Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Improved demand conditions in the overall U.S. housing market continued in 2016, though industry-wide new home sales continue to pace below historical averages. We remain pleased with the overall demand for new homes, which continues along a sustained path of recovery supported by ongoing job creation, low unemployment, a supportive interest rate environment, and a limited supply of new homes. Within this environment, we remain focused on driving additional gains in construction and asset efficiency to deliver higher returns on invested capital. Consistent with our positive market view and long-term business strategy, we expect to use our capital to support future growth while consistently returning funds to shareholders through dividends and share repurchases.

The nature of the homebuilding industry results in a lag between when investments made in land acquisition and development yield new community openings and related home closings. We have looked toward 2016 as a year where we would begin adding volume growth to the efficiency gains we have achieved in recent years. Our prior investments are allowing us to grow the business, as evidenced by 13% growth in net new orders and a 29% increase in home sale revenues to $7.5 billion. We achieved this growth while also maintaining our focus on gross margin performance through community location, strategic pricing, and construction efficiencies.

During 2016, we opened approximately 200 new communities across our local markets as a result of increased land investment over the last few years. Additionally, we acquired substantially all of the assets of JW Homes ("Wieland") in January 2016, which also contributed to the growth in community count. This volume of new community openings can present a challenge in today's environment where entitlement and land development delays are common. We have grown our investment in the business in a disciplined manner by emphasizing smaller projects and working to shorten our years of land supply, including the use of land option agreements when possible. We have also focused our land investments on closer-in locations where we think demand is more sustainable when the market ultimately moderates. We have accepted the trade-off of having to pay more for certain land positions where we can be more confident in future performance. Leveraging our increased land investments, we expect to open an even higher number of new communities in 2017 than we did in 2016, which we expect will help our volume grow in 2017.

Our financial position provided flexibility to increase our investments in future communities while also returning funds to shareholders through dividends and expanded share repurchases. Specifically, we accomplished the following in 2016:

•	Increased our land investment spending by 24% to support future growth while also acquiring the Wieland assets for $430.5 million;

•	Maintained our quarterly dividend at $0.09 per share;

•	Repurchased $600.0 million of shares under our share repurchase plan and authorized an additional $1.0 billion for future repurchases;

•	Issued $2.0 billion of senior notes while also expanding and extending our unsecured revolving credit agreement; and

•	Ended the year with a debt to total capitalization ratio of 40.0%, which is within our targeted range, and a cash, cash equivalents, and restricted cash balance of $723.2 million with no borrowings outstanding under our unsecured revolving credit agreement.

The following is a summary of our operating results by line of business ($000's omitted, except per share data):

	Years Ended December 31,
	2016				2015				2014
Income before income taxes:
Homebuilding	$	860,766			$	757,317			$	635,177
Financial Services	73,084				58,706				54,581
Income before income taxes	933,850				816,023				689,758
Income tax expense	(331,147		)		(321,933		)		(215,420		)
Net income	$	602,703			$	494,090			$	474,338
Per share data - assuming dilution:
Net income	$	1.75			$	1.36			$	1.26

•

Homebuilding income before income taxes improved each year from 2014 to 2016. Revenues increased each year and SG&A leverage improved. In 2016, the revenue increase was partially offset by lower gross margins and higher overhead costs, both of which were partially attributable to the assets acquired from Wieland in January 2016 (see Note 1). Homebuilding income before income taxes also reflected the following significant expense (income) items ($000's omitted):

	2016				2015				2014
Corporate office relocation (see Note 2)	$	8,284			$	4,369			$	16,344
Other severance and lease exit related costs (see Note 1)	13,389				—				—
Land-related charges (see Note 3)	19,336				11,467				11,168
Loss on debt retirements (see Note 6)	657				—				8,584
Applecross matter (see Note 12)	—				20,000				—
Settlement of disputed land transaction (see Note 12)	15,000				—				—
Insurance reserve adjustments (see Note 12)	(55,243		)		(62,183		)		69,267
	$	1,423			$	(26,347	)		$	105,363

For additional information on each of the above, see the applicable Notes to the Consolidated Financial Statements.

The acquisition of certain real estate assets from Wieland in January 2016 and Dominion Homes in August 2014 (see Note 1) were not material to our results of operations or financial condition.

•	The increase in Financial Services income in 2016 compared with 2015 and 2014 was primarily due to an increase in mortgage origination volume. During 2015 and 2014, we reduced our loan origination liabilities by net reserve releases of $11.4 million and $18.6 million, respectively, which favorably impacted Financial Services income. See Note 12.

•	Our effective tax rate was 35.5%, 39.5% and 31.2% for 2016, 2015, and 2014, respectively. See Note 9.

Homebuilding Operations

The following is a summary of income before income taxes for our Homebuilding operations ($000’s omitted):

	Years Ended December 31,
	2016				FY 2016 vs. FY 2015			2015				FY 2015 vs. FY 2014			2014
Home sale revenues	$	7,451,315			29	%		$	5,792,675			2	%		$	5,662,171
Land sale revenues	36,035				(26	)%		48,536				40	%		34,554
Total Homebuilding revenues	7,487,350				28	%		5,841,211				3	%		5,696,725
Home sale cost of revenues (a) (b)	(5,587,974		)		32	%		(4,235,945		)		2	%		(4,149,674		)
Land sale cost of revenues	(32,115		)		(10	)%		(35,858		)		51	%		(23,748		)
Selling, general, and administrative expenses ("SG&A") (b) (c)	(957,150		)		20	%		(794,728		)		(8	)%		(861,390		)
Other expense, net (d)	(49,345		)		184	%		(17,363		)		(35	)%		(26,736		)
Income before income taxes	$	860,766			14	%		$	757,317			19	%		$	635,177
Supplemental data:
Gross margin from home sales (a) (b)	25.0		%		(190) bps			26.9		%		20 bps			26.7		%
SG&A % of home sale revenues (b) (c)	12.8		%		(90) bps			13.7		%		(150) bps			15.2		%
Closings (units)	19,951				16	%		17,127				—	%		17,196
Average selling price	$	373			10	%		$	338			3	%		$	329
Net new orders (e):
Units	20,326				13	%		18,008				8	%		16,652
Dollars	$	7,753,399			23	%		$	6,305,380			13	%		$	5,558,937
Cancellation rate	15		%					14		%					15		%
Active communities at December 31	726				17	%		620				4	%		598
Backlog at December 31:
Units	7,422				10	%		6,731				15	%		5,850
Dollars	$	2,941,512			20	%		$	2,456,565			26	%		$	1,943,861

(a)	Includes the amortization of capitalized interest.

(b)	All periods reflect the reclassification of sales commissions expense from home sale cost of revenues to selling, general, and administrative expenses (see Note 1).

(c)

Includes costs associated with the relocation of our corporate headquarters totaling $1.0 million, $2.0 million, and $7.6 million in 2016, 2015, and 2014, respectively (see Note 2); severance costs of $9.1 million in 2016; adjustments to general liability insurance reserves relating to reserve reversals of $55.2 million in 2016 and $62.2 million in 2015; and a charge of $69.3 million in 2014 (see Note 12).

(d)	Includes a charge of $15.0 million in 2016 related to the settlement of a disputed land transaction and a charge of $20.0 million in 2015 resulting from the Applecross matter (see Note 12). See "Other expense, net" for a table summarizing other significant items.

(e)	Net new orders excludes backlog acquired from Wieland in January 2016 (see Note 1). Net new order dollars represent a composite of new order dollars combined with other movements of the dollars in backlog related to cancellations and change orders.

