decided
                                     by a general judicial reference is not a written contract’’
                                     because it violated a constitutional right to a jury trial. Id.
                                     at 326. Further, respondent failed to fully consider the
                                     impact of Pinnacle Museum Tower Ass’n v. Pinnacle Mkt.
                                     Dev. (US), LLC, 282 P.3d 1217 (Cal. 2012).
                                        The California Supreme Court in Pinnacle determined that
                                     CC&Rs referenced in purchase and sale agreements were
                                     binding on the individual purchasers as well as the home-
                                     owners association. Id. at 1235. The court distinguished Treo
                                     as voiding the jury trial waiver in those CC&Rs as unconsti-
                                     tutional, whereas Pinnacle involved an agreement to
                                     arbitrate, which is favored by public policy. Id. at 1231.
                                        Respondent also ignores the multitude of cases in which
                                     California courts have characterized CC&Rs as contracts,
                                     including those between the developer and the homeowners
                                     association. See, e.g., Villa Milano Homeowners Ass’n v. Il
                                     Davorge, 102 Cal. Rptr. 2d 1, 4–5 (Ct. App. 2000) (construing
                                     CC&Rs, to the extent that the purchasers had constructive
                                     notice, as a contract between the parties and citing cases
                                     where CC&Rs have been construed as contracts). 17
                                           17 Arizona
                                                   courts have held that CC&Rs are contracts ‘‘ ‘between the sub-
                                     division’s property owners as a whole and the individual lot owners.’ ’’ Hor-
                                     ton v. Mitchell, 29 P.3d 870, 872 (Ariz. Ct. App. 2001) (quoting Ariz. Bilt-
                                     more Estates Ass’n v. Tezak, 868 P.2d 1030, 1031 (Ariz. Ct. App. 1993)).
                                     Respondent cites Horton for the proposition that a CC&R is not a contract
                                     between a homebuilder and a buyer. But we are not aware of any caselaw
                                     in Arizona or Colorado that would prevent an owner or a homeowners as-
                                     sociation from bringing suit against a developer for violating CC&Rs. In
                                     Colorado this may be because Colorado statutes specifically grant home-
                                     owners associations standing to bring construction defect claims on behalf
                                     of individual owners for units and common areas even if the CC&Rs do not
                                     authorize such a suit. See Heritage Village Owners Ass’n, Inc. v. Golden
                                     Heritage Investors, Ltd., 89 P.3d 513, 514–515 (Colo. App. 2004) (citing the




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                                       SHI, SHLP, and Vistancia and the buyers of their homes
                                     understood and believed that the parties had contracted for
                                     the entire lifestyle of the development and its amenities. The
                                     purchase and sale agreement is not the exclusive embodi-
                                     ment of that understanding. Consequently, the integration
                                     clauses do not limit the entire contract to the naked purchase
                                     and sale agreement.
                                           2. State Laws Governing Real Property Sales
                                       Respondent further contends that State laws regarding
                                     real property sales support his position that the contract sub-
                                     ject matter consists only of the house, the lot, and improve-
                                     ments to that lot. For instance, the California Civil Code pro-
                                     vides: ‘‘A real property sales contract may not be transferred
                                     by the fee owner of the real property unless accompanied by
                                     a transfer of the real property which is the subject of the con-
                                     tract, and real property may not be transferred by the fee
                                     owner thereof unless accompanied by an assignment of the
                                     contract’’, Cal. Civ. Code sec. 2985.1 (West 2012), and ‘‘[a]
                                     real property sales contract is an agreement in which one
                                     party agrees to convey title to real property to another party
                                     upon the satisfaction of specified conditions set forth in the
                                     contract’’, id. sec. 2985(a) (West 2012 & Supp. 2014).
                                       Colorado courts have called the real estate the subject
                                     matter of real estate contracts and have noted that when the
                                     contract is signed, equitable title immediately transfers to
                                     the purchaser although naked legal title remains with the
                                     seller. Dwyer v. Dist. Court, Sixth Judicial Dist., 532 P.2d
                                     725, 727 (Colo. 1975). And Arizona statutes define a real
                                     estate sales contract as ‘‘an agreement in which one party
                                     agrees to convey title to real estate to another party upon the
                                     satisfaction of specified conditions set forth in the contract.’’
                                     Ariz. Rev. Stat. sec. 32–2101(49) (2012) (West). Thus,
                                     according to respondent, in Arizona, Colorado, and California
                                     the subject of a real estate contract is the real estate being
                                     transferred.
                                       But in California, the legislature has also defined real
                                     property to include ‘‘[t]hat which is incidental or appurtenant
                                     to land’’. Cal. Civ. Code sec. 658(3) (West 2007). The Colorado

                                     Colorado Common Interest Ownership Act, Colo. Rev. Stat. secs. 38–33.3–
                                     101, et seq.).




