The IRS Chief Counsel’s Office has released a memorandum concluding that a homebuilder is not entitled to treat home warranty losses like product liability losses for net operating loss purposes. However, the rationale of the memorandum still leaves open the possibility that a homebuilder might be eligible for the more favorable product liability loss treatment for repair losses due to Chinese drywall or mold remediation.

Net operating losses can generally be carried back for three years in order to generate a tax refund. A special rule allows product liability losses to be carried back 10 years. The longer the carryback period, the more likely a refund will be generated, since the NOL must be carried back to a year where there was a tax liability in order to obtain a refund.

In the facts of the recent Chief Counsel Advice (CCA), the homebuilder filed its return taking the position that losses resulting from its home warranty repair obligations were eligible for this special treatment for product liability losses (known as “specified liability losses”). However, the CCA concluded that home repair warranty losses are not the result of an accident or injury, but rather are in the nature of contractual liabilities. It reasoned that the losses dealt with damages suffered by the product itself (the home), and not to the customer, and so should not be treated as product liability losses.

The CCA takes the position that the damages at issue arise from warranty claims as a result of the failure of the purchased homes, constructed and sold by the taxpayer, to satisfy quality expectations. The CCA uses an example of the explosion of a defective boiler. While damages to an individual resulting from the explosion qualify for the 10-year look back, the costs of repair of the boiler itself do not. In this case the products, according to the CCA, were the entire homes, not the individual components that became an integral part of the homes. Therefore, the liabilities that the builders satisfied through repair and replacement of components do not qualify as product liabilities within the meaning of the applicable regulation.

However, the Service did leave open a means to possibly obtain the more favorable treatment. The CCA “… note[s] in passing that although each home giving rise to a claim had one or more deficiencies in construction, Taxpayer has made no assertion that the individual components such as roof materials, windows, and plumbing pipes that were integrated into the composite structure were defective in any manner. Instead, these component items appear to have been improperly installed. Taxpayer made good on its home warranty, a home construction contract, to rectify these issues of poor workmanship. That the real issue was not defective component parts but instead poor installation is evidenced by the fact that taxpayer did not seek damages for defective products from the products’ manufacturers.” As a result, the ability to claim that the drywall fits within the defective component definition remains open.

The CCA goes on to focus on the concept of “product defect.” While the CCA explains that the regulations do not define the term “defect,” it states that the legislative history indicates that Congress intended to use a federal tax definition of product liability in line with the types of damages recoverable under product liability theories in most states.

Informal discussions with IRS agents involved in drafting the CCA indicate that there is an acknowledgment of the fact that Chinese drywall claims may not be automatically precluded from the benefit of the 10-year period. While it appears that a defective product causing physical harm to the consumer would fall within the benefit of the 10-year period, taking such a position is, of course, contrary to that of the industry and raises potentially serious consequences.

In conclusion, the outcome will be dependent upon a test case and while the CCA on its face appears to indicate that it may not be successful, there is at least sufficient room to argue to the contrary.