Home sale revenues

Home sale revenues for 2016 were higher than 2015 by $1.7 billion, or 29%. The increase was attributable to a 10% increase in the average selling price and a 16% increase in closings. These increases reflect the impact of communities acquired from Wieland during the period, which contributed 6% to the growth in revenue, 4% to the growth in closings and 1% to the increase in average selling price. Excluding the communities acquired from Wieland, the increase in closings reflects the significant investments we are making in opening new communities combined with improved demand. The higher average selling price for 2016 reflects an ongoing shift toward move-up buyers, the inclusion of higher-priced homes offered in Wieland communities, and generally stable market conditions.

Home sale revenues for 2015 were higher than 2014 by $130.5 million, or 2%. The increase was attributable to a 3% increase in the average selling price while closings remained relatively flat. The increase in average selling price reflected a shift in our revenue mix toward move-up buyers. Closing volume was flat as higher net new orders were offset by production delays in certain communities caused by a number of factors, including tight labor resources and adverse weather conditions.

Home sale gross margins

Home sale gross margins were 25.0% in 2016, compared with 26.9% in 2015 and 26.7% in 2014. The assets acquired from Wieland contributed 60 basis points to this decrease for this period, primarily as the result of required fair value adjustments associated with the acquired homes in production and related lots. Gross margins remain strong relative to historical levels and reflect a combination of factors, including shifts in community mix, relatively stable pricing conditions in 2016 following strong pricing conditions in 2015 and 2014, and lower amortized interest costs (1.7%, 2.4%, and 3.4% of home sale revenues in 2016, 2015, and 2014, respectively) combined with higher house construction and land costs as the supply chain has responded to the housing recovery. The lower amortized interest costs resulted from the reduction in our outstanding debt in recent years combined with the significant increase in volume in 2016.

Land sales

We periodically elect to sell parcels of land to third parties in the event such assets no longer fit into our strategic operating plans or are zoned for commercial or other development. Land sale revenues and their related gains or losses vary between periods, depending on the timing of land sales and our strategic operating decisions. Land sales had margin contributions of $3.9 million, $12.7 million, and $10.8 million in 2016, 2015, and 2014, respectively.

SG&A

SG&A as a percentage of home sale revenues was 12.8% and 13.7% in 2016 and 2015, respectively. The gross dollar amount of our SG&A increased $162.4 million, or 20%, in 2016 compared with 2015. SG&A included adjustments to general liability insurance reserves relating to reversals of $55.2 million and $62.2 million in 2016 and 2015, respectively (see Note 12). SG&A also reflects severance costs of $9.1 million in 2016 associated with actions taken to reduce overheads and the substantial completion of our corporate headquarters relocation from Michigan to Georgia, which began in 2013 (see Note 2). Excluding these items, the improvement in our year-over-year SG&A leverage was even greater. The increase in gross dollar SG&A reflects the addition of field resources and other variable costs related to increased production volumes combined with higher costs related to healthcare and professional fees. Additionally, SG&A for 2016 reflects the impact of transaction and integration costs associated with the assets acquired from Wieland in January 2016 (see Note 1).

SG&A as a percentage of home sale revenues was 13.7% and 15.2% in 2015 and 2014, respectively. The gross dollar amount of our SG&A decreased $66.7 million, or 8%, in 2015 compared with 2014. SG&A included reserve reversals totaling $62.2 million in 2015 and charges totaling $69.3 million to increase general liability reserves in 2014 (see Note 12). Additionally, we incurred $2.0 million and $7.6 million in 2015 and 2014, respectively, of employee severance, retention, relocation, and related costs attributable to the relocation of our corporate headquarters (see Note 2). Excluding each of these items, SG&A in both dollars and as a percentage of home sale revenues increased for 2015 compared with 2014. This increase in gross overhead dollars in 2015 was primarily due to investments in increased headcount and information systems along with higher costs in conjunction with the opening of an increased number of new communities.

Other expense, net

Other expense, net includes the following ($000’s omitted):

	2016				2015				2014
Write-offs of deposits and pre-acquisition costs (Note 3)	$	17,157			$	5,021			$	6,099
Loss on debt retirements (Note 6)	657				—				8,584
Lease exit and related costs	11,643				2,463				9,609
Amortization of intangible assets (Note 1)	13,800				12,900				13,033
Interest income	(3,236		)		(3,107		)		(4,632		)
Interest expense	686				788				849
Equity in earnings of unconsolidated entities (Note 5)	(8,337		)		(7,355		)		(8,226		)
Miscellaneous, net	16,975				6,653				1,420
Total other expense, net	$	49,345			$	17,363			$	26,736

Lease exit and related costs for 2016 resulted from actions taken to reduce overheads and the substantial completion of our corporate headquarters relocation from Michigan to Georgia, which began in 2013 and also significantly impacted 2014 (see Note 2). The increase in write-offs of deposits and pre-acquisition costs for 2016 related primarily to one project in California that we elected to not complete. Miscellaneous, net includes a charge of $15.0 million related to the settlement of a disputed land transaction in 2016 and a charge of $20.0 million resulting from the Applecross matter in 2015 (see Note 12). For additional information on each of the above, see the applicable Notes to the Consolidated Financial Statements.

Net new orders

Net new orders increased 13% in 2016 compared with 2015. The increase resulted primarily from selling from a larger number of active communities, which increased 17% to 726 at December 31, 2016. The communities acquired from Wieland contributed to this growth in units by 4%. Excluding the Wieland assets, our growth in net new order units resulted from the higher number of active communities combined with a small improvement in sales pace per community. Net new orders in dollars increased by 23% compared with 2015 due to the growth in units combined with the higher average selling price. The cancellation rate (canceled orders for the period divided by gross new orders for the period) increased slightly in 2016 from 2015 at 15% and 14%, respectively. Ending backlog units, which represent orders for homes that have not yet closed, increased 10% at December 31, 2016 compared with December 31, 2015 as measured in units and increased 20% over the prior year period as measured in dollars. The higher average sales price also contributed to the higher backlog dollars.

Net new orders increased 8% in 2015 compared with 2014. The increase resulted from improved sales per community combined with selling from a larger number of active communities, which increased 4% to 620 active communities at December 31, 2015. The cancellation rate decreased slightly in 2015 from 2014 at 14% and 15%, respectively. Ending backlog units increased 15% at December 31, 2015 compared with December 31, 2014 and increased 26% as measured in dollars due to the increase in average selling price. The higher backlog resulted from higher net new order volume combined with production delays in certain communities in 2015 caused by a number of factors, including tight labor resources and adverse weather conditions.

Homes in production

The following is a summary of our homes in production at December 31, 2016 and 2015:

		2016			2015
Sold		5,138			4,573
Unsold
Under construction		1,703			1,450
Completed		645			471
		2,348			1,921
Models		1,072			1,024
Total		8,558			7,518

The number of homes in production at December 31, 2016 was 14% higher compared to December 31, 2015. The increase in homes under production was due to a combination of factors, including a 17% increase in active communities, a 10% increase in ending backlog units, higher net new order volume, and a decision to purposefully increase the number of unsold homes under construction ("spec homes"). The increase in spec homes reflects our intentions to achieve a more even flow production cycle over the course of 2017 compared with recent years. As part of our inventory management strategy, we will continue to maintain reasonable inventory levels relative to demand in each of our markets. We continue to focus on maintaining a low level of completed specs, though inventory levels tend to fluctuate throughout the year.

