A part of the Tax Reform Act of 1986 enacted the Internal Revenue Code Section 460 which requires the use of the percentage of completion method for long term construction contracts.
Generally, a long term construction contract can be defined as a contract for manufacture, building, installation, or construction of property that is not completed in the tax year which it is being entered into. In addition to using the percentage of completion method, the taxpayer is also required to compare the amount of taxes paid in previous years with the tax that would have been owed if actual costs and contract price had been used to compute gross income.
The proper way to report this computation is to use Form 8697 (Interest Computation under the Look Back Method for Completed Long Term Contracts). These rules are generally very complex and the IRS gives relief from them to small contractors and contractors whose average annual gross receipts for the three previous tax years are $10 million or less.
Home Construction Contract Exception
The IRS gives relief to contractors under the home construction contract exception. To qualify as a home construction contract, the contract must:
1. Be for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvement of, real property.
2. 80% or more of the estimated total contract costs are reasonably expected to be attributable to dwelling units, including any improvements to real property directly related to the dwelling units and located on the site of the dwelling units.
3. The dwelling units must be contained in buildings that have four or fewer dwelling units.
As long as the contract meets the three provisions listed above, it will be except from Code Section 460. Townhouses and row houses constitute separate buildings for this purpose, regardless of how many are attached to one another.
Small Contractor Contract Exception
In generally, the small contractor contract exception requires the following to be met:
1. At the time the contract was entered, it was estimated that the contract would be completed within a 2 year period beginning on the commencement date of the contract.
2. The contractor’s average annual gross receipts for the three taxable years before the year in which the contract was entered into did not exceed $10 million.
As long as these two provisions are met by a small contractor, they will be exempt from Code Section 460.
Keep in mind that even thought a small contractor is exempt from reporting using the percentage of completion method and applying the look back interest rule, they are not exempt from the interest capitalization rules that are applicable to all contractors.