Retail/Restaurant Industry Safe Harbor Under Tangible Property Regulations
The IRS recently issued Revenue Procedure 2015-56 providing a safe harbor for certain taxpayers operating retail or restaurant establishments for determining whether expenditures incurred to “remodel” or “refresh” their property can be expensed under the Tangible Property Regulations released in 2013. Generally, the safe harbor benefits those enhancing the physical appearance and layout of their building to maintain a contemporary and attractive environment for their customers. Through the adoption of the safe harbor, retailers and restaurateurs can now take advantage of the ability to immediately deduct 75% of “qualified” amounts spent to refresh certain property and are required to capitalize the remaining 25%.
|KBKG Insight: “Qualified” property specifically excludes 1245 property, so a cost segregation analysis of any remodeling or refreshing activity should be considered.|
The new rules minimize the need to perform a detailed factual analysis to determine whether each cost incurred during a “remodel-refresh” project is for repair and maintenance or for an improvement. In addition, because the new safe harbor method applies to the entire building or entire leased space, it eliminates the need to apply the unit of property rules separately to each building structure and each building system designated under the capitalization rules. Moreover, the safe harbor eases the factual inquiry into determining whether costs incurred during a “remodel-refresh” project adapt property to a new or different use, requiring qualified taxpayers to exclude from the safe harbor only amounts that adapt more than 20 percent of the total square footage of the building to a new or different use.
|KBKG Insight: Rev. Proc. 2015-56 is effective for tax years beginning on or after January 1, 2014. Practitioners will want to review these rules if they have retail/restaurant clients that have recently incurred major “remodel-refresh” costs to identify any accelerated deductions. In order to utilize the safe harbor, taxpayers must have an applicable financial statement, which for many taxpayers means an audited financial statement.|
Author: John Hanning, CCSP, MBA | Co-Author: Lester Cook, CCSP, ASA
The Tangible Property Regulations introduced the concept of “Unit of Property” and “building systems” along with the requirement to analyze capital expenditures related to a betterment, adaptation, or restoration of the system rather than the entire building as a Unit of Property. Retailers have argued that “refreshing” type activities often require work performed on the building systems outlined within the Tangible Property Regulations and that the requirement to apply a separate legal analysis to the different components of the buildings is especially difficult in their situation. These projects typically involve a planned undertaking to alter the physical appearance and layout of the building to maintain a contemporary and attractive environment, to more efficiently locate different functions and products, to conform to current industry standards and practices, to standardize the customer experience, to offer the most relevant goods, food, or beverages, and to address changes in demographics by changing offerings and their presentation. Typically, taxpayers also perform routine repairs and maintenance during a “remodel-refresh” project.
Code Sec. 162 generally allows a deduction for all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including the costs of repairs and maintenance. Code Sec. 263(a) generally requires the capitalization of amounts paid to acquire, produce, or improve tangible property.
Reg. Sec. 1.162-4 allows taxpayers to deduct amounts paid for repairs and maintenance of tangible property if the amounts are not otherwise required to be capitalized. Reg. Sec. 1.263(a)-3 generally requires taxpayers to capitalize amounts paid to improve a unit of property. Reg. Sec. 1.263(a)-3(d) defines improvements as amounts paid that are for betterment to a unit of property, that restore a unit of property, or that adapt a unit of property to a new or different use.
In addition, Code Sec. 263A requires the capitalization of the direct and allocable indirect costs of real or tangible property produced by a taxpayer for use in its trade or business or acquired for resale. Thus, the rules under Code Sec. 263A require taxpayers to apply an additional analysis to their “remodel-refresh” projects to determine which costs must be capitalized.
Because “remodel-refresh” projects frequently involve work performed on building structures and a variety of building systems, the tangible property regulations generally require taxpayers performing “remodel-refresh” projects to apply separate legal analyses to many different components of the building. Consequently, taxpayers frequently encounter questions regarding whether the costs for a particular “remodel-refresh” project should be characterized as repairs, maintenance, or an improvement of the taxpayers’ property, causing taxpayers to expend significant resources on this factually intensive issue.
To reduce disputes regarding the deductibility or capitalization of “remodel-refresh” costs, Rev. Proc. 2015-56 provides a safe harbor approach under which qualified taxpayers may determine the portions of their “remodel-refresh” costs that may be deducted or must be capitalized for purposes of Code Secs. 162(a), 263(a), and 263A(b)(1).
|KBKG Insight: Taxpayers wishing to avail themselves of the safe harbor must use the automatic change procedures in Rev. Proc. 2015-13.|
Who Qualifies to Use the Safe Harbor
The Rev. Proc. 2015-56 “remodel-refresh” safe harbor applies to a qualified taxpayer that pays qualified costs in the course of performing a “remodel-refresh” project on a qualified building.