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                                     legislature defines real estate to include ‘‘other improvements
                                     and interests that, by custom, usage, or law, pass with a
                                     conveyance of land though not described in the contract of
                                     sale or instrument of conveyance.’’ Colo. Rev. Stat. sec. 38–
                                     33.3–103(25) (2013). And the Arizona legislature also
                                     includes within the definition of real estate ‘‘interests which
                                     by custom, usage or law pass with a conveyance of land
                                     though not described in the contract of sale or instrument of
                                     conveyance.’’ Ariz. Rev. Stat. Ann. sec. 33–1202(19) (2007)
                                     (West). We therefore firmly reject respondent’s contention
                                     that State law definitions of real estate contracts foreclose us
                                     from including the above-referenced documents as an
                                     integral part of the home purchase contracts.
                                        Respondent also advances the statutes of repose from the
                                     three States as supporting his position that the contracts
                                     were completed at the close of escrow. These State statutes
                                     essentially place a time limit on a homebuyer’s right to raise
                                     claims against builders or developers. In Arizona, the statute
                                     of repose begins upon ‘‘substantial completion of the improve-
                                     ment to real property’’. Id. sec. 12–552(A) (2003) (West).
                                        Colorado and California statutes contain similar language.
                                     Cal. Civ. Proc. Code sec. 337.15(a), (g) (West 2006); Colo.
                                     Rev. Stat. sec. 13–80–104(1)(a) (2013). The California statute
                                     defines ‘‘substantial completion’’ to mean the first occurrence
                                     of: ‘‘(1) The date of final inspection by the applicable public
                                     agency. (2) The date of recordation of a valid notice of
                                     completion. (3) The date of use or occupation of the improve-
                                     ment. (4) One year after termination or cessation of work on
                                     the improvement.’’ Cal. Civ. Proc. Code sec. 337.15(g). The
                                     Arizona statute defines the term ‘‘substantial completion’’ as
                                     the date the owner or occupant first uses the improvement,
                                     the improvement is first available for use after completion,
                                     or upon final inspection if required. Ariz. Rev. Stat. Ann. sec.
                                     12–552(E) (2003) (West). The Colorado statute is silent as to
                                     the meaning of substantial completion, but Colorado courts
                                     have indicated it means at least the issuance of a certificate
                                     of occupancy. Shaw Constr., LLC v. United Builder Servs.,
                                     Inc., 296 P.3d 145, 155–156 (Colo. App. 2012).
                                        We conclude that respondent’s emphasis on the statutes of
                                     repose is misplaced. These statutes determine the time from
                                     the date of completion of an improvement which is afforded
                                     to the purchaser to bring suit for construction defects. In




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                                     effect, they operate like a statute of limitation. So, in the
                                     case of homes, the statutes would necessarily run, for
                                     example, from the issuance of a certificate of habitability if
                                     that is the earliest triggering event. But a certificate of occu-
                                     pancy for a particular home would have at most a limited
                                     impact on a homeowners association’s hypothetical cause of
                                     action against SHI, SHLP, or Vistancia for a defect in an
                                     amenity they had constructed.
                                        Respondent also contends that SHI, SHLP, and Vistancia
                                     should not be allowed to hold their homes out as complete for
                                     the purposes of obtaining certificates of occupancy under
                                     State law while simultaneously representing to the Federal
                                     Government that the sales are not complete. Respondent’s
                                     contention lacks merit. The subject matter of the contract is
                                     not limited to the house and the lot, and respondent is com-
                                     paring two different things.
                                        We concur with petitioners that respondent’s interpreta-
                                     tions of the relevant State legal definitions of real estate and
                                     the statutes of repose are too narrow. When viewed in proper
                                     context, the State laws do not necessarily restrict the subject
                                     matter of a real estate contract to just a house and the lot
                                     upon which it sits. Respondent’s analysis is simplistic and
                                     short sighted; it does not acknowledge the complex relation-
                                     ships created by the purchase and sales agreement, espe-
                                     cially SHI’s, SHLP’s, and Vistancia’s obligations that con-
                                     tinue long after the first home is built.
                                           B. Subject Matter of the Contracts
                                       Because we determine that, for the purposes of
                                     ascertaining the proper use of the completed contract method
                                     of accounting as applied to residential home construction,
                                     supra, the contract consisted of more than the purchase and
                                     sale agreement, we must now address the subject matter of
                                     the contract. See sec. 1.460–1(c)(3)(i), Income Tax Regs. In
                                     respondent’s view, the subject matter of the contract consists
                                     solely of the house, the lot, and improvements to the lot.
                                     Under this view, SHI, SHLP, and Vistancia complete their
                                     contracts when escrow closes because at that point the final
                                     completion and acceptance test is met. See sec. 1.460–
                                     1(c)(3)(B), Income Tax Regs. In contrast, petitioners assert
                                     that the subject matter of the contract encompasses the
                                     development in its entirety. Under this view, SHI, SHLP,




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                                     98                   142 UNITED STATES TAX COURT REPORTS                                      (60)


