A new safe harbor allows retail and restaurant taxpayers to deduct 75% of qualifying expenditures paid or incurred to remodel or "refresh" qualified buildings, and capitalize just 25%. This offers a simple computation for taxpayers that would otherwise need to analyze complicated facts to determine what portion of a remodeling project may be deducted as a repair and what must be capitalized as an improvement. The safe-harbor revenue procedure also covers the application of Sec. 263A, the disposition rules, and general asset account elections for the restaurant and retail locations.
The final tangible property regulations include rules regarding when costs incurred to acquire, produce, or improve tangible property must be capitalized or may be deducted (T.D. 9636), and rules regarding full and partial dispositions of tangible depreciable property and general asset account elections (T.D. 9689). The final regulations generally are effective for tax years beginning on or after Jan. 1, 2014.
Retail and restaurant taxpayers regularly incur expenditures to remodel or refresh retail or restaurant buildings to remain competitive and to improve the customer experience. The new revenue procedure, Rev. Proc. 2015-56, provides a remodel/refresh safe-harbor method for applying the improvement criteria in the tangible property regulations to these projects. The safe harbor is effective for tax years beginning on or after Jan. 1, 2014.
The Safe Harbor
Under the remodel/refresh safe-harbor method, a qualified taxpayer treats 75% of its qualified costs paid during the year as Sec. 162 repair expenses and treats the remaining 25% of the qualified costs as an improvement under Sec. 263(a) and Sec. 263A that is to be depreciated under Sec. 168.
To be qualified, a taxpayer must have an applicable financial statement as defined in Regs. Sec. 1.263(a)-1(f)(4). Therefore, taxpayers without audited financial statements are generally not eligible. Qualified taxpayers include those:
- In the trade or business of selling merchandise to customers at retail that conduct activities within North American Industry Classification System (NAICS) codes beginning with 44 or 45 (but excluding certain NAICS codes such as automotive dealers, motor vehicle dealers, gas stations, manufactured home dealers, and nonstore retailers);
- In the trade or business of preparing and selling meals, snacks, or beverages to customer order for immediate on-premises and/or off-premises consumption that conduct activities within NAICS code 722 (except certain businesses such as caterers, hotels, casinos, amusement parks, theaters, etc.); or
- Who own qualified buildings that are leased to the above-listed businesses.
The costs must be incurred for activities on a qualified building, which is a building that is used primarily for selling merchandise to customers at retail or for preparing and selling food or beverages. Costs incurred by a qualified taxpayer at a building not used primarily for retail or as a restaurant (e.g., office headquarters) are not included in the safe harbor.
Rev. Proc. 2015-56 provides a nonexclusive list of 18 types of costs incurred as part of a remodel/refresh project that are eligible for the safe harbor. These costs include painting; relocating departments within the existing footprint; making nonstructural changes to the exterior; and replacing or adding walls, doors, windows, and lighting and plumbing fixtures within the existing footprint of the qualified building.
The safe harbor also provides a list of 12 types of costs that could be incurred during a remodel/refresh project that are excluded from the safe harbor. These include costs related to Sec. 1245 property, land or land improvements, an initial buildout of the leased building for a new lessee, activities to rebrand a building performed within two years of the acquisition or initial lease, material additions to the building, costs incurred in projects where the store closes for more than 21 days, and costs to adapt more than 20% of the building to a new or different use. Therefore, any costs that are excluded from the safe harbor must be analyzed under the final tangible property regulations for improvements.
Although the safe-harbor method minimizes the need for taxpayers and the IRS to perform a detailed factual analysis of each remodel or refresh project, some additional rules make the initial implementation a bit more complex.
Limitation on Partial Disposition Elections
Taxpayers who wish to use the remodel/refresh safe harbor are not permitted to make the partial disposition election under Regs. Sec. 1.168(i)-8(d)(2) or the late partial disposition election under Rev. Proc. 2015-14, Section 6.33, (or its predecessor) for any portion of the original building or to any improvement to the original building. Taxpayers that made those elections (or partial dispositions of modified accelerated cost recovery system (MACRS) property under the temporary regulations and/or in tax years prior to Jan. 1, 2012) must revoke the elections before changing to use the remodel/refresh safe harbor. If the revocation of the late partial disposition election is not made, the taxpayer must apply the change to the safe harbor on a cutoff basis with respect to the buildings for which the revocation was not made. Additionally, no audit protection will be provided for taxpayers that do not revoke their partial disposition elections.
