Been getting a lot of email from nervous readers today about the following article:
In a tax fight that could jolt the real estate business, Howard Hughes Corp (NYSE:HHC) is challenging the U.S. Internal Revenue Service over a $144.1 million tax bill stemming from land sales at Summerlin, an enormous planned community in southern Nevada.
The dispute centers on an accounting practice – known as the “completed contract method” – that the IRS has scrutinized for years. A Tax Court trial is scheduled for November 5 in Las Vegas.
The IRS contends, according to court records, that Howard Hughes improperly deferred taxes on income from sales of residential lots at Summerlin, which sprawls across 35 square miles on the western fringe of Las Vegas.
The company should pay taxes as it books the lot sales and not wait until the project is nearly finished, the IRS said.
But Howard Hughes says its use of the method is permissible under an IRS exemption for home construction, and that developers pay up-front costs and do not know their ultimate taxable gains until a project is almost finished.
Both the company and the IRS declined to comment.
Dallas-based Howard Hughes is a spinoff from General Growth Properties. Though Howard Hughes is the company in court, General Growth is liable for tax payments if the IRS wins, according to the spinoff agreement.
General Growth declined to comment.
Activist investor William Ackman is chairman of Howard Hughes Corp (NYSE:HHC). Ackman’s hedge fund, Pershing Square Capital Management LP, owned 3.6 million Howard Hughes shares as of June 30.
The IRS said in September 2009 that companies using the completed contract accounting method to defer income from land sales for years, or even a decade or more, could trigger an audit.
The IRS has other Tax Court challenges pending with property developers over the completed contract method, or CCM.
“Taxpayers’ misuse of the CCM is a growing trend within the residential construction industry,” the IRS said in a September 2009 internal memo, one of several posted on the IRS website.
HIGH STAKES FOR INDUSTRY
An IRS win in Tax Court could mean property developers would need to pay taxes on a “percentage-of-completion” accounting method, a less-favorable approach for businesses.
The IRS is “taking a pretty hard-line position, saying that you just are not entitled to the completed-contract method,” said David Auclair, principal at accounting firm Grant Thornton.
“This is a big issue for land developers and commercial real estate,” he said.
Homebuilders also use the completed contract method. In July, California-based Shea Homes LP went to trial with the IRS over this issue.
The company could owe up to $61 million in federal and state taxes, Shea said in Securities and Exchange Commission filings.
Wilkes Graham, senior vice president at Compass Point Research & Trading LLC, said a court loss for Howard Hughes and General Growth would not deal a blow to their shareholders.
But, he said, the challenge to the accounting method will be watched by other companies.
“It’s a bigger deal overall,” he said. For companies using the completed contract method, “those entities would be at risk” if the IRS wins, he said.
Howard Hughes got a tax bill in February 2011 for allegedly under-paying taxes in 2007 and 2008 on Summerlin, a project that the company does not expect to sell out until 2039.
Hurt by the recent financial crisis, Summerlin’s acreage sales are starting to recover this year. The development’s land covers an area half the size of the District of Columbia.
As a developer, Howard Hughes builds the infrastructure at Summerlin – roads, sewer and water, electricity. The company makes money when it sells developed properties to home builders.
A Tax Court loss by Howard Hughes would hurt the development industry just as it is starting to recover.
Developers beginning new projects may need to pay taxes sooner, adding an up-front cost for the businesses, said Richard Shavell, a vice chairman at the Associated Builders and Contractors, an industry group. “If the IRS wins, they could cause a lot of uncertainty,” he said.
They want to know “does Howard Hughes Corp (NYSE:HHC) have anything to worry about?”. For the answer we have to go back to March of 2011 and my little spat with Simon Property Group, Inc (NYSE:SPG)’s David Simon. We were arguing over whether or not his offer for General Growth Properties Inc (NYSE:GGP) when it was still in Chapter 11 was identical to the offer Brookfield Asset Management Inc.(NYSE:BAM) (TSE:BAM.A) made. I said it wasn’t and the main reason it wasn’t was because of the treatment of the Spinco, then GGO, now Howard Hughes Corp (NYSE:HHC).
Here is the applicable sections (bold type) and here is the whole post:
From the “Cornerstone Agreement”
“On or prior to the Effective Date, the Company shall incorporate getgoods de AG (ETR:GGO) with issued and outstanding capital stock consisting of at least the GGO Common Share Amount of shares of common stock (the “GGO Common Stock”), designate an employee of the Company familiar with the Identified Assets and reasonably acceptable to each Purchaser to serve as a representative of GGO (the “GGO Representative”) and shall contribute to GGO (directly or indirectly) the assets (and/or equity interests related thereto) set forth in Exhibit E hereto and have GGO assume directly or indirectly the associated liabilities (the “Identified Assets”); provided, however, that to the extent the Company is prohibited by Law from contributing one or more of the Identified Assets to getgoods de AG (ETR:GGO) or the contribution thereof would breach or give rise to a default under any Contract, agreement or instrument that would, in the good faith judgment of the Company in consultation with the GGO Representative, impair in any material respect the value of the relevant Identified Asset or give rise to additional liability (other than liability that would not, in the aggregate, be material) on the part of GGO or the Company or a Subsidiary of the Company, the Company shall (i) to the extent not prohibited by Law or would not give rise to such a default, take such action or cause to be taken such other actions in order to place GGO, insofar as reasonably possible, in the same economic position as if such Identified Asset had been transferred as contemplated hereby and so that, insofar as reasonably possible, substantially all the benefits and burdens (including all obligations thereunder but excluding any obligations that arise out of the transfer of the Identified Asset to the extent included in Permitted Claims) relating to such Identified Asset, including possession, use, risk of loss, potential for gain and control of such Identified Asset, are to inure from and after the Closing to GGO (provided that as soon as a consent for the contribution of an Identified Asset is obtained or the contractual