On November 19, the IRS released Revenue Procedure 2015-56, which provides a safe harbor method of accounting for costs incurred by retailers and restaurants in remodel and refresh projects. In general, the safe harbor favorably allows taxpayers to deduct 75% of such costs under section 162 and capitalize the remaining 25% under sections 263(a).
The rules are the culmination of a multiyear effort by the retail and restaurant industries to obtain clarity for frequently incurred remodel and refresh costs. The rules may be applied retroactively for taxable years beginning on or after January 1, 2014.
Background—The Tax Stakes
Deduction vs. Capitalization. Under section 162, taxpayers may deduct amounts paid for repair and maintenance of tangible property unless the amounts are otherwise required to be capitalized.
Under Reg. § 1.263(a)-3 (commonly known as the “repair regulations”), taxpayers must capitalize amounts paid to improve a unit of property. For this purpose, the repair regulations define an improvement as the betterment or restoration of a unit of property, or the adaptation of a unit of property to a new or different use. The repair regulations treat the building structure (i.e., walls, partitions, floors, and ceilings) as a separate unit of property from each of the building’s systems (e.g., HVAC, plumbing, and electrical).
Refresh vs. Remodel Costs under the Repair Regulations. The repair regulations permit the deduction of costs to “refresh” property, but require the capitalization of remodeling costs.
For instance, Reg. 1.263(a)-3(j)(3), Example 6, provides that “refresh” costs are generally deductible. In that example, the taxpayer owns a chain of retail stores. To maintain the appearance and functionality of its stores, the taxpayer periodically pays amounts to “refresh” the look and layout of its stores. The work consists of cosmetic and layout changes to the store’s interiors and general repairs and maintenance to the store building, including relocating lighting, moving one wall to accommodate the reconfiguration of tables and racks, patching holes in walls, repainting the interior structure, replacing damaged ceiling tiles, cleaning and repairing flooring throughout the store building, and power washing building exteriors.
Example 6 concludes that all of the costs of the refresh are deductible as repairs that keep the store buildings’ structures and systems in their ordinarily efficient operating condition.
By contrast, Reg. 1.263(a)-3(j)(3), Example 8, provides that more extensive “remodel” costs must be capitalized. In that example, the taxpayer owns a chain of retail stores. In response to changes in the retail market, the taxpayer decides to upgrade its stores to offer higher end products to a different type of customer. To offer these products and attract different types of customers, the taxpayer must substantially remodel its stores. It replaces large parts of the exterior walls with windows, replaces escalators with a monumental staircase, adds a new glass enclosed elevator, rebuilds the interior and exterior facades, replaces vinyl floors with ceramic flooring, replaces ceiling tiles with acoustical tiles, and removes and rebuilds walls to move changing rooms and create specialty departments. The work also includes upgrades to increase the capacity of the buildings' electrical systems to accommodate the structural changes. The work to the electrical system also involves the installation of new more efficient and mood enhancing lighting fixtures. In addition, the work includes remodeling all bathrooms by replacing contractor-grade plumbing fixtures with designer-grade fixtures that conserve water and energy.
Example 8 concludes that all of the costs of the remodel are improvements to the buildings’ structures and systems that must be capitalized.
Need for Additional Guidance. It can be difficult for retailers and restaurants to distinguish between deductible refresh costs and capitalizable remodeling costs. For that reason, following the finalization of the repair regulations in September 2013, the retail and restaurant industries sought additional guidance from the IRS, ultimately resulting in the safe harbor method set forth in Revenue Procedure 2015-56. As described below, the new safe harbor makes it unnecessary for retailers and restaurants to draw lines between refresh and remodel costs.
Who May Use the Safe Harbor?
The safe harbor method applies to (1) retailers, (2) restaurants, and (3) taxpayers that own or lease a building and lease or sublease the building to a retailer or restaurant (each of which is referred to as a “qualified taxpayer”). Certain taxpayers are not eligible, however, including automobile dealers, gas stations, hotels and casinos.
What Are Remodel and Refresh Costs?
Remodel and refresh costs are amounts paid by a qualified taxpayer for remodel, refresh, repair, maintenance, or similar activities performed on a qualified building (defined below) to alter the building’s physical appearance and/or layout for one or more of the following purposes:
- Maintain a contemporary and attractive appearance;
- More efficiently locate retail or restaurant functions and products;
- Conform to current retail or restaurant building standards and practices;
- Standardize the consumer experience if a qualified taxpayer operates more than one qualified building;
- Offer the most relevant and popular goods within the industry; or
- Address changes in demographics by changing product or service offerings and their presentations.
