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.

Such damages, the IRS concluded, do not constitute property damage under Section 172(f)(4). In fact, according to East River Steamship Corporation v. Transamerica Delaval, Inc., 476 US 858 (1986), “…damage to the product itself has certain attributes of a products liability claim…. But the injury suffered…is the essence of a warranty action, through which a contracting party can seek to recoup the benefit of its bargain….”

When a particular element, such as a window, becomes an integral part of a home, and a defect in the element or the faulty installation of the element results in damages to other parts of the home, the majority of courts have concluded that the problems constitute damages to the product itself. Therefore, the damages claimed do not constitute damages to other property.

The damages at issue in the CCA discussed in this column arose from warranty claims that the homebuilder’s customers asserted against the company as a result of the failure of the homes to satisfy expectations related to quality. The products were the entire homes, not individual components that became an integral part of the homes. Consequently, all the liabilities that the homebuilder satisfied by repairing and replacing components of the homes related to the various warranties constituted contractual repair or replacement liabilities, not product liabilities. And under the tax rules, specifically Regulation Section 1.172-13(b)(2)(ii), product liability does not include liabilities arising under warranty theories relating to repair or replacement of the property that are essentially contract liabilities.4

Defects
The IRS further stated in the CCA memo that “…we are also of the view that the damages in this case are not attributable to a product defect….” To constitute product liability, the damages in question must be attributable to a product defect. Defects, the IRS noted, may be qualitative or may constitute safety defects. For Section 172(f)(4) purposes, the IRS concluded, defect means (only) a safety defect.

Although some of the defects giving rise to the damages at issue might, if left unattended for a sufficient period, ultimately result in the collapse of the structure, none of the defects made the homes “unreasonably dangerous.” Therefore, the construction deficiencies did not make the homes defective within the meaning of Section 172(f)(4).

Accordingly, the portion of the NOL sustained by homebuilders attributable to repairing the homes pursuant to the warranties may not be carried back 10 years. That portion of the NOL did not meet the standards for classification as a product liability loss. As a result, in this case, the liability for damages was not on account of damage to or loss of the use of property caused by any defect in any product manufactured by the homebuilder.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

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