Rev. Proc. 2015-56 also provides automatic consent to a change to revoke the partial disposition election(s) and/or to use the appropriate asset for disposition purposes. Depending on the year in which the disposition was made, this may require a concurrent change to use the appropriate asset for disposition purposes and/or a choice between filing an amended return on or before the first year that the taxpayer uses the new safe harbor, or filing a time-limited automatic method change for the taxpayer's first or second tax year beginning after Dec. 31, 2013. Thus, calendar-year taxpayers who have already filed their 2014 returns are eligible to make the revocation of the late partial disposition election as a method change only on the 2015 return. The Sec. 481(a) adjustment required for the revocation must be taken into account entirely in the year of change.
Requirement to Use General Asset Accounts
A qualified taxpayer must include the capitalizable portion of any expenditures under the remodel/refresh safe harbor in general asset accounts going forward and must make retroactive general asset account elections to include the cost of the original building and improvements incurred in years prior to the safe harbor. The late general asset account election for the building and any previous improvements is a change in method of accounting that is included as part of the method change to the safe harbor.
This election will not allow the taxpayer to take dispositions on any portion of the building (or improvements) unless it has a qualifying disposition under Regs. Sec. 1.168(i)-1(e), which is generally a disposition of the entire building or leasehold interest.
The safe harbor provides that amounts paid to which the safe harbor applies are not capitalized separately under Secs. 263A(a)(1)(B) and (b)(1). This provides additional relief from the burdensome calculations that would otherwise be required. However, taxpayers must continue to analyze whether the amounts are allocable to inventory. Additionally, a taxpayer using the remodel/refresh safe harbor must keep specific documentation related to the method in its workpapers. The appendix to Rev. Proc. 2015-56 has an example of the type of documentation required.
A change to use the remodel/refresh safe harbor is a change in method of accounting for which the IRS has provided automatic consent by adding the safe-harbor method to Rev. Proc. 2015-14. Certain eligibility requirements for filing automatic method changes are waived for the first or second tax year beginning after Dec. 31, 2013, for these changes. This means that taxpayers who filed a method change for the same item within the last five years or who are in their final year of a trade or business are eligible to make these method changes for those two years.
A safe harbor with over 50 pages of rules may seem a bit overwhelming at first, but this long-awaited guidance for retailers and restaurant operators provides an approach that may resolve controversy regarding the analysis of complicated factors related to remodel/refresh projects for these taxpayers. It does not provide huge simplification, as a taxpayer applying the remodel/refresh safe harbor must still analyze its qualifying costs under most of the improvement rules in Regs. Sec. 1.263(a)-3. However, the remodel/refresh safe harbor does exempt taxpayers from having to determine whether the qualifying costs are capitalizable as a major component or substantial structural part of the qualified building, which may become one of the most disputed areas of the new improvement regulations. Thus, the remodel/refresh safe harbor is similar to the routine maintenance safe harbor in Regs. Sec. 1.263(a)-3(i). That is, the routine maintenance safe harbor similarly requires taxpayers to determine whether costs are routine maintenance by jumping through the hoops of analyzing expenditures under almost the entire improvement rules other than the major-component test.
Additionally, the dispositions and general asset accounts rules in particular will require extra attention during implementation, but they do ease the burden related to tracking dispositions of remodel/refresh improvements. Once implemented, the methodology is likely to become a simpler, more straightforward documentation procedure in future years because taxpayers are no longer required to evaluate whether replacements are major components.
Taxpayers eligible to use the safe-harbor method should consult a tax adviser to determine the next steps for implementing these procedures, as failure to properly take into account all of the procedures may prevent a Sec. 481(a) adjustment for some or all of a taxpayer's remodel/refresh costs on qualified buildings.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.