Examples of remodel and refresh costs that are eligible for the safe harbor (“qualified costs”) include:
- Painting, polishing, or finishing interior walls;
- Adding, replacing, repairing, maintaining, or relocating permanent floor, ceiling, or wall coverings, or 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 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, or replacing 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 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.
A “qualified building” is defined as each building unit of property used by a qualified taxpayer primarily for selling merchandise to customers at retail or primarily for preparing and selling food or beverages to customer order for immediate on-premises and/or off-premises consumption.
What Costs Are Not Eligible?
Certain costs are not specifically excluded from the definition of remodel and refresh, including:
- Section 1245 property (e.g., display tables and racks);
- Intangible property (e.g., computer software);
- Land, nondepreciable land improvements, and depreciable land improvements such as sidewalks, parking lots, and depreciable landscaping;
- The initial acquisition, production, or lease of a qualified building;
- The initial build-out of a leased qualified building for a new lessee;
- Activities to rebrand a qualified building performed within two taxable years following the acquisition or initial lease of the building by the taxpayer;
- Activities performed to ameliorate a material condition or defect that existed prior to the qualified taxpayer’s acquisition or lease of the qualified building;
- Material additions to a qualified building or its systems, i.e., enlarging, expanding, or extending the square footage of the qualified building;
- Restoration of a casualty loss;
- Adapting more than 20% of the total square footage of a qualified building to a new or different use as part of a remodel-refresh project; and
- Remodel-refresh costs incurred during a temporary closing (i.e., closing the qualified building during normal business hours for more than 21 consecutive calendar days).
How is the Safe Harbor Method Applied?
In General. A taxpayer relying on the safe harbor must treat 75% of its qualified costs paid during the taxable year as deductible under section 162(a) and must treat the remaining 25% of its qualified costs as costs for improvements to a qualified building under section 263(a) (“the capital expenditure portion”).
Treatment of the Capital Expenditure Portion. The capital expenditure portion is treated as a separate asset subject to depreciation under section 167 and 168. To the extent the costs satisfy the requirements for qualified leasehold improvement property, qualified restaurant property, or as qualified retail improvement property (as defined in sections 168(e)(6), (7), and (8), respectively), the capital expenditure portion may be depreciated on a straight-line basis over 15 years if placed in service before January 1, 2015 (and possibly later if Congress extends such treatment). Any other amounts included capital expenditure portion are classified as nonresidential real property under section 168(e)(2)(B) and may be depreciated over 39 years.
Example. Taxpayer operates a chain of retail stores. To maintain a contemporary and attractive environment, to continue to offer the most relevant and popular products, and to reflect the changing demographics of its customers, the taxpayer periodically undertakes planned projects whereby it incurs amounts to alter the physical appearance and layout of the buildings it uses for its retail sales. Each project includes activities such as relocating or changing the square footage of certain departments, check-out areas, storage spaces, and dressing rooms within the footprint of the existing buildings; removing, constructing, and altering walls within the footprint of the existing buildings; moving lighting and replacing lighting fixtures with more efficient lighting; replacing bathroom fixtures with more updated and efficient fixtures; replacing or reconfiguring display tables and racks; patching and repainting interior walls and exterior structures; and replacing floor tiles, ceiling tiles, and signage. These projects also include changes to the electrical systems, HVAC systems, and plumbing systems within the buildings’ existing footprints to accommodate the structural changes, new product offerings, and bathroom upgrades. The taxpayer’s retail stores remain open to customers during the project, although parts of the store buildings are closed at different times during the process. In Year 1, the taxpayer pays $3 million for these activities to be performed on one of its qualified buildings and places the related property into service. Of the $3 million, the taxpayer pays $1 million for section 1245 property, including new display tables and racks, information kiosks, check-out counters, and other equipment. For Year 1, the taxpayer files a change in method of accounting to use the remodel-refresh safe harbor method of accounting.
The example concludes that the taxpayer’s $3 million project on its building is a remodel-refresh project as described in the safe harbor. Of the $3 million remodel-refresh costs, $1 million was paid for section 1245 property, which is excluded from qualified remodel-refresh costs. The taxpayer may apply the remodel-refresh safe harbor method to the remaining $2 million, of which (1) 75% ($1,500,000) is deductible under section 162, and (2) the remaining 25% ($500,000) must be capitalized under section 263(a).
Because the remodel-refresh safe harbor is a method of accounting, taxpayers seeking to rely on the safe harbor must follow the IRS procedures for automatic approval of accounting method changes.
In addition, to apply the remodel-refresh safe harbor, the taxpayer must elect include the capital expenditure portion in a general-asset account under section 168(i)(4). This election will limit the ability of the taxpayer to recognize a loss for future replacements of property placed in service as part of the remodel-refresh project.
The revenue procedure also contains detailed substantiation and recordkeeping requirements.