                                     and Vistancia complete their contracts for the purposes of
                                     section 460 when they incur 95% of the allocable costs attrib-
                                     utable to the subject matter of the contract, which is the
                                     development as a whole, and the homebuyers use the subject
                                     matter. See sec. 1.460–1(c)(3)(A), Income Tax Regs. Peti-
                                     tioners contend that the final completion and acceptance test
                                     is met only when the last road is paved and the final bond
                                     is released.
                                        The regulations accompanying section 460 explicitly
                                     acknowledge that the subject matter of a home construction
                                     contract extends beyond the construction of a home. See sec.
                                     1.460–3(b)(2)(iii), Income Tax Regs. When determining
                                     whether a contract qualifies as a home construction contract,
                                     the taxpayer takes into account the total costs of dwelling
                                     units, improvements to the related real property at the site
                                     of the dwelling unit, and the ‘‘allocable share of the cost that
                                     the taxpayer reasonably expects to incur for any common
                                     improvements’’. Id.
                                        Respondent contends that this inclusion is solely for the
                                     purposes of determining whether the taxpayer meets the 80%
                                     test, which determines whether the contract in question is a
                                     home construction contract. Under this theory, a taxpayer
                                     computes the 95% completion test, for which the taxpayer
                                     uses as a part of the denominator only ‘‘total allocable con-
                                     tract costs attributable to the subject matter’’, sec. 1.460–
                                     1(c)(3)(i)(A), Income Tax Regs., without regard to costs allo-
                                     cable to common improvements. But, as petitioners point out,
                                     the regulations also state that, in determining when a con-
                                     tract is begun and completed, ‘‘a taxpayer must consider all
                                     relevant allocable contract costs incurred and activities per-
                                     formed by itself, by related parties on its behalf, and by the
                                     customer, that are incident to or necessary for the long-term
                                     contract.’’ Sec. 1.460–1(c)(1), Income Tax Regs. According to
                                     this interpretation, because the sale price on a home
                                     construction contract includes an allocable share of the cost
                                     of common improvements, sec. 1.460–3(b)(2)(iii), Income Tax
                                     Regs., then the total allocable contract costs must also
                                     include the allocable share of common improvement costs.
                                     Given the divergent positions, the parties ask the Court to
                                     interpret this aspect of the regulations. 18
                                           18 Implicit   in the parties’ positions is that the regulation is valid and en-




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                                        As an initial matter, we must ask what deference, if any,
                                     we should give to respondent’s interpretation of the regula-
                                     tions. Neither party appears to address this issue.
                                     Respondent appears to believe that no such inquiry is nec-
                                     essary because the regulation is clear on its face. While he
                                     concedes that ‘‘[t]he regulations do not define the phrase
                                     ‘subject matter of the contract’ ’’, he also contends that we
                                     should give those words their ‘‘ordinary, contemporary
                                     meaning’’, implying that no ambiguity in the regulation
                                     exists.
                                        Petitioners also do not address or raise the issue of
                                     whether and to what extent we should defer to respondent’s
                                     interpretation of the regulations. But, petitioners’ briefs are
                                     replete with references to respondent’s ‘‘litigating position’’,
                                     presumably a reference to precedent in which we have
                                     declined to give deference to litigating positions. See, e.g.,
                                     Garnett v. Commissioner, 132 T.C. 368, 381 (2009) (citing
                                     Gen. Dynamics Corp. & Subs. v. Commissioner, 108 T.C. 107,
                                     120–121 (1997)); see also Stromme v. Commissioner, 138 T.C.
                                     213, 223 n.2 (2012) (Holmes, J., concurring); Pierre v.
                                     Commissioner, 133 T.C. 24, 40–41 (2009) (Cohen, J., concur-
                                     ring), supplemented by T.C. Memo. 2010–106.
                                        Petitioners use the term ‘‘litigating position’’ presumably in
                                     an attempt to distinguish the current set of facts from that
                                     of Auer v. Robbins, 519 U.S. 452, 461 (1997), in which the
                                     Supreme Court deferred to an agency’s interpretation of its
                                     own regulations expressed in an amicus brief requested by
                                     the Court. Generally, courts do not have to defer to such liti-
                                     gating positions that are unsupported by regulations, rulings,
                                     or administrative practice. Bowen v. Georgetown Univ. Hosp.,
                                     488 U.S. 204, 212 (1988). Respondent does not claim that his
                                     titled to deference under Chevron U.S.A. Inc. v. Natural Res. Def. Council,
                                     Inc., 467 U.S. 837 (1984). These positions are understandable in the light
                                     of administrative law governing deference to regulations, Mayo Found. for
                                     Med. Educ. & Research v. United States, 562 U.S. 44 (2011), and the con-
                                     gressional directive to the Secretary to promulgate regulations concerning
                                     accounting for long-term contracts, sec. 460(h); see ADVO, Inc. & Subs. v.
                                     Commissioner, 141 T.C. 298, 322 (2013). But cf. United States v. Home
                                     Concrete & Supply, LLC, 566 U.S. ll, 132 S. Ct. 1836 (2012). Likewise,
                                     as to Administrative Procedure Act requirements, see Dominion Res., Inc.
                                     v. United States, 681 F.3d 1313 (Fed. Cir. 2012), Cohen v. United States,
                                     650 F.3d 717 (D.C. Cir. 2011), and Burks v. United States, 633 F.3d 347
                                     (5th Cir. 2011).




