Federal tax law provides special tax accounting rules for long-term construction and manufacturing contracts that are not completed in the same taxable year they are entered into. These statutory rules generally require developers of large condominium projects to use the percentage-of-completion method of accounting when pre-selling condominium units during the construction phase. Under percentage-of-completion, the developer includes a portion of the contract price in gross income annually as he or she incurs construction and other contract costs.
Under the completed contract method, in contrast, a developer would recognize the contract amount as income when the sale closed and the buyer took possession of the condominium unit.
The completed contract method would provide a more accurate and clear reflection of income from condominium construction. Large condominium projects regularly take two or three years to complete, or even longer. In these cases, the developer will often market units to the public prior to completion and accept deposits from prospective buyers in order to secure construction financing. The buyer agrees to purchase the unit at a future date. During the construction period, the developer does not receive “draws” or “progress payments” from the buyer. The developer is not entitled to the balance of the purchase price or access to the original deposit until the condominium unit is delivered and the buyer closes. In the interim, the developer uses construction financing to pay for the expenses related to the condominium development. Typically, the lender will require that all dollars received upon sale of the condominium units first go towards paying down the construction financing, exacerbating the phantom income issue for the developer.
In addition, the developer retains title to the property until closing, bears all economic risk until closing, and finishes construction under the developer’s own terms and direction. The deposit usually constitutes the sole amount at risk for the buyer, who is specifically limited to a refund of the deposit as “liquidated damages” in the event of a default by the developer. Such a default occurs where the developer, for whatever reason, fails to build or fails to convey the house on the date of closing. Similarly, under the terms of a typical contract, the deposit constitutes the only damages recoverable by the developer in the event of a default by the buyer.
Lastly, State law and contractual commitments typically restrict the developer’s access to deposits, and until the transaction is completed and the buyer takes possession, there is no certainty that the developer will receive the proceeds from the sale.
All of these factors demonstrate how the percentage-of-completion method of accounting creates a mismatch of cash flow and tax liability. In order to pay tax on this phantom income, developers must have other revenue streams, or they must secure financing or capital from another source. This limits the amount of capital developers have to fund projects. Financial institutions will not finance tax payments through construction financing because tax payments are not considered a cost of the project. Failure to find the additional financing or capital needed to prepay tax on the phantom income threatens a taxpayer’s ability to follow through with construction projects that strong underlying economic fundamentals would otherwise justify.
In short, the current tax accounting rules create artificial hurdles to high-density condominium construction, distort the economics of residential construction, and serve no discernible tax policy purpose. The pre-sale of condominium units should not trigger the recognition of income until the individual contracts are completed.
The tax accounting rules requiring the percentage-of-completion method were designed to prevent the abusive deferral of income by defense and government contractors. Congress was concerned that large defense contractors were using the completed contract method of accounting to defer income recognition for long-term contracts under which substantial progress payments would be made prior to the completion of the contract. The rules were not intended to apply to residential construction.
The existing, discriminatory tax rule for condominium construction is particularly harmful in light of the significant and often measureable economic, environmental, and social benefits of high-density residential development. High-density development brings down the costs of infrastructure, as well as the costs of key public services: police, fire, and emergency medical assistance. The environmental benefits include reduced vehicle emissions and smaller ecological footprints that minimize encroachment on farms, forests, and other sensitive areas. In addition, research links high-density growth to greater labor productivity and economic innovation
In the last Congress, the Fair Accounting for Condominium Construction Act (H.R. 3659, 115th Cong.) would have ended this unfair treatment, but it was not enacted.
Fortunately, the Treasury Department can solve this problem and provide a lift to homebuilding and the economy by finalizing pending, proposed tax regulations related to condominium construction. Residential buildings with four or fewer units currently qualify for a home construction exception that allows the developer to use the completed contract method of accounting. Under this method, the income is recognized when the sale closes and the buyer takes possession. A proposed Treasury regulation would clarify that all residential condominium construction is eligible for the completed contract method of accounting. REG-120844-07 (Sep. 29, 2008). In short, each condominium unit would be treated as a separate building for purposes of determining whether the underlying contract qualifies as a home construction contract. The change would not reduce developers’ tax liability. It would simply align the timing of the income more appropriately.
Eliminating unfair taxes on the income of new condominium construction would help ensure that projects move forward and put more Americans to work. Treasury should finalize its proposed regulation on condominium construction immediately.