Controlled lots

The following is a summary of our lots under control at December 31, 2016 and 2015:

		December 31, 2016									December 31, 2015
		Owned			Optioned			Controlled			Owned			Optioned			Controlled
Northeast		6,296			4,019			10,315			6,361			4,114			10,475
Southeast		16,050			8,232			24,282			11,161			7,933			19,094
Florida		22,164			8,470			30,634			21,230			9,636			30,866
Midwest		11,800			8,639			20,439			13,093			6,985			20,078
Texas		13,541			9,802			23,343			13,308			7,052			20,360
West		29,428			4,817			34,245			30,766			6,440			37,206
Total		99,279			43,979			143,258			95,919			42,160			138,079
Developed (%)		31	%		19	%		28	%		28	%		12	%		23	%

Of our controlled lots, 99,279 and 95,919 were owned and 43,979 and 42,160 were under land option agreements at December 31, 2016 and 2015, respectively. While competition for well-positioned land is robust, we continue to pursue strategic land positions that drive appropriate returns on invested capital. The remaining purchase price under our land option agreements totaled $2.1 billion at December 31, 2016. These land option agreements generally may be canceled at our discretion and in certain cases extend over several years. Our maximum exposure related to these land option agreements is generally limited to our deposits and pre-acquisition costs, which totaled $195.4 million, of which $9.8 million is refundable, at December 31, 2016.

Homebuilding Segment Operations

Our homebuilding operations represent our core business. Homebuilding offers a broad product line to meet the needs of homebuyers in our targeted markets. As of December 31, 2016, we conducted our operations in 49 markets located throughout 25 states. For reporting purposes, our Homebuilding operations are aggregated into six reportable segments:

Northeast:		Connecticut, Maryland, Massachusetts, New Jersey, New York, Pennsylvania, Virginia
Southeast:		Georgia, North Carolina, South Carolina, Tennessee
Florida:		Florida
Midwest:		Illinois, Indiana, Kentucky, Michigan, Minnesota, Missouri, Ohio
Texas:		Texas
West:		Arizona, California, Nevada, New Mexico, Washington

We also have a reportable segment for our financial services operations, which consist principally of mortgage banking and title operations. The Financial Services segment operates generally in the same markets as the Homebuilding segments.

The following table presents selected financial information for our reportable Homebuilding segments:

	Operating Data by Segment ($000's omitted)
	Years Ended December 31,
	2016				FY 2016 vs. FY 2015			2015				FY 2015 vs. FY 2014			2014
Home sale revenues:
Northeast	$	696,003			2	%		$	679,082			(4	)%		$	708,465
Southeast (a)	1,485,809				40	%		1,058,055				11	%		949,134
Florida	1,274,237				26	%		1,012,391				11	%		913,758
Midwest	1,233,110				22	%		1,012,460				16	%		869,271
Texas	1,033,387				23	%		840,766				(2	)%		856,613
West	1,728,769				45	%		1,189,921				(13	)%		1,364,930
	$	7,451,315			29	%		$	5,792,675			2	%		$	5,662,171
Income before income taxes:
Northeast (b)	$	81,991			(1	)%		$	82,616			(20	)%		$	103,865
Southeast (a)	145,011				(16	)%		172,330				10	%		156,513
Florida	205,049				4	%		196,525				3	%		190,441
Midwest	120,159				31	%		91,745				16	%		78,863
Texas	152,355				26	%		121,329				(9	)%		133,005
West	225,771				33	%		169,394				(33	)%		254,724
Other homebuilding (c)	(69,570		)		9	%		(76,622		)		73	%		(282,234		)
	$	860,766			14	%		$	757,317			19	%		$	635,177
Closings (units):
Northeast	1,418				(5	)%		1,496				(5	)%		1,568
Southeast (a)	3,901				19	%		3,276				4	%		3,160
Florida	3,441				19	%		2,896				5	%		2,752
Midwest	3,418				15	%		2,961				15	%		2,581
Texas	3,726				11	%		3,357				(10	)%		3,750
West	4,047				29	%		3,141				(7	)%		3,385
	19,951				16	%		$	17,127			—	%		17,196
Average selling price:
Northeast	$	491			8	%		$	454			—	%		$	452
Southeast (a)	381				18	%		323				8	%		300
Florida	370				6	%		350				5	%		332
Midwest	361				6	%		342				2	%		337
Texas	277				11	%		250				10	%		228
West	427				13	%		379				(6	)%		403
	$	373			10	%		$	338			3	%		$	329

(a)	Southeast includes the acquisition in January 2016 of substantially all of the assets of Wieland (see Note 1).

(b)	Northeast includes a charge of $15.0 million in 2016 related to the settlement of a disputed land transaction and a charge of $20.0 million in 2015 resulting from the Applecross matter (see Note 12).

(c)

Other homebuilding includes the amortization of intangible assets, amortization of capitalized interest, and other items not allocated to the operating segments, in addition to: losses on debt retirements of $0.7 million and $8.6 million in 2016 and 2014, respectively (see Note 6); adjustments to general liability insurance reserves relating to reversals of $55.2 million and $62.2 million in 2016 and 2015, respectively, and a charge of $69.3 million in 2014 (see Note 12); and costs associated with the relocation of our corporate headquarters totaling $8.3 million, $4.4 million, and $16.3 million in 2016, 2015, and 2014, respectively (see Note 2).

The following tables present additional selected financial information for our reportable Homebuilding segments:

		Operating Data by Segment ($000's omitted)
		Years Ended December 31,
		2016				FY 2016 vs. FY 2015			2015				FY 2015 vs. FY 2014			2014
Net new orders - units:
Northeast		1,361				(8	)%		1,479				5	%		1,408
Southeast (a)		3,810				10	%		3,454				12	%		3,075
Florida		3,585				13	%		3,168				12	%		2,841
Midwest		3,636				27	%		2,862				23	%		2,329
Texas		3,793				11	%		3,429				(9	)%		3,773
West		4,141				15	%		3,616				12	%		3,226
		20,326				13	%		18,008				8	%		16,652
Net new orders - dollars:
Northeast		$	674,066			—	%		$	674,637			4	%		$	649,202
Southeast (a)		1,483,139				28	%		1,160,590				23	%		944,567
Florida		1,340,181				16	%		1,152,705				21	%		954,892
Midwest		1,351,828				32	%		1,024,784				26	%		815,968
Texas		1,060,217				17	%		905,003				3	%		881,843
West		1,843,968				33	%		1,387,661				6	%		1,312,465
		$	7,753,399			23	%		$	6,305,380			13	%		$	5,558,937
Cancellation rates:
Northeast		11		%					12		%					12		%
Southeast (a)		15		%					10		%					12		%
Florida		12		%					11		%					10		%
Midwest		12		%					13		%					13		%
Texas		18		%					19		%					19		%
West		19		%					18		%					18		%
		15		%					14		%					15		%
Unit backlog:
Northeast		387				(13	)%		444				(4	)%		461
Southeast (a)		1,371				20	%		1,146				18	%		968
Florida		1,418				11	%		1,274				27	%		1,002
Midwest		1,307				20	%		1,089				(8	)%		1,188
Texas		1,412				5	%		1,345				6	%		1,273
West		1,527				7	%		1,433				50	%		958
		7,422				10	%		6,731				15	%		5,850
Backlog dollars:
Northeast		$	189,595			(10	)%		$	211,532			(2	)%		$	215,977
Southeast (a)		583,760				45	%		403,568				34	%		301,033
Florida		556,226				13	%		490,282				40	%		349,968
Midwest		501,079				31	%		382,360				3	%		370,036
Texas		402,491				7	%		375,660				21	%		311,424
West		708,361				19	%		593,163				50	%		395,423
		$	2,941,512			20	%		$	2,456,565			26	%		$	1,943,861

(a)	Southeast includes the acquisition of substantially all of the assets of Wieland in January 2016 (see Note 1).