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                                     position in these cases constitutes ‘‘fair and considered judg-
                                     ment on the issue’’ rather than ‘‘a post hoc rationalization for
                                     past agency action’’. Massachusetts v. Sebelius, 638 F.3d 24,
                                     34 (1st Cir. 2011) (citing Chase Bank USA, N.A. v. McCoy,
                                     562 U.S. 195, 209 (2011)). Thus, respondent does not argue
                                     his position is entitled to any special deference, and we
                                     accord it none.
                                        In matters of regulatory construction, the rules of statutory
                                     construction apply. Caltex Oil Venture v. Commissioner, 138
                                     T.C. 18, 34 (2012). 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 ‘‘ordi-
                                     nary, contemporary, common meaning.’’ Hewlett-Packard Co.
                                     & Consol. Subs. v. Commissioner, 139 T.C. 255, 264 (2012).
                                     ‘‘Subject matter’’ is not defined by the regulations or the
                                     statute. According to respondent the plain meaning of ‘‘sub-
                                     ject matter of the contract’’ means only the house, the lot,
                                     and improvements on that lot. Petitioners, however, contend
                                     that the term ‘‘subject matter of the contract’’ must be
                                     viewed in the light of the regulatory definition of a home
                                     construction contract.
                                        We disagree with the basic premise of respondent’s conten-
                                     tion. ‘‘Subject matter of the contract’’ does not in our view
                                     have the plain meaning he contends. As we concluded above,
                                     SHI’s, SHLP’s, and Vistancia’s contracts each encompass
                                     more than just the house, the lot, and the improvements to
                                     the lot. If we were to ascribe a plain meaning to the term,
                                     then the subject matter of the contracts would include the
                                     common improvements.
                                        Further supporting the view that the regulation is not as
                                     narrow as respondent contends is the context of the regu-
                                     latory scheme generally. In construing the regulation, we do
                                     not just look at the words or phrases in isolation, but rather
                                     we read these words and phrases in their context and with
                                     a view to their place in the overall statutory scheme. FDA v.
                                     Brown & Williamson Tobacco Corp., 529 U.S. 120, 133
                                     (2000). Thus, we look at the contract completion tests in sec-
                                     tion 1.460–1(c)(3), Income Tax Regs., in the context of the
                                     entire section 460 regulatory scheme, including section




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                                     1.460–3, Income Tax Regs., concerning long-term construc-
                                     tion contracts, and, of course, the statute itself. 19
                                        Section 1.460–1(c)(3)(i)(A), Income Tax Regs., states that
                                     the contract is completed upon ‘‘[u]se of the subject matter of
                                     the contract by the customer for its intended purpose (other
                                     than for testing) and at least 95 percent of the total allocable
                                     contract costs attributable to the subject matter have been
                                     incurred by the taxpayer’’. The final completion and accept-
                                        19 The little legislative history that exists supports our conclusions. Be-

                                     fore 1986 taxpayers could account for long-term contracts under what is
                                     known as the completed contract method or the percentage of completion
                                     method. See sec. 446(c) until 1965, then sec. 451 (1954 as amended), and
                                     sec. 1.451–3(a), Income Tax Regs. (1986).
                                        In 1986, Congress began to cut back on the completed contract method,
                                     allowing only 60% of revenue to be deferred under this method. Tax Re-
                                     form Act of 1986, Pub. L. No. 99–514, sec. 804(a), 100 Stat. at 2358. In
                                     1987 this percentage was reduced to 30%. Omnibus Budget Reconciliation
                                     Act of 1987, Pub. L. No. 100–203, sec. 10203, 101 Stat. at 1330–394. In
                                     1988 Congress further scaled back the amount of income that could be de-
                                     ferred under the completed contract method. TAMRA sec. 5041. By 1989
                                     long-term contracts had to be reported under the percentage of completion
                                     method. Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101–239,
                                     sec. 7621(a), 103 Stat. at 2375.
                                        Congress added the exception for home construction contracts from the
                                     percentage of completion method of accounting as an intended relief meas-
                                     ure in 1988 as part of TAMRA. Senator Dennis DeConcini and Representa-
                                     tive Richard T. Schulze each proposed identical amendments to the respec-
                                     tive Senate and House versions of the bill. S. 2694, 100th Cong. (1988)
                                     (text at 134 Cong. Rec. 20862 (Aug. 8, 1988)); H.R. 5151, 100th Cong.
                                     (1988). Both legislators were concerned with the potential recognition of in-
                                     come not yet received by the homebuilders and matching costs with reve-
                                     nues. 134 Cong. Rec. 20722–20723 (Aug. 5, 1988) (Sen. DeConcini); 29962–
                                     29963 (Oct. 12, 1988) (Sen. DeConcini); 134 Cong. Rec. 20202 (Aug. 3,
                                     1988) (Rep. Schulze). They were also reacting to an advance release of an
                                     IRS pronouncement that would apply the percentage of completion method
                                     of accounting to contracts for the construction and sale of a home. See also
                                     Notice 88–66, 1988–1 C.B. 522, 554.
                                        Their proposed amendments were narrower than what ultimately
                                     emerged from conference. They called for an exemption for residential real
                                     property contracts that were estimated to be completed within 12 months
                                     of being entered into. S. 2694; H.R. 5151. Senator DeConcini believed this
                                     12-month rule would prohibit deferral for builders of custom homes. 134
                                     Cong. Rec. 20723. The conference report is silent as to the rationale for the
                                     home construction contract exception as it exists now, but what ultimately
                                     emerged was broader than the earlier proposed 12-month rule. What mat-
                                     ters is the law as written. Shady Grove Orthopedic Assocs., P.A. v. Allstate
                                     Ins. Co., 559 U.S. 393, 403 (2010).




