A Refresher on Tax Treatment for Residential Construction
Economic recovery in the U.S. has resulted in an uptick in residential construction. With new single family homes, condos, and apartment complexes dotting the landscape, it’s an opportune time to revisit tax treatment when reporting profits and losses on these types of contracts.
The uniform tax code makes a distinction between home and residential construction contracts:
- Projects may be covered by the home construction regulations if they contain up to 4 dwelling units – e.g., a single family home, a duplex, 4-unit row housing (townhouses).
- “Residential construction” covers building with any number of dwelling units.
Tax treatment for home construction allows the developer to defer recognition of any profit or loss until the project is substantially complete. This milestone occurs when 95% of the estimated project costs have been expended and the building is ready to be used for its intended purpose.
For residential construction projects, developers may defer 30% of a jobs gross profit until the completion of their efforts (a la home construction). They must account for the remaining 70% using the percentage of completion method. Under these rules, developers estimate project revenues and costs at the start of the project. At the close of each reporting period, they account for the percentage of costs that have been invested in the project and remit a proportionate share of taxes based on their best estimates of profits at project completion.
When projects traverse multiple years, developers render annual adjustments to their revenue and costs estimates and modify their tax payments accordingly. If it turns out that they underreported income in the final analysis, they pay interest along with their taxes. If they overreported income, the government pays them interest. This is often referred to as the lookback calculation. Home construction contracts are not subject to this lookback calculation.
In addition to the timing of tax remittances, there’s one other significant difference between home and residential construction. For Alternative Minimum Tax (AMT) purposes, long-term contracts are required to use the percentage of completion method. Home construction contract are not subject to this AMT requirement; residential construction projects are subject to this AMT requirement.
If a project must be classified as residential construction, the developer needs proper documentation to capture anticipated income (revenue less costs) as well as a tracking system to capture costs incurred throughout the life of the project. When these elements are in place, it’s not terribly complicated to calculate taxes and provide remittances in a timely manner. On the other hand, it can be unpleasant to backtrack after the fact and create the audit trail when a tax deadline looms.
Your CPA is a good resource for determining the proper classification for your construction project. He or she can provide expert guidance to ensure that you track project classification appropriately as they occur, thereby saving you time, money, and headaches downstream. And, of course, you’ll get an early warning about your quarterly tax liabilities so that you can have the right amount of resources on hand when they’re due.