The following table presents additional selected financial information for our reportable Homebuilding segments:

		Operating Data by Segment ($000's omitted)
		Years Ended December 31,
		2016				FY 2016 vs. FY 2015			2015				FY 2015 vs. FY 2014			2014
Land-related charges*:
Northeast		$	2,079			(37	)%		$	3,301			17	%		$	2,824
Southeast		3,089				2	%		3,022				65	%		1,826
Florida		715				(84	)%		4,555				835	%		487
Midwest		3,383				46	%		2,319				(1	)%		2,347
Texas		515				75	%		295				(8	)%		321
West		8,960				(443	)%		(2,615		)		(254	)%		1,696
Other homebuilding		595				1	%		590				(65	)%		1,667
		$	19,336			69	%		$	11,467			3	%		$	11,168

*	Land-related charges include land impairments, net realizable value adjustments for land held for sale, and write-offs of deposits and pre-acquisition costs. Other homebuilding consists primarily of write-offs of capitalized interest resulting from land-related charges. See Notes 3 and 4 to the Consolidated Financial Statements for additional discussion of these charges.

Northeast:

The length and complexity of the entitlement process in the Northeast have led to essentially flat volumes in recent years. For 2016, Northeast home sale revenues increased 2% compared with 2015 due to a 5% decrease in closings and an 8% increase in average selling price. The decrease in closings occurred in the Northeast Corridor and Mid-Atlantic while the increase in average selling price occurred across all markets. The decreased income before income taxes resulted from lower margins in the Mid-Atlantic and increased overhead expense in both the Northeast Corridor and Mid-Atlantic. Net new orders decreased 8%, primarily in the Northeast Corridor and Mid-Atlantic.

For 2015, Northeast home sale revenues decreased 4% compared with 2014 due to a 5% decrease in closings. Average selling price remained flat over 2014. The decrease in closings occurred in Mid-Atlantic and New England and contributed to the lower income before income taxes. Net new orders increased 5%, primarily due to higher order levels in the Northeast Corridor.

Northeast income before income taxes also includes a charge of $15.0 million related to the settlement of a disputed land transaction in 2016 and a charge of $20.0 million resulting from the Applecross matter in 2015 (see Note 12).

Southeast:

In 2016, the Southeast was significantly impacted by the acquisition of substantially all of the assets of Wieland in January 2016 (see Note 1). For 2016, Southeast home sale revenues increased 40% compared with 2015 due to an 18% increase in the average selling price combined with a 19% increase in closings. The increases in the average selling price and closings occurred across all markets. These increases are primarily due to contributions from the assets acquired from Wieland. Excluding those closings, revenues still increased compared with the prior year. Income before income taxes decreased 16% as a result of lower gross margins combined with higher overhead costs, including transaction and integration costs associated with the assets acquired from Wieland. Net new orders increased 10%, primarily due to the assets acquired from Wieland. While demand conditions remain favorable, we have experienced some moderation in pace.

For 2015, Southeast home sale revenues increased 11% compared with 2014 due to an 8% increase in the average selling price combined with a 4% increase in closings. The increases in the average selling price and closings were broad-based, though Tennessee experienced declines. The increased income before income taxes resulted primarily from higher revenues. Net new orders increased 12% in 2015 mainly due to increased order levels in Raleigh and Georgia, partially offset by a decline in Tennessee.

Florida:

For 2016, Florida home sale revenues increased 26% compared with 2015 due to a 6% increase in the average selling price combined with a 19% increase in closings. The increase in average selling price occurred across all markets. The increased income before income taxes for 2016 resulted primarily from higher revenues. Net new orders increased by 13% in 2016 due primarily to an increase in active communities in North and West Florida.

For 2015, Florida home sale revenues increased 11% compared with 2014 due to a 5% increase in the average selling price combined with a 5% increase in closings. The increase in the average selling price occurred in both North and South Florida. The increased income before income taxes for 2015 resulted from higher revenues. Net new orders increased by 12% in 2015 due primarily to an increase in active communities in North and West Florida.

Midwest:

For 2016, Midwest home sale revenues increased 22% compared with the prior year period due to a 15% increase in closings combined with a 6% increase in the average selling price. The higher closing volume led to a 31% increase in income before income taxes. The higher revenues occurred across all markets. Net new orders increased across all markets.

For 2015, Midwest home sale revenues increased 16% compared with the prior year period due to a 15% increase in closings combined with a 2% increase in the average selling price. The increase in closing volumes was driven by our acquisition of certain real estate assets from Dominion Homes in August 2014. Partially offsetting this were lower closings in Illinois-St Louis. The increased income before income taxes resulted from higher revenues. Net new orders increased by 23% in 2015 compared with 2014, mainly due to the acquisition of certain real estate assets from Dominion Homes combined with higher orders in Indianapolis-Cleveland and Minnesota.

Texas:

For 2016, Texas home sale revenues increased 23% compared with the prior year period due to an 11% increase in closings combined with an 11% increase in the average selling price. The increase in average selling price was broad-based across all markets, while the increase in closings occurred across all markets with the exception of San Antonio. The higher revenues and higher closings led to increased income before taxes. Net new orders increased 11% across all markets.

For 2015, Texas home sale revenues decreased by 2% compared with the prior year period due to a 10% decrease in closings, partially offset by a 10% increase in the average selling price. These trends were broad-based, though Houston's closings were down 16%, in part due to the impact of lower oil prices on the local economy. In other markets, the lower closings resulted primarily from tight labor resources combined with delays in opening new communities, in part due to challenging weather conditions earlier in the year. The lower revenues led to the decreased income before income taxes for 2015. Net new orders decreased by 9% for 2015, led by a 19% decline in Houston.

West:

For 2016, West home sale revenues increased 45% compared with the prior year period due to a 29% increase in closings combined with a 13% increase in the average selling price. The increased closings and increased average selling price occurred across all markets. The increased income before income taxes resulted from higher revenues and gross margins in all markets except for Southern California. Net new orders increased by 15% in 2016 compared with 2015 due to higher order levels primarily in Las Vegas and Northern California, offset by a slight decrease in Arizona.

For 2015, West home sale revenues decreased 13% compared with the prior year period due to a 7% decrease in closings combined with a 6% decrease in the average selling price. The decreased closings and decreased average selling price were driven primarily by the Pacific Northwest, Northern California, and Southern California as the result of the timing of our community openings combined with a shift in the mix of closings toward lower priced communities. The decreased income before income taxes resulted from lower revenues, lower gross margins, and higher overhead as we invested in new communities. Net new orders increased by 12% in 2015 compared with 2014 due to higher order levels across all divisions except the Pacific Northwest and Southern California.

Financial Services Operations

We conduct our Financial Services operations, which include mortgage and title operations, through Pulte Mortgage and other subsidiaries. In originating mortgage loans, we initially use our own funds, including funds available pursuant to credit agreements with third parties. Substantially all of the loans we originate are sold in the secondary market within a short period of time after origination, generally within 30 days. We also sell the servicing rights for the loans we originate through fixed price servicing sales contracts to reduce the risks and costs inherent in servicing loans. This strategy results in owning the loans and related servicing rights for only a short period of time. Operating as a captive business model primarily targeted to supporting our Homebuilding operations, the business levels of our Financial Services operations are highly correlated to Homebuilding. Our Homebuilding customers continue to account for substantially all loan production. We believe that our capture rate, which represents loan originations from our Homebuilding operations as a percentage of total loan opportunities from our Homebuilding operations, excluding cash closings, is an important metric in evaluating the effectiveness of our captive mortgage business model. The following table presents selected financial information for our Financial Services operations ($000’s omitted):

	Years Ended December 31,
	2016				FY 2016 vs. FY 2015			2015				FY 2015 vs. FY 2014			2014
Mortgage operations revenues	$	142,262			27	%		$	111,810			14	%		$	97,787
Title services revenues	38,864				34	%		28,943				4	%		27,851
Total Financial Services revenues	181,126				29	%		140,753				12	%		125,638
Expenses (a)	(108,573		)		32	%		(82,047		)		15	%		(71,057		)
Other income (expense), net	531				—	%		—				—	%		—
Income before income taxes	$	73,084			24	%		$	58,706			8	%		$	54,581
Total originations:
Loans	13,373				17	%		11,435				6	%		10,805
Principal	$	3,706,745			27	%		$	2,929,531			10	%		$	2,656,683

(a) Includes loan origination reserve releases of $11.4 million and $18.6 million in 2015 and 2014, respectively.

