Legal Opinion Negates IRS Tract Prepayment Ruling : Builders Had Feared That Advanced Taxes on Home Sales Might Cause Them Some Cash-Flow Problems

Tract home builders apparently need not be worried that a recent change in the Internal Revenue Code will force them to prepay millions of dollars in taxes--and that could save new-home buyers thousands of dollars each.

In June, the Internal Revenue Service modified its long-term contract rules to require most home builders to account for taxable income at the time a contract is entered into, rather than at settlement.

As an example, said Kim Rutledge of accountant Arthur Young & Co.’s San Diego office, a builder who took a $5,000 deposit last month on a $200,000 home that wouldn’t be completed until next January would have to pay taxes on most of his expected profit this year.

Builders said the change could cause some serious cash-flow problems because much of their capital in the early stages of a development is eaten up by labor and material costs, leaving little to pay the IRS. Some said they would have to increase the size of buyers’ deposits or raise prices to meet their new tax burden.

However, said Rutledge, a recent legal opinion received by Arthur Young says a review of California law and common real estate practice indicates that the typical contract for a residence to be constructed by a non-custom home builder doesn’t fit the IRS’ definition of a construction contract. As a result, Rutledge said, the new rules apparently “would not . . . apply to residential developers, resulting in tax savings for the developers and in cost savings for home buyers.”