Homebuilder Loss Claim Crumbles

A homebuilder's assertion that its losses are related to "product liability" had no foundation in existing law, says the IRS.

Homebuilders recently scored a major tax victory by securing the ability to carry back certain losses — referred to as “applicable net operating losses (NOLs)” — for five years. Ordinarily, under the Internal Revenue Code — specifically, Section 172(b)(1)(A)(i) — an NOL can be carried back only two years preceding the taxable year in which the NOL was sustained.1 However, some homebuilders were not satisfied with only a five-year carryback and sought to classify a portion of their NOLs as “product liability losses,” which are eligible for a 10-year carryback. But this effort has been summarily rejected by the Internal Revenue Service in a chief counsel advice memorandum (CCA).2

The taxpayer to which the CCA pertained was a “major homebuilder.” The homebuilder incurred NOLs for its taxable years ending in Year 1 and Year 2, “because of severe weakness in the real estate industry.” As explained in the memo, the homebuilder provides the buyers of its homes with a limited A-Year warranty on workmanship and defective materials, a limited B-Year warranty that says certain systems (such as septic systems) will satisfy specified performance standards, and a limited C-Year warranty on structural and major construction defects. Most of the deductions under consideration were for correcting A-Year warranty defects.

All or most of the liabilities incurred by the homebuilder were caused by “poor workmanship” in the installation of the parts and supplies that comprised the homes, rather than by inherently defective parts and supplies. At issue was whether the homebuilder’s liabilities arising from its breach of warranties qualified as product liabilities. The answer was no.

Here’s the rationale. The portion of an NOL that qualifies as a “specified liability loss” (SLL) may be carried back 10 years. In Section 172(f)(1)(A), the tax code defines an SLL, in part, as the sum of the following amounts: any amount allowable as a deduction under Section 162 or Section 165 that is attributable to (1) product liability or (2) expenses incurred in the investigation or settlement of, or opposition to, claims against a taxpayer based on product liability.

Further, 172(f)(4) defines product liability as liability of the taxpayer for damages caused by personal injury or emotional harm to individuals, or damage to or loss of the use of property caused by any defect in any product that is manufactured, leased, or sold by the taxpayer. The caveat: the injury, harm, or damage must arise after the taxpayer has completed or terminated operations with respect to, and has relinquished possession of, the product.

WillensFinal“[U]nder the tax rules…product liability does not include liabilities arising under warranty theories relating to repair or replacement of the property that are essentially contract liabilities.” — Robert Willens

In short, product liability encompasses liability for damages caused by damage to or loss of the use of property caused by a defect in any product manufactured by the taxpayer.

“Property” Does Not Encompass the Product Itself
The IRS noted that some courts have concluded that buildings do not constitute “products” for product liability purposes.3 However, even if it is appropriate to treat the dwellings at issue here as products, the damages at issue do not qualify as product liability. This is because the products are the completed dwellings, and the damages at issue are damages to the product itself.

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