	Years Ended December 31,
	2016				2015				2014
Supplemental data:
Capture rate	81.2		%		82.9		%		80.2		%
Average FICO score	750				749				749
Loan application backlog	$	1,670,160			$	1,310,173			$	980,863
Funded origination breakdown:
Government (FHA, VA, USDA)	23		%		25		%		24		%
Other agency	70		%		69		%		70		%
Total agency	93		%		94		%		94		%
Non-agency	7		%		6		%		6		%
Total funded originations	100		%		100		%		100		%

Revenues

Total Financial Services revenues during 2016 increased 29% compared with 2015. The increase resulted from a higher loan origination volume resulting from higher volumes in the Homebuilding segment combined with higher revenues per loan, which were largely attributable to a higher average loan size combined with favorable market conditions. Total Financial Services revenues during 2015 increased 12% compared with 2014 as the result of a higher capture rate and higher revenues per loan, which were attributable to a higher average loan size combined with a modest improvement in loan pricing. The improvement in loan pricing in 2015 resulted primarily from a spike in mortgage industry refinancing volume in early 2015, which reduced competitive pricing pressures for new originations. Loan pricing came under more pressure in more recent months as industry refinancing volume receded. However, the overall pricing environment for new originations remains favorable.

Since 2007, the mortgage industry has experienced a significant overall tightening of lending standards and a shift toward agency production. Adjustable rate mortgages (“ARMs”) accounted for 5% of funded loan production in 2016 compared with 6% and 11% in 2015 and 2014, respectively. The shifts in ARM volume contributed to the higher revenues per loan in 2016 and 2015 as ARMs generally contain lower margins. Additionally, fixed rate mortgages tend to have higher servicing values.

Loan origination liabilities

Our mortgage operations may be responsible for losses associated with mortgage loans originated and sold to investors in the event of errors or omissions relating to representations and warranties that the loans sold met certain requirements, including representations as to underwriting standards, the existence of primary mortgage insurance, and the validity of certain borrower representations in connection with the loan. If a loan is determined to be faulty, we either repurchase the loans from the investors or reimburse the investors' losses (a “make-whole” payment).

Estimating the required liability for these potential losses requires a significant level of management judgment. During 2015 and 2014, we reduced our loan origination liabilities by net reserve releases of $11.4 million and $18.6 million, respectively, based on probable settlements of various repurchase requests and existing conditions. Such adjustments are reflected in Financial Services expenses. Given the ongoing volatility in the mortgage industry, changes in values of underlying collateral over time, and other uncertainties regarding the ultimate resolution of these claims, actual costs could differ from our current estimates. See Note 12 to the Consolidated Financial Statements.

Income before income taxes

The increased income before income taxes for 2016 as compared with 2015 is due to higher origination volume and an increase in revenue per loan combined with better overhead leverage.

The increased income before income taxes for 2015 as compared with 2014 is due to higher origination volume and an increase in revenue per loan. The increase in expenses over the prior period is largely a result of an increase in headcount caused by the higher origination volume, combined with the impact of changes in loan loss reserves discussed above.

Income Taxes

Our effective tax rate was 35.5%, 39.5% and 31.2% for 2016, 2015, and 2014, respectively. The 2016 effective tax rate differs from the federal statutory rate primarily due to state income taxes, the reversal of a portion of our valuation allowance related to a legal entity restructuring, the favorable resolution of certain state income tax matters, the impact on our net deferred tax assets due to changes in business operations and state tax laws, and recognition of energy efficient home credits. The 2015 effective tax rate exceeds the federal statutory rate primarily due to state income taxes and the impact of changes in business operations and state tax laws to our net deferred tax assets. The 2014 effective tax rate is less than the federal statutory rate primarily due to the reversal of a portion of our valuation allowance related to certain state deferred tax assets, along with the favorable resolution of certain federal and state income tax matters.

Liquidity and Capital Resources

We finance our land acquisition, development, and construction activities and financial services operations using internally-generated funds supplemented by credit arrangements with third parties and capital market financing. We routinely monitor current and expected operational requirements and financial market conditions to evaluate accessing other available financing sources, including revolving bank credit and securities offerings.

At December 31, 2016, we had unrestricted cash and equivalents of $698.9 million, restricted cash balances of $24.4 million, and $530.9 million available under our revolving credit facility. We follow a diversified investment approach for our cash and equivalents by maintaining such funds with a broad portfolio of banks within our group of relationship banks in high quality, highly liquid, short-term deposits and investments.

Our ratio of debt to total capitalization, excluding our Financial Services debt and limited recourse notes payable, was 40.0% at December 31, 2016.

Senior unsecured notes

In February 2016, we issued $1.0 billion of senior unsecured notes, consisting of $300.0 million of 4.25% senior notes due March 1, 2021, and $700.0 million of 5.50% senior notes due March 1, 2026. The net proceeds from this senior notes issuance were used to fund the retirement of $465.2 million of our senior notes that matured in May 2016, with the remaining net proceeds used for general corporate purposes. In July 2016 we issued an additional $1.0 billion of senior unsecured notes, consisting of an additional $400.0 million of the 4.25% senior notes due March 1, 2021, and $600.0 million of 5% senior notes due January 15, 2027. The net proceeds from the July senior notes issuance were used for general corporate purposes and to pay down approximately $500.0 million of outstanding debt, including the remainder of the previously existing term loan facility. The senior notes issued in 2016 are unsecured obligations, and rank equally in right of payment with the existing and future senior unsecured indebtedness of the Company and each of the guarantors, respectively. The notes are redeemable at our option at any time up to the date of maturity. We retired outstanding debt totaling $965.2 million, $238.0 million, and $245.7 million during 2016, 2015, and 2014, respectively.

Revolving credit facility

In June 2016, we entered into an amended and restated senior unsecured revolving credit facility (the “Revolving Credit Facility”) that provided for an increase in our maximum borrowings from $500.0 million to $750.0 million and extended the maturity date from July 2017 to June 2019. The Revolving Credit Facility contains an uncommitted accordion feature that could increase the size of the Revolving Credit Facility to $1.25 billion, subject to certain conditions and availability of additional bank commitments. The Revolving Credit Facility also provides for the issuance of letters of credit that reduce the available borrowing capacity under the Revolving Credit Facility with a sublimit of $375.0 million at December 31, 2016. The interest rate on borrowings under the Revolving Credit Facility may be based on either the London Interbank Offered Rate ("LIBOR") or Base Rate plus an applicable margin, as defined therein. We had no borrowings outstanding and $219.1 million and $191.3 million of letters of credit issued under the Revolving Credit Facility at December 31, 2016 and 2015, respectively.

The Revolving Credit Facility contains financial covenants that require us to maintain a minimum Tangible Net Worth, a minimum Interest Coverage Ratio, and a maximum Debt-to-Capitalization Ratio (as each term is defined in the Revolving Credit Facility). As of December 31, 2016, we were in compliance with all covenants. Outstanding balances under the Revolving Credit Facility are guaranteed by certain of our wholly-owned subsidiaries. Our available and unused borrowings under the Revolving Credit Facility, net of outstanding letters of credit, amounted to $530.9 million and $308.7 million as of December 31, 2016 and 2015, respectively.