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                                     102                 142 UNITED STATES TAX COURT REPORTS                                      (60)


                                     ance test states simply: ‘‘Final completion and acceptance of
                                     the subject matter of the contract.’’ Sec. 1.460–1(c)(3)(i)(B),
                                     Income Tax Regs. But ‘‘to determine whether final comple-
                                     tion and acceptance of the subject matter of a contract have
                                     occurred, a taxpayer must consider all relevant facts and cir-
                                     cumstances.’’ Sec. 1.460–1(c)(3)(iv)(A), Income Tax Regs. In
                                     one test, the taxpayer looks to allocable costs attributable to
                                     the subject matter of the contract; in the other test, all rel-
                                     evant facts and circumstances inform the subject matter of
                                     the contract. It is clear that, in the context of the language
                                     surrounding the phrase ‘‘subject matter of the contract’’, the
                                     definition is necessarily broader than that advocated by
                                     respondent.
                                        The context of the phrase in relation to the rest of the
                                     regulatory scheme also indicates a broader interpretation. As
                                     stated earlier, section 460 defines ‘‘home construction con-
                                     tract’’ for the purposes of a specific subsection. Sec.
                                     460(e)(6)(A). And, as mentioned, 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’’. Sec. 1.460–3(b)(2)(iii), Income
                                     Tax Regs. While the definition of ‘‘home construction con-
                                     tract’’ in the statute and the regulations does not necessarily
                                     mean that this definition carries over to the use of the term
                                     ‘‘contract’’ in the rest of the statute and the regulations, it is
                                     at a minimum instructive.
                                        In addition, the regulations instruct taxpayers to ‘‘consider
                                     all relevant allocable contract costs * * * that are incident to
                                     or necessary for the long-term contract’’, sec. 1.460–1(c)(1),
                                     Income Tax Regs., in determining the contract commence-
                                     ment and completion dates. And ‘‘allocable contract costs’’ is
                                     a defined term. Sec. 1.460–1(b)(3), Income Tax Regs. For the
                                     purposes of home construction contracts, such costs include
                                     ‘‘the cost of any activity that is incident to or necessary for
                                     the taxpayer’s performance under a long-term contract.’’ Sec.
                                     1.460–5(d)(1), Income Tax Regs. The regulations expressly
                                     include within the definition of ‘‘allocable contract costs’’
                                     indirect costs such as those related to equipment and facili-
                                     ties, labor, indirect materials and supplies, quality control
                                     and inspection, and certain taxes. Sec. 1.460–5(d)(2)(i),
                                     Income Tax Regs.




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                                     (60)                SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                  103


                                        Thus, at the very minimum, the 95% completion test, as
                                     applied here, looks to costs beyond just those associated with
                                     the house, the lot, and improvements to the lot. The facts
                                     and circumstances gloss on the final completion and accept-
                                     ance test also indicates that the subject matter of the con-
                                     tract in these cases is more than just the house, the lot, and
                                     improvements to the lot. Ultimately, this outcome is sup-
                                     ported by our conclusion, supra, that SHI’s, SHLP’s, and
                                     Vistancia’s contracts consist of more than the purchase and
                                     sale agreement alone. When the contract documents are read
                                     together, the subject matter of the contract is quite clearly
                                     more than just the house, the lot, and improvements to the
                                     lot.
                                        Respondent further contends that, under these contracts,
                                     the 95% completion test can never occur before final comple-
                                     tion because the 95% completion test contains a use require-
                                     ment. See sec. 1.460–1(c)(3)(A), Income Tax Regs. Under this
                                     theory, the subject matter is the house and the lot, and the
                                     subject matter is used on the same day the contract is com-
                                     pleted and accepted. Respondent bases his contention on the
                                     erroneous assumption that the subject matter of the contract
                                     is only the house and lot. While the house may be complete
                                     as of the close of escrow and the purchaser may be using the
                                     house at that time, the entire subject matter of the contract
                                     may not yet be completed or used.
                                        The subject matter of the contract includes the house, the
                                     lot, and improvements to the lot as well as the common
                                     improvements in the development. Thus, for the purpose of
                                     the 95% completion test, SHI, SHLP, and Vistancia correctly
                                     tested the total allocable costs associated with the develop-
                                     ment against the costs incurred to date. For purposes of the
                                     final completion and acceptance test, SHI, SHLP, and
                                     Vistancia appropriately decided that, on the basis of the facts
                                     and circumstances, final completion did not occur until the
                                     final bonds were released and the final road paved. 20
                                           20 Sec.
                                               1.460–1(c)(3)(iv)(A), Income Tax Regs., contains a caveat as to the
                                     facts and circumstances component of the completion and acceptance test:
                                     ‘‘Nevertheless, a taxpayer may not delay the completion of a contract for
                                     the principal purpose of deferring federal income tax.’’ Respondent does not
                                     suggest that SHI, SHLP, or Vistancia intentionally delayed the completion
                                     of their contracts, either through not paving the final road or not securing
                                                                                                       Continued




