So you’re remodeling or refreshing the real property for your retail or restaurant business. What do you capitalize and what can you deduct for tax purposes?
No way around it, taxes can be complicated. And if you own real property, the IRS made them a bit more complicated when it released the tangible property regulations. While the results were often favorable to taxpayers, the benefits came with an increased tax burden. (For more on this topic, refer to our white paper Overview: Tangible Property Regulations and our blog post Ready for the Tangible Property Regulations? An Overview.)
After issuing the tangible property regulations, the IRS released a revenue procedure with a safe harbor rule to simplify determining the costs that can be deducted and those that must be capitalized and depreciated. It also published a FAQ to address questions raised by taxpayers and practitioners.
Remodel-Refresh Safe Harbor Basics
The safe harbor rule applies to eligible taxpayers engaged in the trade or business of operating a retail establishment or a restaurant.
Under safe harbor, as a qualifying taxpayer you can deduct 75 percent of the eligible costs of your project in the year of the remodel or refresh project and then capitalize the remaining 25 percent. You can do so without conducting a lengthy analysis as generally required under the tangible property regulations.
A remodel-refresh project is a planned undertaking by a qualifying taxpayer on a qualifying building to alter its physical appearance or layout. The project can be done for any of a number of reasons, including to maintain a contemporary and attractive appearance and to more efficiently locate business products and functions.
A qualifying taxpayer is one with an applicable financial statement (essentially a financial statement audited for other than tax reasons — for example, a filing with the SEC or a creditor) and that is in the trade or business of either of the following:
selling merchandise to customers at retail, with limited exceptions (retail)
preparing and selling meals, snacks, or beverages to customers for immediate, on-premises or off-premises consumption (restaurant)
A building is considered to qualify for the safe harbor if it is used — whether owned or leased — by a qualifying taxpayer.
Qualifying Remodel or Refresh Activities
Not all expenditures qualify for the safe-harbor. Following are among the most significant and common costs that do qualify:
painting, polishing, or finishing interior walls
changing permanent floor, ceiling, or wall coverings
changing kitchen fixtures
changing signage or fixtures
relocating departments, eating areas, or other similar areas within the existing footprint of the qualifying building
repairing, maintaining, retrofitting, relocating, adding, or replacing building systems — including windows, doors and roof — within the existing footprint of the qualifying building
The following expenditures do not qualify:
initial build-out of a leased building for a new lessee
costs associated with personal property
material additions to a qualifying building, including building systems, that enlarge, expand or extend the square footage of the building
Additional Guidance from the IRS FAQ
The IRS’s FAQ contains questions and responses related to the following issues:
changing a method of accounting to use the remodel-refresh safe harbor
qualifying for the remodel-refresh safe harbor
using the remodel-refresh safe harbor
coordination with other provisions of the Internal Revenue Code and regulations
Changing a Method of Accounting
To adopt the safe-harbor method, you must file for an accounting method change (in this case, 222) with the IRS, using Form 3115.
Once you file for the accounting method change, all future remodel-refresh projects for your qualifying buildings are subject to the safe harbor.
As part of the safe harbor rule, you cannot make partial disposition elections to claim retirement losses on building components, such as a replaced original roof. If you previously claimed one or more retirement losses on structural components of a building, the safe harbor must be applied to the building on a prospective-only basis — unless the earlier elections are revoked.
Qualifying for the Remodel-Refresh Safe Harbor
The IRS FAQ clarifies that your primary activity determines whether you are a qualified taxpayer for this purpose. In other words, retailers and restaurant owners may be considered qualified taxpayers even if they also conduct activities outside of the retail or restaurant business. Whether your retail or restaurant operations is your primary activity is based on all facts and circumstances.
The IRS FAQ provides examples for taxpayers with both brick-and-mortar retail stores and an online retail business. If the taxpayer primarily conducts its business activities as an online retailer, none of the brick-and-mortar stores will qualify for the safe harbor. All of the brick-and-mortar stores will qualify if the online operation is not the primary business.
Using the Remodel-Refresh Safe Harbor
The remodel-refresh safe harbor requires 25 percent of the project’s expenditures to be capitalized. This capitalized amount can qualify for accelerated depreciation as qualified leasehold improvements, qualified restaurant property or qualified retail improvement property. (For more on this topic, refer to our blog post Improving Your Leased Business Property? Know the Beneficial Tax Rules for Qualified Leasehold Improvements and Qualified Improvement Property.)
The amount that qualifies for accelerated depreciation must be substantiated. You must be able to provide proof of the expenditures that qualify under any of the previously mentioned categories. Any remaining unsubstantiated portion is classified as nonresident real property and depreciated over a 39 year period.
Coordination with Other Provisions
Separate regulations allow you to elect to capitalize amounts paid for repairs and maintenance — as long as the amounts are also capitalized for your accounting records. The remodel-refresh safe harbor does not as the expensed amount (75 percent) is an expense for tax purposes but is capitalized for accounting purposes. As a result, the remodel-refresh and the repairs and maintenance regulations cannot both be applied in the same tax year.
This provides you with a tax planning opportunity: You may choose, on an annual basis, to elect to capitalize repair and maintenance costs or to apply the remodel-refresh safe harbor.
Are you interested in a remodel or refresh of your business?