Limited recourse notes payable

Certain of our local homebuilding operations maintain limited recourse collateralized notes payable with third parties totaling $19.3 million at December 31, 2016. These notes have maturities ranging up to four years, are collateralized by the applicable land positions to which they relate, have no recourse to any other assets, and are classified within accrued and other liabilities. The stated interest rates on these notes range up to 5.00%.

Pulte Mortgage

Pulte Mortgage provides mortgage financing for the majority of our home closings by utilizing its own funds and funds made available pursuant to credit agreements with third parties. Pulte Mortgage uses these resources to finance its lending activities until the loans are sold in the secondary market, which generally occurs within 30 days.

Pulte Mortgage maintains a master repurchase agreement (the “Repurchase Agreement”) with third party lenders. In August 2016, Pulte amended its Repurchase Agreement to extend the effective date to August 2017, and adjusted the maximum aggregate commitment amount according to seasonal borrowing capacity needs. In December 2016, Pulte Mortgage again amended its Repurchase Agreement to increase the maximum aggregate commitment amount to cover seasonal borrowing capacity needs. The maximum aggregate commitment was $360.0 million during the seasonally high borrowing period from December 27, 2016 through January 12, 2017. At all other times, the maximum aggregate commitment ranges from $175.0 million to $200.0 million. The purpose of the changes in capacity during the term of the agreement is to lower associated fees during seasonally lower volume periods of mortgage origination activity. Borrowings under the Repurchase Agreement are secured by residential mortgage loans available-for-sale. The Repurchase Agreement contains various affirmative and negative covenants applicable to Pulte Mortgage, including quantitative thresholds related to net worth, net income, and liquidity. Pulte Mortgage had $331.6 million and $267.9 million outstanding under the Repurchase Agreement at December 31, 2016, and 2015, respectively, and was in compliance with its covenants and requirements as of such dates.

Share repurchase programs

In previous years, our Board of Directors authorized and announced a share repurchase program. In July 2016, our Board of Directors approved an increase of $1.0 billion to such authorization. We repurchased 30.9 million, 21.2 million, and 12.9 million shares in 2016, 2015, and 2014, respectively, for a total of $600.0 million, $433.7 million, and $245.8 million in 2016, 2015, and 2014, respectively. At December 31, 2016, we had remaining authorization to repurchase $1.0 billion of common shares.

Dividends

Our declared quarterly cash dividends totaled $122.2 million, $117.9 million, and $86.4 million in 2016, 2015, and 2014, respectively.

Cash flows

Operating activities

Our net cash provided by operating activities in 2016 was $68.3 million, compared with net cash used in operating activities of $337.6 million in 2015 and net cash provided by operating activities of $307.9 million in 2014. Generally, the primary drivers of our cash flow from operations are profitability and changes in inventory levels. Our positive cash flow from operations for 2016 was primarily due to income before income taxes of $933.9 million, which was largely offset by a net increase in inventories of $897.1 million as the result of land acquisition and development investment to support future operations as well as more homes under construction as the result of higher production levels. Additionally, residential mortgage loans available-for-sale increased $99.5 million as the result of an increase in loan originations in the month of December compared with the prior year.

Our negative cash flow from operations for 2015 was primarily due to a net increase in inventories of $917.3 million resulting from increased land investment, combined with a net increase in residential mortgage loans available-for-sale of $104.6 million, partially offset by our income before income taxes of $816.0 million.

Our positive cash flow from operations for 2014 was primarily due to our income before income taxes of $689.8 million, offset by a net increase in inventories of $337.9 million and an increase in residential mortgage loans available-for-sale of $53.7 million.

Investing activities

Net cash used in investing activities totaled $471.2 million in 2016, compared with $34.6 million in 2015 and $122.6 million in 2014. The use of cash from investing activities in 2016 was primarily due to the acquisition of certain real estate assets from Wieland (see Note 1).

The use of cash from investing activities in 2015 was primarily due to $45.4 million of capital expenditures and an $8.6 million increase in residential mortgage loans held for investment.

The use of cash from investing activities in 2014 was primarily due to the acquisition of certain real estate assets from Dominion Homes (see Note 1) and $48.8 million of capital expenditures related primarily to new community openings and the relocation of our corporate headquarters.

Financing activities

Net cash provided by financing activities was $350.7 million in 2016, compared with $161.6 million and $529.1 million of net cash used in financing during 2015 and 2014, respectively. The net cash provided by financing activities for 2016 resulted primarily from the proceeds of the February and July senior unsecured notes issuances for $2.0 billion, offset by the retirement of debt totaling $986.9 million, which included $465.2 million of our senior notes that matured in May 2016 and repayment of our previously outstanding term loan. During 2016, we repurchased 30.9 million common shares for $600.0 million under our repurchase authorization, made payments of $124.7 million for cash dividends, and had net borrowings of $63.7 million under the Repurchase Agreement related to a seasonal increase in residential mortgage loans available-for-sale.

Repayments of debt were $239.2 million and $250.6 million in 2015 and 2014, respectively, offset by incremental borrowings of $127.6 million and $34.6 million under the Repurchase Agreement during 2015 and 2014, respectively. Cash used in financing activities for 2015 was offset by $498.1 million of proceeds from the Term Loan executed in September 2015, and also includes dividend payments of $116.0 million and the repurchase of common shares under our share repurchase authorization for $442.7 million. Cash used in financing activities in 2014 reflects dividend payments of $75.6 million, and the repurchase of common shares under our share repurchase authorization for $253.0 million.

Inflation

We, and the homebuilding industry in general, may be adversely affected during periods of inflation because of higher land and construction costs. Inflation may also increase our financing costs. In addition, higher mortgage interest rates affect the affordability of our products to prospective homebuyers. While we attempt to pass on to our customers increases in our costs through increased sales prices, market forces may limit our ability to do so. If we are unable to raise sales prices enough to compensate for higher costs, or if mortgage interest rates increase significantly, our revenues, gross margins, and net income could be adversely affected.

Seasonality

Although significant changes in market conditions have impacted our seasonal patterns in the past and could do so again, we historically experience variability in our quarterly results from operations due to the seasonal nature of the homebuilding industry. We generally experience increases in revenues and cash flow from operations during the fourth quarter based on the timing of home closings. This seasonal activity increases our working capital requirements in our third and fourth quarters to support our home production and loan origination volumes. As a result of the seasonality of our operations, our quarterly results of operations are not necessarily indicative of the results that may be expected for the full year.

Contractual Obligations and Commercial Commitments

The following table summarizes our payments under contractual obligations as of December 31, 2016:

	Payments Due by Period ($000’s omitted)
	Total				2017				2018-2019				2020-2021				After 2021
Contractual obligations:
Long-term debt (a)	$	5,066,941			$	296,587			$	330,750			$	1,015,875			$	3,423,729
Operating lease obligations	122,924				25,349				42,546				22,747				32,282
Other long-term liabilities (b)	21,037				12,359				4,485				4,193				—
Total contractual obligations (c)	$	5,210,902			$	334,295			$	377,781			$	1,042,815			$	3,456,011

(a)	Represents principal and interest payments related to our senior notes.

(b)	Represents limited recourse collateralized financing arrangements and related interest payments.

(c)	We do not have any payments due in connection with capital lease or long-term purchase obligations.