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                                     104                 142 UNITED STATES TAX COURT REPORTS                                      (60)


                                       In addition, respondent contends that in effect what SHI,
                                     SHLP, and Vistancia have done is the same as aggregating
                                     the different home purchase contracts. As respondent cor-
                                     rectly points out, taxpayers are to apply the completion tests
                                     of the regulations on a contract-by-contract basis. See sec.
                                     1.460–1(c)(3)(i), Income Tax Regs. The statute and the regu-
                                     lations do allow taxpayers to aggregate contracts, but only in
                                     certain situations, for the purposes of section 460. Sec.
                                     460(f)(3); sec. 1.460–1(e), Income Tax Regs. According to
                                     respondent, not only do the aggregation rules not apply in
                                     these cases but SHI, SHLP, and Vistancia did not file the
                                     requisite statement with their Federal income tax returns as
                                     required by the regulations. See sec. 1.460–1(e)(4), Income
                                     Tax Regs. But SHI, SHLP, and Vistancia did not aggregate
                                     contracts. Rather, they tested completion dates of individual
                                     contracts using their conception of the subject matter of
                                     those contracts.
                                       To summarize, we agree with petitioners that the contracts
                                     consist of more than just the purchase and sale agreements
                                     and that the subject matter of the contracts includes the
                                     costs of common improvements for the purpose of testing
                                     their completion date. Therefore, the contracts will generally
                                     meet the 95% completion test before they meet the final
                                     completion and acceptance test. Under the completed con-
                                     tract method of accounting, SHI, SHLP, and Vistancia are
                                     entitled to defer income from their contracts until 95% of the
                                     total contract costs, allocable to the subject matter of the con-
                                     tract, is incurred or the development or phase of the develop-
                                     ment, as the case may be, is completed and accepted.
                                           C. Secondary Items
                                       Respondent asks that if we agree with petitioners’ reading
                                     of ‘‘subject matter of the contract’’ then we find that the costs
                                     not directly associated with the houses, the lots, and
                                     improvements to the lots constitute secondary items under
                                     section 1.460–1(c)(3)(ii), Income Tax Regs. Respondent con-
                                     tends that because SHI, SHLP, and Vistancia and the home-
                                     buyers treated the common improvements contemplated in
                                     the contract as secondary items ‘‘subordinate in importance

                                     the release of the final bond. We mention this caveat only for the sake of
                                     completeness.




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                                     (60)                SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                  105


                                     to the house’’, the regulations forbid them from taking those
                                     items into account in determining the contract completion
                                     date. Petitioners, on the other hand, maintain that these
                                     common improvements are not secondary items and that the
                                     parties to each contract did not treat or consider the items
                                     as secondary items in the contracts but rather integral
                                     aspects of the homes’ purchase and sale.
                                        Section 1.460–1(c)(3)(ii), Income Tax Regs., provides:
                                             (ii) Secondary items. The date a contract accounted for using the CCM
                                           [completed contract method] is completed is determined without regard
                                           to whether one or more secondary items have been used or finally com-
                                           pleted and accepted. If any secondary items are incomplete at the end
                                           of the taxable year in which the primary subject matter of a contract is
                                           completed, the taxpayer must separate the portion of the gross contract
                                           price and the allocable contract costs attributable to the incomplete sec-
                                           ondary item(s) from the completed contract and account for them using
                                           a permissible method of accounting. A permissible method of accounting
                                           includes a long-term contract method of accounting only if a separate
                                           contract for the secondary item(s) would be a long-term contract, as
                                           defined in paragraph (b)(1) of this section.

                                     The regulations do not define ‘‘secondary items’’, and ordi-
                                     narily we would resort to the tools of regulatory analysis dis-
                                     cussed above. But respondent and petitioners are essentially
                                     in agreement as to the meaning of this phrase. In their
                                     briefs, they both urge us to read secondary items as items
                                     that the contracting parties intend to be secondary. We
                                     concur that the questions of what is a secondary item in a
                                     contract and what is the primary subject matter of a contract
                                     are questions to be answered by reference to the facts and
                                     intent of the contracting parties.
                                        Here again, the parties’ disagreement over the nature of
                                     the contracts becomes paramount. Respondent’s interpreta-
                                     tion of the contracts as being merely about the house, the lot,
                                     and the improvements to the lot necessarily informs his
                                     belief that the common improvements must be secondary
                                     items. Similarly, petitioners’ view of the contracts as being
                                     about the lifestyle including access to the planned commu-
                                     nity, the amenities, and the infrastructure, necessarily
                                     informs their belief that the common improvements are part
                                     of the primary subject matter of the contract.
                                        We agree with petitioners. As discussed at length, the
                                     contractual documents consist of more than just the purchase
                                     and sale agreement. When the contract documents are exam-