A qualified taxpayer is one who has an Applicable Financial Statement (as defined under Reg. Sec. 1.263(a)-1(f)(4)), and in general:
- Is in the trade of selling merchandise, including goods to resellers such as warehouse clubs, home improvement stores.
- EXCLUDED: automotive dealers, other motor vehicle dealers, gas stations, manufactured home dealers, and non-store retailers
- Is 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.
- EXCLUDED: hotels and motels; civic or social organizations; or amusement parks, theaters, casinos, country clubs, or similar recreation facilities, special food services, food service contractors, caterers, and mobile food services.
A qualified cost “remodel, refresh, repair, maintenance, or similar activity includes:
- Painting, polishing, or finishing interior walls;
- Adding, replacing, repairing, maintaining, or relocating permanent floor, ceiling, or wall coverings, including millwork;
- Adding, replacing, repairing, maintaining, or relocating kitchen fixtures;
- Adding, replacing, or modifying signage or fixtures;
- Relocating departments, eating areas, check-out areas, kitchen areas, beverage areas, management space, storage space, or similar areas, within the existing footprint of the qualified building;
- Increasing or decreasing the square footage of departments, eating areas, check-out areas, kitchen areas, beverage areas, management space, storage space, or similar areas within the existing footprint of the qualified building;
- Adding, relocating, or removing a room or rooms (for example, dressing rooms, “private” dining space, front office space, or break rooms) within the existing footprint of the qualified building;
- Moving, constructing, or altering walls within the existing footprint of the qualified building;
- Adding, relocating, removing, replacing, or re-lamping lighting fixtures, or adding reflectors, mirrors, or other similar devices to existing lighting fixtures;
- Repairing, maintaining, retrofitting, relocating, adding, or replacing building systems within the existing footprint of the qualified building;
- Making non-structural changes to exterior facades;
- Relocating, replacing, or adding windows or doors within the existing footprint of the qualified building;
- Repairing, maintaining, or replacing the roof or portion of the roof within the existing footprint of the qualified building;
- Replacing façade materials around windows and entrances;
- Repair and maintenance to the qualified building that directly benefits or is incurred by reason of a “remodel-refresh” project;
- Removal and demolition, other than demolition subject to § 280B, of structural components of a qualified building (for example, insulation, windows, drywall, and similar property) that directly benefit or are incurred by reason of a “remodel-refresh” project;
- Obtaining permits or other similar authorizations that directly benefit or are incurred by reason of a “remodel-refresh” project; and
- Architectural, engineering, and similar services that directly benefit or are incurred by reason of a “remodel-refresh” project. Meaning, indirect costs incurred during a “remodel-refresh” project that are required to be capitalized should be included retail safe harbor calculation (75%/25%).
Specifically excluded remodel-refresh costs include:
- Section 1245 Property (as defined in §1245(a)(3));
- An intangible under §1.263(a)-4(b), including the creation or maintenance of software
- Land, including non-depreciable land improvements described in Asset Class 00.3 of Rev. Proc. 1987-56;
- The initial acquisition, production, or lease of a qualified building, including purchase price, construction costs, transaction costs, and the costs of work performed prior to the date that the qualified building is initially placed in service by the qualified taxpayer,
- The initial build-out of a leased qualified building, or a portion thereof, for a new lessee;
- Activities to rebrand a qualified building performed within two taxable years following the closing date of:
- The acquisition or initial lease of the qualified building by the qualified taxpayer or person related, or
- The acquisition by the qualified taxpayer or a person related to the qualified taxpayer of a controlling interest in the qualified building or in a lease of the qualified building;
- Activities performed to ameliorate a material condition or defect that existed prior to the qualified taxpayer’s acquisition or lease of the qualified building or that arose during the production of the qualified building, regardless of whether the qualified taxpayer was aware of the condition at the time of acquisition or production;
- Material additions to the qualified building, including the building systems;
- Restoration caused by damage to the qualified building for which the qualified taxpayer is required to take a basis adjustment as a result of casualty loss;
- Adapting more than twenty percent of the total square footage of a qualified building to new or different uses;
- Remodel-refresh costs incurred during a temporary closing lasting more than 21 consecutive calendar days;
- The cost of any property for which the qualified taxpayer has claimed deduction under §179, §179D, or §190.
