Retailer and Restaurant Remodel-Refresh Safe Harbor: Frequently Asked Questions

Editor: Kevin D. Anderson, CPA, J.D.

On Nov. 19, 2015, the IRS issued Rev. Proc. 2015-56, which provides certain retailers and restaurants a safe-harbor method of accounting for remodel or refresh expenditures on qualified buildings. Historically, the treatment of remodel and refresh costs has been a contentious examination area. The revenue procedure is intended to reduce disputes over which costs are required to be capitalized and depreciated over time and which costs can be expensed currently as a repair.

Through the adoption of the safe harbor, retailers and restaurants with an applicable financial statement (qualified taxpayers) are able to take 75% of qualified costs as an immediate deduction. The remaining 25% of qualified costs is capitalized and depreciated over time. This revenue procedure is effective immediately for tax years beginning on or after Jan. 1, 2014. Taxpayers have had significant questions regarding the safe harbor. Below are some of the most frequently asked questions:

Q: Do all retailers and restaurants qualify for the safe harbor?

A: Traditional retailers (North American Industry Classification System (NAICS) codes beginning with 44 and 45) and restaurants (NAICS codes within 722) generally qualify. However, certain industries have been specifically excluded, including automotive dealers, gas stations (including attached convenience stores), manufactured home dealers, nonstore retailers, hotels, amusement parks, theaters, casinos, country clubs, caterers, and mobile food services.Determinations are made on the basis of the taxpayer’s primary activity.

Q: What buildings qualify under the safe harbor?

A: The safe harbor applies to buildings primarily used for selling merchandise to retail customers and buildings used to prepare and sell food or beverages to customer order for immediate on-premises and/or off-premises consumption. This category excludes administrative office buildings, distribution centers, and off-premises food preparation facilities. Leased buildings can qualify for lessors and lessees.

Q: What are qualified costs?

A: Qualified costs are a qualified taxpayer’s remodel-refresh costs less a qualified taxpayer’s excluded remodel-refresh costs.

Q: What costs are excluded remodel-refresh costs?

A: Specifically excluded remodel and refresh costs include, but are not limited to, the following: Sec. 1245 property, intangibles (including software), land, land improvements, initial acquisition or lease of the qualified building, rebranding within two years, activities to ameliorate a material condition or defect that existed before the acquisition or lease, casualty repairs, material additions to the qualified building, costs incurred during a temporary closing (more than 21 consecutive days), changing use of more than 20% of the total square footage, and Sec. 179 deductions.

Q: Are indirect costs incurred during a remodel or refresh project required to be included in the computation?

A: Yes, the indirect costs are required to be included in the retail safe-harbor calculation.

Q: Should a cost-segregation study be performed to identify the “qualified expenditures”?

A: Taxpayers should not rely on what was capitalized for book purposes. A cost-segregation study, if not previously performed, is recommended.

Q: Can a taxpayer elect to apply the remodel-refresh safe harbor on a project-by-project basis?

A: The safe harbor is a method of accounting, and a taxpayer that uses the method must apply it to all of the taxpayer’s qualified costs until the taxpayer secures permission from the IRS to use another method of accounting.

Q: How does a taxpayer treat the capitalized portion of the cost (25%)?

A: The taxpayer may treat the nonqualified cost as 15-year property under qualified leasehold improvements, qualified restaurant property, or qualified retail property, to the extent it can substantiate that the capital expenditure qualifies as one of these types of property. Otherwise, the balance is treated as nonresidential real property (39-year property). The taxpayer must include the capitalized portion in a general asset account (GAA) at the modified accelerated cost recovery system (MACRS) asset class level. (To use the safe harbor, a taxpayer must make an election to include any asset that is MACRS property and that comprises a qualified building (including the capitalized portion) in a GAA.)

Q: How does the safe-harbor election interact with the Regs. Sec. 1.263(a)-3(n) election to capitalize repair and maintenance costs?

A: The IRS indicated in remarks to the American Bar Association Tax Section meeting in January that the two elections are mutually exclusive (see Richman, “ABA Meeting: Anticipated Guidance for 2016 Includes Tax Extenders Changes,” 2016 TNT 20-12 (Feb. 1, 2016)).

Q: Can a smaller taxpayer without an applicable financial statement use the 75%/25% safe harbor as a guidepost for its tax treatment of remodels and refreshes?

A: The IRS has indicated that a taxpayer that does not qualify should not use the safe harbor but instead should be fully applying the tangible property regulations (id.).

Q: Is statistical sampling permitted in determining the amount of the deduction?

A: A qualified taxpayer using the safe harbor may use statistical sampling in determining the Sec. 481(a) adjustment if the taxpayer follows the sampling procedure set forth in Rev. Proc. 2011-42.

Q: Can a taxpayer take a partial disposition of a capitalized amount?

A: Taxpayers may not claim partial dispositions on qualified building properties.

Q: May a taxpayer use the safe harbor if it has already made a partial-disposition election in a prior year?

A: The taxpayer must revoke the partial-disposition election. The taxpayer can do this in two ways. The taxpayer may revoke the election by filing an automatic accounting method change no later than the second tax year beginning after Dec. 31, 2013. There is a required one-year spread of the unfavorable Sec. 481(a) adjustment. Instead of filing a method change, if the tax year for which the taxpayer made the partial disposition election is still open, the taxpayer may amend the return. The amended return must be filed no later than the due date, including extensions, of the taxpayer’s federal tax return for the first tax year that the taxpayer uses the remodel-refresh safe harbor and must include the adjustment to taxable income for the revocation of the partial disposition election and any collateral adjustments to taxable income or to tax liability. A revocation is required to obtain audit protection.

Q: May a taxpayer take a disposition of a capital amount in a later tax year?

A: A disposition of the capitalized portion is permitted where the taxpayer has made a qualifying disposition of the building under Regs. Sec. 1.168(i)-1(e)(3)(iii)(B)(3). A qualifying disposition for these purposes includes the cessation, termination, or disposition of an entire qualified building, other than by transfer to a supplies, scrap, or similar account, and the termination of a lease for an entire qualified building if the lessee irrevocably disposes of or abandons the leasehold improvements associated with that qualified building other than by transfer to a supplies, scrap, or similar account.

Q: What should a taxpayer do to elect the safe-harbor method?

A: The taxpayer must file accounting method change number 222 to elect the safe-harbor method. The late GAA election is part of this change. If the taxpayer has previously made a timely or late partial-disposition election and wishes to revoke it, the taxpayer must file accounting method change number 221 to revoke the election.

EditorNotes

Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.