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                                     106                 142 UNITED STATES TAX COURT REPORTS                                      (60)


                                     ined together, it becomes readily apparent that the primary
                                     subject matter of the contracts includes the house, the lot,
                                     improvements to the lot, and common improvements to the
                                     development. As a factual matter, we find the amenities to
                                     be of great importance to and a crucial aspect of SHI’s,
                                     SHLP’s, and Vistancia’s sales effort, obtaining of govern-
                                     mental approval of the development, and the buyers’ pur-
                                     chase decision, and thus the amenities are an essential ele-
                                     ment of the home purchase and sale contract.
                                           D. Conclusion
                                       We have found that the contract documents consist of
                                     much more than just the purchase and sale agreement. This
                                     conclusion leads us to hold that SHI, SHLP, and Vistancia
                                     appropriately included the costs of common improvements in
                                     determining the contract completion date. Furthermore, the
                                     nature of the business and the contract documents also lead
                                     us to conclude that the common improvements are not sec-
                                     ondary items and do not have to be accounted for separately.
                                     IV. Clear Reflection of Income
                                        We have determined that SHI, SHLP, and Vistancia prop-
                                     erly used a permissible method of accounting. Yet the ques-
                                     tion remains whether that method of accounting clearly
                                     reflects income. See sec. 446(b). The Commissioner has wide
                                     discretion in determining whether a method of accounting
                                     clearly reflects income. Thor Power Tool Co. v. Commissioner,
                                     439 U.S. 522, 532 (1979). If, however, SHI’s, SHLP’s, and
                                     Vistancia’s method of accounting clearly reflects income, then
                                     respondent cannot be permitted to change their method of
                                     accounting even to a method that more clearly reflects
                                     income. Photo-Sonics, Inc. v. Commissioner, 357 F.2d 656,
                                     658 n.1 (9th Cir. 1966), aff ’g 42 T.C. 926 (1964); Keith v.
                                     Commissioner, 115 T.C. 605, 617 (2000). Whether a method
                                     of accounting clearly reflects income is a question of fact.
                                     Peninsula Steel Prods. v. Commissioner, 78 T.C. 1029, 1045
                                     (1982).
                                        SHI, SHLP, and Vistancia expended a great deal of capital
                                     early on in the construction of their developments. The land
                                     acquisition costs alone were a large percentage of the total
                                     development cost. On top of that, they incurred upfront costs




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                  107


                                     such as grading the land, installing sewer, water, gas, elec-
                                     tric, and other utilities, and constructing roads, not to men-
                                     tion the entitlement costs and bond costs. Many of these
                                     costs were incurred before the first home was constructed, let
                                     alone sold. Once they began selling homes, it was some time
                                     before revenue from those sales exceeded the already
                                     incurred project costs. They were contractually or legally
                                     required to complete the items associated with these costs.
                                     Because their projects were longer projects, and given the
                                     nature of the home construction industry, costs are difficult
                                     to predict, and they could not accurately determine their
                                     profit until the development was nearly completed.
                                        The 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 comple-
                                     tion method of accounting. But the clearly articulated excep-
                                     tion for homebuilders is, as to them, generously broad and
                                     reflects a deliberate choice by Congress that home construc-
                                     tion contracts should be treated differently and accorded the
                                     more generous deferral of the completed contract method.
                                     SHI’s, SHLP’s, and Vistancia’s use of the completed contract
                                     method was specifically contemplated by Congress and is a
                                     permissible, congressionally sanctioned clear reflection of
                                     income.
                                        We note that SHLP admittedly applied the 95% completion
                                     test in 2002 and 2003 by comparing the number of homes
                                     closed in escrow in the development to the number of homes
                                     projected to be built in the development. This calculation was
                                     an incorrect application of the completed contract method of
                                     accounting. But the 2002 tax year is not in issue, and the
                                     parties introduced evidence showing that for SHLP’s long-
                                     term contracts in 2003, the 95% completion test had not yet
                                     been met. Thus, the completed contract method of accounting
                                     as properly applied renders the same result as the result
                                     which was reported for the 2003 tax year, and it clearly
                                     reflects the income of SHLP for that 2003 tax year.
                                        Respondent points out that Trilogy at La Quinta and
                                     Vistancia were divided into phases for purposes of testing
                                     contract completion, but other developments were not simi-
                                     larly divided. Respondent appears to be implying that such
                                     a discrepancy in the application of the 95% completion test
                                     demonstrates that SHI’s, SHLP’s, and Vistancia’s use of the




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                                     108                 142 UNITED STATES TAX COURT REPORTS                                      (60)