We are subject to certain obligations associated with entering into contracts (including land option contracts) for the purchase, development, and sale of real estate in the routine conduct of our business. Option contracts for the purchase of land enable us to defer acquiring portions of properties owned by third parties and unconsolidated entities until we have determined whether to exercise our option, which may serve to reduce our financial risks associated with long-term land holdings. At December 31, 2016, we had $195.4 million of deposits and pre-acquisition costs, of which $9.8 million is refundable, relating to option agreements to acquire 43,979 lots with a remaining purchase price of $2.1 billion. We expect to acquire the majority of such land within the next two years and the remainder thereafter.

At December 31, 2016, we had $21.5 million of gross unrecognized tax benefits and $12.2 million of related accrued interest and penalties. We are currently under examination by various taxing jurisdictions and anticipate finalizing the examinations with certain jurisdictions within the next twelve months. The final outcome of these examinations is not yet determinable. The statute of limitations for our major tax jurisdictions remains open for examination for tax years 2005 - 2016.

The following table summarizes our other commercial commitments as of December 31, 2016:

	Amount of Commitment Expiration by Period ($000’s omitted)
	Total				2017				2018-2019				2020-2021				After 2021
Other commercial commitments:
Guarantor credit facilities (a)	$	750,000			$	—			$	750,000			$	—			$	—
Non-guarantor credit facilities (b)	360,000				360,000				—				—				—
Total commercial commitments (c)	$	1,110,000			$	360,000			$	750,000			$	—			$	—

(a)	The $750.0 million in 2018-2019 represents the capacity of our unsecured revolving credit facility, under which no borrowings were outstanding, and $219.1 million of letters of credit were issued at December 31, 2016.

(b)	Represents the capacity of the Repurchase Agreement, of which $331.6 million was outstanding at December 31, 2016. The capacity of $360.0 million is effective through January 12, 2017 after which it ranges from $175.0 million to $200.0 million until its expiration in August 2017.

(c)	The above table excludes an aggregate $1.1 billion of surety bonds, which typically do not have stated expiration dates.

Off-Balance Sheet Arrangements

We use letters of credit and surety bonds to guarantee our performance under various contracts, principally in connection with the development of our homebuilding projects. The expiration dates of the letter of credit contracts coincide with the expected completion date of the related homebuilding projects. If the obligations related to a project are ongoing, annual extensions of the letters of credit are typically granted on a year-to-year basis. At December 31, 2016, we had outstanding letters of credit of $219.1 million. Our surety bonds generally do not have stated expiration dates; rather, we are released from the bonds as the contractual performance is completed. These bonds, which approximated $1.1 billion at December 31, 2016, are typically outstanding over a period of approximately three to five years. Because significant construction and development work has been performed related to the applicable projects but has not yet received final acceptance by the respective counterparties, the aggregate amount of surety bonds outstanding is in excess of the projected cost of the remaining work to be performed.

In the ordinary course of business, we enter into land option agreements in order to procure land for the construction of houses in the future. At December 31, 2016, these agreements had an aggregate remaining purchase price of $2.1 billion. Pursuant to these land option agreements, we provide a deposit to the seller as consideration for the right to purchase land at different times in the future, usually at predetermined prices.

At December 31, 2016, aggregate outstanding debt of unconsolidated joint ventures was $4.6 million, of which our proportionate share was $1.3 million. See Note 5 to the Consolidated Financial Statements for additional information.

Critical Accounting Policies and Estimates

The accompanying consolidated financial statements were prepared in conformity with U.S. generally accepted accounting principles. When more than one accounting principle, or the method of its application, is generally accepted, we select the principle or method that is appropriate in our specific circumstances (see Note 1 to our Consolidated Financial Statements). Application of these accounting principles requires us to make estimates about the future resolution of existing uncertainties; as a result, actual results could differ from these estimates. In preparing these consolidated financial statements, we have made our best estimates and judgments of the amounts and disclosures included in the consolidated financial statements, giving due regard to materiality.

Revenue recognition

Homebuilding – Homebuilding revenue and related profit are generally recognized when title to and possession of the property are transferred to the buyer. In situations where the buyer’s financing is originated by Pulte Mortgage, our wholly-owned mortgage subsidiary, and the buyer has not made an adequate initial or continuing investment, the profit on such sale is deferred until the sale of the related mortgage loan to a third-party investor has been completed. If there is a loss on the sale of the property, the loss on such sale is recognized at the time of closing.

Financial Services – Mortgage servicing fees represent fees earned for servicing loans for various investors. Servicing fees are based on a contractual percentage of the outstanding principal balance, or a contracted set fee in the case of certain sub-servicing arrangements, and are credited to income when related mortgage payments are received or the sub-servicing fees are earned. Loan origination fees, commitment fees, and certain direct loan origination costs are recognized as incurred. Expected gains and losses from the sale of residential mortgage loans and their related servicing rights are included in the measurement of written loan commitments that are accounted for at fair value through Financial Services revenues at the time of commitment. Subsequent changes in the fair value of these loans are reflected in Financial Services revenues as they occur. Interest income is accrued from the date a mortgage loan is originated until the loan is sold. Loans are placed on non-accrual status once they become greater than 90 days past due their contractual terms. Subsequent payments received are applied according to the contractual terms of the loan.

Inventory and cost of revenues

Inventory is stated at cost unless the carrying value is determined to not be recoverable, in which case the affected inventory is written down to fair value. Cost includes land acquisition, land development, and home construction costs, including interest, real estate taxes, and certain direct and indirect overhead costs related to development and construction. For those communities for which construction and development activities have been idled, applicable interest and real estate taxes are expensed as incurred. Land acquisition and development costs are allocated to individual lots using an average lot cost determined based on the total expected land acquisition and development costs and the total expected home closings for the community. The specific identification method is used to accumulate home construction costs.

We capitalize interest cost into homebuilding inventories. Each layer of capitalized interest is amortized over a period that approximates the average life of communities under development. Interest expense is allocated over the period based on the timing of home closings.

Cost of revenues includes the construction cost, average lot cost, estimated warranty costs, and closing costs applicable to the home. Sales commissions are classified within selling, general, and administrative expenses. The construction cost of the home includes amounts paid through the closing date of the home, plus an accrual for costs incurred but not yet paid, based on an analysis of budgeted construction costs. This accrual is reviewed for accuracy based on actual payments made after closing compared with the amount accrued, and adjustments are made if needed. Total community land acquisition and development costs are based on an analysis of budgeted costs compared with actual costs incurred to date and estimates to complete. The development cycles for our communities range from under one year to in excess of ten years for certain master planned communities. Adjustments to estimated total land acquisition and development costs for the community affect the amounts costed for the community’s remaining lots.

We test inventory for impairment when events and circumstances indicate that the cash flows estimated to be generated by the community are less than its carrying amount. Such indicators include gross margins or sales paces significantly below expectations, construction costs or land development costs significantly in excess of budgeted amounts, significant delays or changes in the planned development for the community, and other known qualitative factors. Communities that demonstrate potential impairment indicators are tested for impairment by comparing the expected undiscounted cash flows for the

community to its carrying value. For those communities whose carrying values exceed the expected undiscounted cash flows, we determine the fair value of the community and impairment charges are recorded if the fair value of the community’s inventory is less than its carrying value.

We generally determine the fair value of each community’s inventory using a combination of discounted cash flow models and market comparable transactions, where available. These estimated cash flows are significantly impacted by estimates related to expected average selling prices and sale incentives, expected sales paces, expected land development and construction timelines, and anticipated land development, construction, and overhead costs. The assumptions used in the discounted cash flow models are specific to each community. Due to uncertainties in the estimation process, the significant volatility in demand for new housing, the long life cycles of many communities, and potential changes in our strategy related to certain communities, actual results could differ significantly from such estimates.

