Homebuilder Loss Claim Crumbles

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.

"[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.

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

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