If a home builder asks, “Can we use the cash method and deduct construction costs as we pay them?” the honest answer is: sometimes—but not because the books say “cash” or “work in progress.”
The tax answer starts by separating what the builder owns from what the builder is contractually required to build for a customer. Then you choose the overall accounting method, contract method, and capitalization treatment that fit the facts. Those are related decisions, but they are not the same decision.
Is the project a spec home or a customer construction contract?
A WIP balance can represent very different tax situations:
- Builder-owned or spec home. The builder is producing property for its own account and has no binding customer agreement requiring the unfinished construction. Section 460’s long-term-contract rules generally do not apply just because the project crosses year-end. Land and home-production costs generally remain in the property’s tax basis until the home is sold.
- Binding customer construction contract. The agreement requires the builder to construct or improve real property, the required construction is unfinished when the agreement is entered, and the work is not completed in that same tax year. This is the branch where the long-term-contract rules matter.
- Same-year customer job. The contract is entered and completed in one tax year. It is not a Section 460 long-term contract, but ordinary capitalization and income-timing rules still apply.
Treasury Regulation 1.460-1 supplies the long-term-contract definitions. Title and risk of loss can matter elsewhere, but they do not replace the binding-agreement and construction tests.
“Exempt construction contract” in plain English
A qualifying exempt construction contract is a construction agreement that crosses tax years but is allowed not to use mandatory percentage-of-completion accounting.
“Exempt” does not mean tax-free. It does not automatically permit the cash method, and it does not turn every construction payment into a current deduction. It means the builder may consider another permissible method for that contract.
For a calendar-year 2025 contract, use two gates:
Gate 1: Is it a long-term construction contract?
The customer agreement must require unfinished real-property construction, and the contract must cross the builder’s tax year. An unsold spec home without that agreement is not an exempt contract; it is builder-owned property. A contract entered and completed during 2025 is not a long-term contract, so no Section 460 exemption is needed.
A land-transfer agreement is not a construction contract when the estimated construction costs, excluding land, are less than 10% of the total contract price.
Gate 2: Does a 2025 exemption apply?
There are two principal lanes:
- Home construction contract. At least 80% of the estimated allocable contract costs must relate to dwelling units in buildings containing four or fewer units and to directly related on-site improvements. Land, materials, and services count in that contract-cost test. This exemption from mandatory PCM does not have a gross-receipts ceiling or two-year completion test, although separate capitalization rules may still apply.
- Other small-contractor construction contract. The builder must not be a tax shelter, must reasonably expect completion within two years of the contract’s commencement, and must satisfy the Section 448(c) gross-receipts test. For a tax year beginning in 2025, that threshold is $31 million of average annual gross receipts for the prior three tax years, subject to aggregation, predecessor, and short-year rules. See Rev. Proc. 2024-40, Section 2.31.
Passing either lane removes mandatory PCM for that contract. It does not finish the method analysis.
The first-year method menu
A genuine first return may contain several compatible methods because each method answers a different question.
Cash method
Reports eligible income when received and eligible ordinary costs when paid. Paying a bill does not make land, an unsold home, equipment, certain materials, prepayments, or required capitalized interest deductible.
Accrual method
Reports income and expenses under the applicable right-to-income, liability, and economic-performance rules. An “incurred” book entry is not enough if another rule requires capitalization or deferral.
Completed-contract method (CCM)
Generally defers contract income and allocable contract costs until completion. CCM is available only for qualifying exempt long-term contracts; it is not a method for builder-owned spec homes.
Percentage-of-completion method (PCM)
Recognizes contract revenue and allocable costs as the project progresses. It is not a costs-now, revenue-later method. Progress revenue comes with the current cost treatment.
Exempt-contract percentage-of-completion method (EPCM)
Uses a permitted progress measure for an exempt contract. Progress revenue is still recognized, and the contract must first be exempt.
Percentage-of-completion/capitalized-cost method (PCCM)
Under the pre-2026 framework, PCCM generally uses 70% PCM and 30% of an exempt method for certain non-home residential contracts. This is principally a 2025-contract issue for a calendar-year taxpayer; the later law removed this special statutory lane for affected contracts.
A separate method may apply to qualifying common improvements that benefit multiple lots or units. Rev. Proc. 2023-9 provides an Alternative Cost Method for eligible accrual-method developers. It is a controlled project-cost method, not a blanket deduction for unsold-home basis.
Can a builder deduct costs when paid or incurred?
Sometimes. The easier way to understand cash method is:
Cash method generally follows the bank account only after the item qualifies as a current expense.
An ordinary office bill may be deductible when paid. The same is not automatically true for a check that buys land, builds an unsold home, purchases equipment, prepays a future benefit, or funds another capital asset.