What Qualifies to Use the Safe Harbor
A qualified building is each building unit of property used by a qualified taxpayer, as defined in § 1.48-1(e)(1), and its structural components, as defined in § 1.48-1(e)(2), and in general:
- For condominiums – the building unit of property is each individual unit owned by the qualified taxpayer.
- For Cooperatives – the building unit of property is the portion of the building in which the qualified taxpayer has possessory rights.
- For Leased buildings – the building unit of property is the building and its structural components subject to the lease. Meaning the UOP is applied to a portion of a building such as a store, a floor, or certain square footage as defined by the lease.
A “remodel-refresh” project in general means, a planned undertaking to alter the stores/restaurants physical appearance and/or layout for one or more of the following purposes:
- To maintain a contemporary and attractive appearance;
- To more efficiently locate retail or restaurant functions and products;
- To conform to current retail or restaurant building standards and practices;
- To standardize the consumer experience if a qualified taxpayer operates more than one building;
- To offer the most relevant and popular goods within the industry; or
- To address changes in demographics by changing product or service offerings and their presentations.
|KBKG Insight: A “remodel-refresh” project does not include a planned undertaking solely to repaint or to clean the interior or exterior of an existing qualified building. These are often referred to in the industry as Preventative Maintenance Programs and are generally expensed in full as repair and maintenance costs.|
How to Compute the Safe Harbor
Subject to certain exceptions, the “remodel-refresh” safe harbor applies to all of the qualified taxpayer’s qualified costs paid during the tax year, and in general a taxpayer who uses the “remodel-refresh” safe harbor is required to use the method for all of its qualified costs as defined later in this analysis. To use the “remodel-refresh” safe harbor, the qualified taxpayer must comply with six separate requirements.
- The qualified taxpayer must treat 75% of its qualified costs paid during the tax year as amounts deductible under Code Sec. 162(a) (“the deduction portion”) and must treat the remaining 25% of its qualified costs paid during the tax year as costs for improvements to a qualified building under Code Sec. 263(a) and as costs for the production of property for use in the qualified taxpayer’s trade or business under Code Sec. 263A (“the capital expenditure portion”).
- The qualified taxpayer must document its qualified costs in a manner substantially similar to the standard set forth in Appendix A of Rev. Proc. 2015-56.
- The capital expenditure portion must be charged to a capital account. The capital expenditure portion for each qualified building is a separate asset or assets for depreciation purposes and is depreciated under Code Secs. 167 and 168 beginning when the capital expenditure portion is placed in service by the qualified taxpayer. The qualified taxpayer must make an election to include the capital expenditure portion in a general asset account (GAA).
- A qualified taxpayer must not make the partial disposition election under Reg. Sec. 1.168(i)-8(d)(2) for any portion of an original qualified building or any portion of any improvement or addition to an original qualified building. If a qualified taxpayer had previously made the partial disposition, prior to the first tax year that the qualified taxpayer uses the “remodel-refresh” safe harbor, the qualified taxpayer must revoke that partial disposition election.
- If a qualified taxpayer recognized a gain or loss upon the disposition of a component of a qualified building, a structural component of a qualified building, or a component of such structural component (1) under Reg. Sec. 1.168(i)-1T or Reg. Sec. 1.168(i)-8T that component or structural component is not an improvement or addition, or (2) in a tax year beginning before January 1, 2012, that component or structural component is MACRS property, such qualified taxpayer must change its present method of accounting to be in accord with Reg. Sec. 1.168(i)-1(e)(2)(viii) or Reg. Sec. 1.168(i)-8(c)(4) (determination of asset disposed of), on or before the first tax year that the qualified taxpayer uses the “remodel-refresh” safe harbor, and take the entire amount of the Code Sec. 481(a) adjustment into account in computing the qualified taxpayer’s taxable income for that year of change.
- A qualified taxpayer must make a general asset account election under Code Sec. 168(i)(4) and Reg. Sec. 1.168(i)-1(l) to include in a general asset account any asset that is MACRS property and that comprises a qualified building.
Q&A Section with KBKG Experts
Question: If I elect to apply the retail safe harbor can I do that on a project by project basis?
Answer: No, a qualified taxpayer within the scope of this revenue procedure who uses the “remodel-refresh” safe harbor is required to use the method for all of its qualified costs until the qualified taxpayer secures permission from the IRS to use another method of accounting.