                                     completed contract method does not clearly reflect income.
                                     For instance, the entire Costa Azul development, as indicated
                                     by the public report, was to consist of 17 phases, which at
                                     first glance seems like a lot. But a closer look at the public
                                     report reveals that the projected total number of homes in
                                     Costa Azul was 83, and each phase was to be rather small.
                                     For instance, phase 10 consisted of four residential lots.
                                     Trilogy, on the other hand, was to consist of 23 phases with
                                     a projected 1,365 residences on 1,203 residential lots. The
                                     ninth phase was to consist of 48 residential lots.
                                        In addition, for the purposes of these cases, the parties
                                     stipulated that the Costa Azul development as contemplated
                                     by SHLP was only a small, relatively short-term buildout
                                     aspect of that overall development. In effect, it was equiva-
                                     lent to a phase of the overall development. The Costa Azul
                                     development, as initially proposed to the Land Committee,
                                     was a short-term, 37-home development, and, as stipulated
                                     by the parties, Costa Azul was developed in eight phases
                                     with 42 total lots. 21 While Costa Azul as presented in this
                                     case differs from Costa Azul as presented in the public
                                     report, SHLP’s use of the completed contract method of
                                     accounting clearly reflected income. There is no material evi-
                                     dence in the record, and we discern none, that SHLP
                                     attempted to manipulate or to delay its Costa Azul project or
                                     contracts to obtain a longer deferral period. 22
                                        Respondent also contends that petitioners’ interpretation of
                                     the subject matter of the contract ‘‘creates the nonsensical
                                     situation of the subject matter of each individual contract for
                                     the sale of a house being the entire development and, thus,
                                     including the subject matter of every other past, present, and
                                     future house.’’ He goes on to state that a purchaser of one
                                       21 The record is unclear why the number of lots as stipulated differs from

                                     the number of homes projected in the Land Committee report. Perhaps
                                     some houses were constructed on multiple lots, or some lots were used as
                                     common areas. What is clear is that the project as originally contemplated
                                     in the public report did not fully materialize when the real estate market
                                     turned and SHLP did not purchase the remaining lots.
                                       22 The appropriate scope of each contract as it involves common or exclu-

                                     sive off-lot amenities is a factual question. Respondent has not shown that
                                     SHI’s, SHLP’s, or Vistancia’s choices of development or phase as the scope
                                     for purposes of the 95% test as it involves off-lot amenities were improper
                                     or unreasonable as to any of the eight representative developments.




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                                     (60)               SHEA HOMES, INC. & SUBS. v. COMMISSIONER                                  109


                                     home has no claim to any unsold or previously sold lots and
                                     homes. Certainly this latter statement is correct. The con-
                                     tract does not include the houses and lots other than that
                                     which is purchased; but the subject matter of each individual
                                     purchased house still includes the development or phase of
                                     the development and its common improvements and amen-
                                     ities. Thus, while there are commonalities in the subject mat-
                                     ters of the contracts, such as the amenities and other
                                     common improvements, the subject matters as to the indi-
                                     vidual house and lot are not identical. 23
                                        For these reasons, we conclude that respondent may not
                                     change SHI’s, SHLP’s, and Vistancia’s method of accounting
                                     even if his proposed method more clearly reflects income. See
                                     Prabel v. Commissioner, 91 T.C. at 1112.
                                     V. Conclusion
                                       SHI, SHLP, and Vistancia are permitted to report income
                                     and loss from the sales of homes in their planned develop-
                                     ments using the completed contract method of accounting as
                                     consistent with this Opinion. 24
                                           23 Furthermore,
                                                        we reject the characterization that what SHI, SHLP,
                                     and Vistancia have done, and what we approve of, is in substance an ag-
                                     gregation of contracts. Contracting parties have a right to their own con-
                                     tract for the purposes of State law, and it is this contract that we test in
                                     determining the subject matter of the contract. In the case of much larger,
                                     decades-long developments, the meeting of the minds between the pur-
                                     chaser and the seller would be much less likely to include an amenity or
                                     common improvement with a completion date unreasonably far in the fu-
                                     ture. Here, the subject matter of SHI’s, SHLP’s, and Vistancia’s contracts
                                     includes the development. In a different case, under different facts, similar
                                     treatment of an unreasonably long-term development may in essence be an
                                     aggregation.
                                        24 We are cognizant that our Opinion today could lead taxpayers to be-

                                     lieve that large developments may qualify for extremely long, almost un-
                                     limited deferral periods. We would caution those taxpayers that a deter-
                                     mination of the subject matter of the contract is based on all the facts and
                                     circumstances. If Vistancia, for example, attempted to apply the contract
                                     completion tests by looking at all contemplated phases, it is unlikely that
                                     the subject matter as contemplated by the contracting parties could be
                                     stretched that far. Further, sec. 1.460–1(c)(3)(iv)(A), Income Tax Regs.,
                                     may prohibit taxpayers from inserting language in their contracts that
                                     would unreasonably delay completion until such a super development is
                                     completed.




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                                     110                 142 UNITED STATES TAX COURT REPORTS                                      (60)


                                       The Court has considered all of the parties’ contentions,
                                     arguments, requests, and statements. To the extent not dis-
                                     cussed herein, the Court concludes that they are meritless,
                                     moot, or irrelevant.
                                                                          Decisions will be entered for petitioners.

                                                                               f




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