Consider a simple fictional comparison:
- A builder pays $100,000 of labor and subcontract costs to construct an unsold spec home. Those payments generally stay in the home’s tax basis. The checks cleared, but the builder still owns what the payments produced.
- Assume instead that the customer—not the builder—owns the property, and the builder pays $100,000 of ordinary labor and service costs on a qualifying exempt customer contract under an otherwise permissible cash method. Those costs may be taken into account when paid if no contract, material, capitalization, related-party, or other rule requires a different result. Under that cash method, unrestricted customer receipts are generally included when actually or constructively received. Refundable deposits and nonincidental materials require separate analysis.
The difference is not the account name. It is the legal and economic role of the project and the method that properly applies to it. Property ownership does not by itself determine Section 460 classification; the example uses it only to isolate why one payment creates builder-owned property and the other may be an ordinary contract cost.
There is no general home-builder method that deducts all project WIP now while postponing all related contract revenue. PCM pairs current contract costs with progress revenue. CCM generally defers both. Builder-owned property keeps its production costs in basis until recovery through sale or another tax event.
2025 and 2026 contracts do not use the same residential rule
Public Law 119-21, Section 70430 broadened the residential-construction exception for contracts entered into in taxable years beginning after July 4, 2025. For a calendar-year taxpayer, that generally means contracts entered during 2026 and later—not simply every contract signed after July 4, 2025.
An affected residential construction contract is one that would satisfy the home-construction definition but for the limit of four or fewer dwelling units per building; the 80% estimated-cost test still matters. These contracts are exempt from mandatory PCM, and the former special 70/30 PCCM rule was removed.
A separate capitalization test remains. For a residential contract not accounted for under PCM, Section 263A generally applies unless, when the contract is entered, the builder both reasonably expects completion within the applicable period beginning on the contract commencement date—two years for a home contract or three years for other residential construction—and meets the Section 448(c) gross-receipts test. For a tax year beginning in 2026, that threshold is $32 million; later years require the indexed amount then in effect. See Rev. Proc. 2025-32, Section 4.30.
The IRS issued Rev. Proc. 2026-32 on September 4, 2026. It modifies DCN 236 for certain changes to stop Section 263A capitalization and adds DCN 275 for affected residential contracts changing from PCM or PCCM to an exempt method, or beginning Section 263A capitalization. These changes generally use cutoff treatment, no Section 481(a) adjustment, and reduced Form 3115 requirements. The modified procedures generally apply to Forms 3115 filed after September 4, 2026, with additional transition rules—including one for certain returns filed on or before September 21, 2026. The exact route and deadline require a filing-specific review. None of this turns a genuine first adoption into a method change.
First-year adoption versus Form 3115
On a genuine first federal return, a taxpayer generally adopts a permissible accounting method by using it consistently on the timely filed original return. The same principle can apply the first year the taxpayer enters a particular contract type and may adopt a permissible method for that class.
That is different from changing an established method. Form 3115 may become relevant when an established method exists for the same material item or contract classification, an earlier year should have applied a required method, or the taxpayer later wants to change the adopted treatment. A one-year error does not automatically establish a method or make Form 3115 the answer; it requires a separate correction analysis. Rev. Proc. 2026-32 now includes procedures for certain established-method changes involving affected residential contracts, but the exact route depends on method history and filing dates.
The practical point: do not file Form 3115 merely because a first-year trial balance has WIP. First establish whether there is an existing method to change.
What to gather before choosing a method
Build a contract-by-contract and project-by-project schedule containing:
- the date each agreement became binding and the contract commencement date;
- the expected and actual completion dates;
- whether the builder or a customer owns the project being produced;
- dwelling units per building and support for the 80% cost test;
- land, materials, services, site work, and common-improvement costs;
- gross receipts for the relevant prior years, including related entities and predecessors;
- tax-shelter status and entity ownership;
- customer deposits, billings, collections, retainage, and advances;
- equipment, model-home, financing, and production-period interest costs; and
- every overall, contract, capitalization, and common-improvement method previously used.
This schedule turns a vague “cash versus accrual” question into a set of supportable decisions. It also connects the tax return to the builder’s job-costing and financial reporting without treating the book WIP label as the tax conclusion.
JAG’s tax-planning work starts with the contracts, dates, ownership, and method history. The goal is to choose a permissible first-year structure that can be followed consistently—not to force every project into one convenient label.
This article addresses general federal tax considerations and is current through September 5, 2026. The governing contract year, entity structure, state law, and project facts can change the result.
Joe Gallegos, CPA/CVA
Partner-in-Charge · JAG CPA & Co.
Author of The Ultimate Guide to Choosing a CPA
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