Residential mortgage loans available-for-sale

In accordance with ASC 825, “Financial Instruments” (“ASC 825”), we use the fair value option for our residential mortgage loans available-for-sale. Election of the fair value option for residential mortgage loans available-for-sale allows a better offset of the changes in fair values of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. Changes in the fair value of these loans are reflected in revenues as they occur.

Loan origination liabilities

Our mortgage operations may be responsible for losses associated with mortgage loans originated and sold to investors in the event of errors or omissions relating to representations and warranties made by us that the loans met certain requirements, including representations as to underwriting standards, the existence of primary mortgage insurance, and the validity of certain borrower representations in connection with the loan. If a loan is determined to be faulty, we either repurchase the loan from the investors or reimburse the investors' losses (a “make-whole” payment).

Estimating the required liability for these potential losses requires a significant level of management judgment. During 2015 and 2014, we reduced our loan origination liabilities by net reserve releases of $11.4 million and $18.6 million, respectively, based on probable settlements of various repurchase requests and existing conditions. Reserves provided (released) are reflected in Financial Services expenses. Given the ongoing volatility in the mortgage industry, changes in values of underlying collateral over time, and other uncertainties regarding the ultimate resolution of these claims, actual costs could differ from our current estimates.

Allowance for warranties

Home purchasers are provided with a limited warranty against certain building defects, including a one-year comprehensive limited warranty and coverage for certain other aspects of the home’s construction and operating systems for periods of up to ten years. We estimate the costs to be incurred under these warranties and record a liability in the amount of such costs at the time revenue is recognized. Factors that affect our warranty liability include the number of homes sold, historical and anticipated rates of warranty claims, and the cost per claim. We periodically assess the adequacy of our recorded warranty liability for each geographic market in which we operate and adjust the amounts as necessary. Actual warranty costs in the future could differ from our estimates.

Income taxes

We evaluate our deferred tax assets each period to determine if a valuation allowance is required based on whether it is "more likely than not" that some portion of the deferred tax assets would not be realized. The ultimate realization of these deferred tax assets is dependent upon the generation of sufficient taxable income during future periods. We conduct our evaluation by considering all available positive and negative evidence. This evaluation considers, among other factors, historical operating results, forecasts of future profitability, the duration of statutory carryforward periods, and the outlooks for the U.S. housing industry and broader economy. The accounting for deferred taxes is based upon estimates of future results. Differences between estimated and actual results could result in changes in the valuation of our deferred tax assets that could have a material impact on our consolidated results of operations or financial position. Changes in existing tax laws could also affect actual tax results and the realization of deferred tax assets over time.

Unrecognized tax benefits represent the difference between tax positions taken or expected to be taken in a tax return and the benefits recognized for financial statement purposes. We follow the provisions of ASC 740, “Income Taxes” (“ASC 740”), which prescribes a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. Significant judgment is required to evaluate uncertain tax positions. Our evaluations of tax positions consider a variety of factors, including changes in facts or circumstances, changes in law, correspondence with taxing authorities, and effective settlements of audit issues. Changes in the recognition or measurement of uncertain tax positions could result in material increases or decreases in income tax expense (benefit) in the period in which the change is made. Interest and penalties related to unrecognized tax benefits are recognized as a component of income tax expense (benefit).

Self-insured risks

At any point in time, we are managing over 1,000 individual claims related to general liability, property, errors and omission, workers compensation, and other business insurance coverage. We reserve for costs associated with such claims (including expected claims management expenses) on an undiscounted basis at the time product revenue is recognized for each home closing and periodically evaluate the recorded liabilities based on actuarial analyses of our historical claims. The actuarial analyses calculate estimates of the ultimate cost of all unpaid losses, including estimates for incurred but not reported losses ("IBNR"). IBNR represents losses related to claims incurred but not yet reported plus development on reported claims.

Housing market conditions have been volatile across most of our markets over the past ten years, and we believe such conditions can affect the frequency and cost of construction defect claims. Additionally, IBNR estimates comprise the majority of our liability and are subject to a high degree of uncertainty due to a variety of factors, including changes in claims reporting and resolution patterns, third party recoveries, insurance industry practices, the regulatory environment, and legal precedent. State regulations vary, but construction defect claims are reported and resolved over an extended period often exceeding ten years. Changes in the frequency and timing of reported claims and estimates of specific claim values can impact the underlying inputs and trends utilized in the actuarial analyses, which could have a material impact on the recorded reserves. Additionally, the amount of insurance coverage available for each policy period also impacts our recorded reserves. Because of the inherent uncertainty in estimating future losses and the timing of such losses related to these claims, actual costs could differ significantly from estimated costs.

Adjustments to reserves are recorded in the period in which the change in estimate occurs. During 2016 and 2015, we reduced general liability reserves by $55.2 million and $29.6 million, respectively, as a result of changes in estimates resulting from actual claim experience observed being less than anticipated in previous actuarial projections. During 2015, we also recorded a general liability reserve reversal of $32.6 million, resulting from a legal settlement relating to plumbing claims initially reported to us in 2008 and for which our recorded liabilities were adjusted over time based on changes in facts and circumstances. These claims ultimately resulted in a class action lawsuit involving a national vendor and numerous other homebuilders, homebuyers, and insurance companies. In 2015, a global settlement was reached, pursuant to which we funded our agreed upon share of settlement costs, which were significantly lower than our previously estimated exposure. During 2014, we increased general liability insurance reserves by $69.3 million, which was primarily driven by estimated costs associated with siding repairs in certain previously completed communities.

The changes in actuarial estimates in 2016, 2015, and 2014 were driven by changes in actual claims experience that, in turn, impacted actuarial estimates for potential future claims. These changes in actuarial estimates did not involve any changes in actuarial methodology but did impact the development of estimates for future periods, which resulted in adjustments to the IBNR portion of our recorded liabilities.

Our recorded reserves for all such claims totaled $831.1 million and $924.6 million at December 31, 2016 and 2015, respectively, the vast majority of which relate to general liability claims. The recorded reserves include loss estimates related to both (i) existing claims and related claim expenses and (ii) IBNR and related claim expenses. Liabilities related to IBNR and related claim expenses represented approximately 70% and 74% of the total general liability reserves at December 31, 2016 and 2015, respectively. The actuarial analyses that determine the IBNR portion of reserves consider a variety of factors, including the frequency and severity of losses, which are based on our historical claims experience supplemented by industry data. The actuarial analyses of the reserves also consider historical third party recovery rates and claims management expenses. Because of the inherent uncertainty in estimating future losses related to these claims, actual costs could differ significantly from estimated costs. Based on the actuarial analyses performed, we believe the range of reasonably possible losses related to these claims is $750 million to $975 million. While this range represents our best estimate of our ultimate liability related to these claims, due to a variety of factors, including those factors described above, there can be no assurance that the ultimate costs realized by us will fall within this range.

In certain instances, we have the ability to recover a portion of our costs under various insurance policies. Estimates of such amounts are recorded when recovery is considered probable. Our receivables from insurance carriers totaled $307.3 million and $362.7 million at December 31, 2016 and 2015, respectively. The insurance receivables relate to costs incurred or to be incurred to perform corrective repairs, settle claims with customers, and other costs related to the continued progression of both known and anticipated future construction defect claims that we believe to be insured related to previously closed homes. We believe collection of these insurance receivables is probable based on the legal merits of our positions after review by legal counsel, favorable legal rulings received to date, the credit quality of our carriers, and our long history of collecting significant amounts of insurance reimbursements under similar insurance policies related to similar claims, including significant amounts funded by the above carriers under different policies. While the outcome of these matters cannot be predicted with certainty, we do not believe that the resolution of such matters will have a material adverse impact on our results of operations, financial position, or cash flows.