Question: How do I treat the capitalized portion of the cost?
Answer: The qualified taxpayer must make an election to include the capital expenditure portion in a general asset account under § 168(i)(4) and § 1.168(i)-1. In establishing a general asset account (GAA), all assets that are MACRS property, that comprise qualified buildings, that are placed in service in the same taxable year, and that meet the requirements in § 1.168(i)-1(c)(2), must be grouped in the same general asset account (GAA).
Question: Is a retail/restaurant taxpayer “required” to place all capitalized items into general asset account (GAA)?
Answer: No, only to the extent that the taxpayer is utilizing the Retail Safe Harbor.
Question: Can I treat the remaining non-qualified cost (25%) as Qualified Leasehold Improvements (QLI), Qualified Restaurant Property, or Qualified Retail Property to accelerate the recovery period?
Answer: Yes, but the taxpayer must support that position under those rules. If it cannot be supported, the balance is treated as nonresidential real property recovered over 39 years. Remember, all assets placed in service in a given year must be placed into a GAA at the MACRS asset class level.
Question: If a taxpayer utilizes the Retail Safe Harbor, must they place the original construction in a GAA?
Answer: Yes; however, if a qualified taxpayer has multiple qualified buildings, the qualified taxpayer may have separate general asset accounts for the original cost of each original qualified building, including the original structural components of that building.
- For example, Store #A was originally constructed in 2010 and the cost was capitalized as 39 year property. Subsequently, a remodel took place in 2016 for which the retail safe harbor is applied resulting in $200k of Qualified Leasehold Improvements recovered over 15 years. In order for the taxpayer to use the Retail Safe Harbor they are required to file a late GAA Election on Form 3115 to include all original cost in a general asset account for any asset that is MACRS property.
Question: Are indirect costs incurred during a “remodel-refresh” project required to be capitalized? If so, are these cost included in the retail safe harbor calculation?
Answer: Yes to both parts
Question: What if a taxpayer moved out of a leased space, could they take a full disposition for the abandoned asset in that tax year?
Answer: Yes, the disposition limitation applies when the disposition of an improvement is a result of a “remodel-refresh”. In this case the “remodel-refresh” project does not constitute a qualifying disposition under § 1.168(i)-1(e)(3)(iii)(B)(3).
Question: Can a taxpayer take a disposition of a capitalized amount in a later tax year?
Answer: Yes, but the taxpayer must make a full disposition of this cost.
- For example, Store #A was remodeled in 2016 for which the retail safe harbor was applied resulting in $200k of Qualified Leasehold Improvements recovered over 15 years. Store A was remodeled again in 2020 removing all finishes installed during the 2016 remodel. In this case the taxpayer can take a full disposition under Accounting Method Change #205/#206 to recover the un-depreciated balanced.
Question: Can a taxpayer using the safe harbor take a “Partial” Disposition of a capitalized amount in a later tax year?
Answer: No, a taxpayer cannot make the partial disposition election.
- For example, Store A was remodeled in 2016 for which the retail safe harbor was applied resulting in $200k of QLHI recovered over 15 years. Store A was remodeled again in 2020 removing only a small portion of the finishes installed during the 2016 remodel. In this case the taxpayer cannot take a partial disposition.
Question: What if the taxpayer already made a partial disposition election in a prior year?
Answer: The taxpayer must revoke the partial disposition election, in order to use the safe harbor rules for the year in which the disposition was taken. There are two ways to complete this. 1) Amend the return (subject to limitations stated in R.P. 2015-56) or 2) file an Automatic Accounting Method Change filed no later than the second taxable year beginning after 12/31/2013. What if they do nothing? In this case the taxpayer may only utilize the “remodel-refresh” safe harbor on a cut-off basis for the qualified building to which the unrevoked partial disposition election pertains.
Question: If my client elects the “safe harbor for small taxpayers” under § 1.263(a)-3(h) can they apply the “remodel-refresh” safe harbor?
Answer: No, in general these rules apply to taxpayers with audited financial statements (AFS) and a taxpayer may not elect to apply the safe harbor for small taxpayers under § 1.263(a)-3(h).
Question: Can I use Statistical Sampling in conjunction with the “remodel-refresh” safe harbor?
Answer: Yes, a qualified taxpayer changing its method of accounting under this section 10.13 may use statistical sampling in determining the § 481(a) adjustment only by following the sampling procedures provided in Rev. Proc. 2011-42, 2011-37 I.R.B. 318.