Being a contractor means working under lots of different agreements, including T&M (time and materials) or T&M + Markup. But this: "The house was certainly not in inventory." is not what you told us. He either was building a Spec project (his own project to be sold) or it was his Personal project or he meant it to be his own Rental Income project. Spec = on speculation, to sell in a hot market.

"and he knew his sub contractor was going to purchase it within a month of when he started building."

What matters is when it went under contract, though. Not when he "knew" something was likely.

"The installment sale would lower the amount in taxes due this year and he will most likely have much less income in the following years."

Well, if I lend you the money to buy your new home, you pay me interest. That is reportable income. If I am the one that sold you the house, I am getting Profit + Interest, so that is more income.

For waiving their labor, that also reduces the basis in the house, and that is a potential taxable gain, later. What happens, though, is they buy materials "on the business" but that is for the personal project, etc. You cannot even begin to unravel this, until someone gets audited, for instance. A Worker Comp audit, a Sales Tax audit, or a Tax audit is where these things come to light.