Book revenue for a construction contractor follows ASC 606, usually cost to cost. Tax revenue follows section 460 unless an exception applies. Which method a contract falls under is a contract-by-contract question, and Public Law 119-21 widened the exception for residential work. A CPA firm that audits or prepares for contractors should map each open contract to the right tax method and reconcile it to the book number.
When section 460 applies
Section 460(f) defines a long-term contract as a contract for the manufacture, building, installation or construction of property that is not completed within the taxable year in which it is entered into. A contract started and finished in the same year is outside section 460. Two or more interdependent contracts, by reason of pricing or otherwise, may be treated as one contract under section 460(f)(3), so a split into phases does not by itself create short contracts.
For a long-term contract under section 460, the taxpayer uses the percentage-of-completion method. Section 460(b)(1) compares costs allocated to the contract and incurred before year end with estimated total contract costs, and on completion the taxpayer pays or receives look-back interest. A contract is completed on the earlier of customer use of the subject matter for its intended purpose with at least 95 percent of total allocable costs incurred, or final completion and acceptance (Treas. Reg. 1.460-1(c)(3)).
The exceptions in section 460(e)
Section 460(e)(1) says the percentage-of-completion rules do not apply to either of the following:
- Any residential construction contract. Under section 460(e)(4)(B), this is a construction contract for which 80 percent or more of estimated total contract costs are reasonably expected to be attributable to dwelling units and improvements directly related to them on the site. Until the 2025 amendment the exception covered only a home construction contract, meaning dwelling units in buildings with four or fewer units, with each townhouse or rowhouse treated as a separate building. Public Law 119-21 replaced "home construction contract" with "residential construction contract" in section 460(e)(1)(A) and struck the former special rule for residential contracts that were not home construction contracts. The change applies to contracts entered into in taxable years beginning after July 4, 2025, so a calendar-year contractor sees it for 2026 contracts.
- Any other construction contract if the taxpayer estimates, when the contract is entered into, that it will be completed within the two-year period beginning on the contract commencement date, and meets the gross receipts test of section 448(c) for the year the contract is entered into. For taxable years beginning in 2026, Revenue Procedure 2025-32 sets the section 448(c) limit at $32,000,000 of average annual gross receipts over the three prior years.
A residential contract that is not a home construction contract and fails the tests of the second bullet (with a three-year completion period substituted for two years) is still outside percentage of completion, but section 263A applies to it. A tax shelter prohibited from using the cash method cannot use the second bullet. For a taxpayer that is not a corporation or partnership, the gross receipts test is applied as if each trade or business were a corporation or partnership.
A construction contract, for this purpose, is a contract for the building, construction, reconstruction or rehabilitation of, or the installation of an integral component to, or improvements of, real property (section 460(e)(3)). The contract commencement date is the first date any costs allocable to the contract are incurred, other than bidding or negotiating expenses (section 460(g)).
What exempt contracts can use
An exempt contract is not forced into any one method. Treas. Reg. 1.460-4(c)(1) lists the permissible exempt contract methods as percentage of completion, the exempt-contract percentage-of-completion method, the completed contract method, or any other permissible method under section 446. The exempt-contract version can measure progress by labor hours or work performed instead of cost to cost, and the look-back method does not apply to it.
Under the completed contract method, the contractor takes the gross contract price and all allocable contract costs into account in the completion year (Treas. Reg. 1.460-4(d)(1)). Gross contract price includes holdbacks and retainages the taxpayer is entitled to receive, whether or not due or paid.
A method change made because of the section 448(c) test is treated as initiated by the taxpayer and made with the consent of the Secretary, and it is made on a cut-off basis for contracts entered into on or after the year of change (section 460(e)(2)(B)). Section 263A(i) separately exempts a taxpayer that meets the same gross receipts test, covered in the section 448 gross receipts test guide.
Worked example
A contractor with average gross receipts of $28,000,000 over the prior three years signs a commercial contract in 2026 for $4,000,000. It estimates completion in 18 months, so both tests are met. Estimated total cost is $3,200,000. At December 31, 2026 it has incurred $1,600,000.
- Book (cost to cost): 1,600,000 divided by 3,200,000 is 50 percent. Revenue is $2,000,000 and gross profit is $400,000.
- Tax (completed contract): the contract is not complete, so no income is reported in 2026.
- Temporary difference: $400,000. At a 21 percent rate, the deferred tax liability is $84,000.
This difference reverses in the year of completion. The deferred tax entry is shown in ASC 740 deferred tax journal entries.
Completion year
The contract is accepted in 2027 and total costs equal the $3,200,000 estimate. Tax income in 2027 is the gross contract price of $4,000,000 less $3,200,000 of costs, or $800,000. Book income was $400,000 in 2026 and the remaining $400,000 in 2027. The $84,000 liability reverses (400,000 times 21 percent) and 2027 taxable income exceeds 2027 book income by $400,000.
A contract that fails the test
The same contractor has average receipts of $34,000,000 when it signs a second contract. The receipts test fails, so section 460(a) applies. With the same 50 percent complete figures, the contract is taxed on $2,000,000 of revenue in the first year, matching book except for any difference in how costs are allocated under section 460(c), and look-back interest is computed when the contract is completed.
Common errors
- Testing receipts in the year of completion. Section 460(e)(1)(B)(ii) tests the year the contract is entered into.
- Counting the two years from the signing date. The period begins on the contract commencement date.
- Updating the two-year estimate every year. The statute uses the estimate made when the contract is entered into.
- Treating interdependent contracts as separate. Section 460(f)(3) allows them to be treated as one.
- Ignoring the 80 percent computation for residential work. The classification is made from estimated total contract costs.
- Pooling the receipts of a sole proprietor's separate businesses. For a taxpayer that is not a corporation or partnership, the test treats each trade or business as if it were one.
Working paper
- A contract list showing date entered, commencement date, estimated completion, residential classification and the 80 percent computation.
- The three-year average receipts computation, including related entities as required by the aggregation rules.
- A tax-to-book bridge by contract that agrees to the WIP schedule.
- A memo of the method in use and any open accounting method change.
For the audit side of the same contracts, see construction contractor audits under ASC 606.
Sources
- Legal Information Institute, 26 U.S.C. 460, Special rules for long-term contracts: https://www.law.cornell.edu/uscode/text/26/460
- Internal Revenue Service, Revenue Procedure 2025-32 (2026 inflation adjustments): https://www.irs.gov/pub/irs-drop/rp-25-32.pdf
- eCFR, 26 CFR 1.460-1, Long-term contracts (completion and commencement date definitions): https://www.ecfr.gov/current/title-26/section-1.460-1
- eCFR, 26 CFR 1.460-4, Methods of accounting for long-term contracts (exempt contract methods): https://www.ecfr.gov/current/title-26/section-1.460-4
- Legal Information Institute, 26 U.S.C. 263A, Capitalization and inclusion in inventory costs of certain expenses: https://www.law.cornell.edu/uscode/text/26/263A
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