The question of whether to capitalize or deduct expenditures related to tangible property has historically been one of the most contentious issues between taxpayers and the IRS. A new Revenue Procedure offers a safe harbor for certain remodel/refresh projects, which may add some certainty to the tax treatment in these situations.
The Department of the Treasury and the IRS attempted to add some clarity to the "capitalize vs. deduct" issue when they released a series of new regulations, collectively known as the "Repair Regs" or the "Tangible Property Regs." These regulations provided many new rules and multiple examples intended to help guide taxpayers in determining whether to capitalize or currently deduct expenditures related to tangible property. Unfortunately, the new regulations were not entirely successful in bringing about this intended clarity. One area where there remains a great deal of uncertainty is in the remodeling or refreshing of restaurant and retail space. These projects involve changes to many different components of a building, and there are many potential areas of disagreement as to whether the three tests for capitalization under the new regulations (the "betterment," "restoration," and "adaptation" tests) are met in regards to any specific expenditure.
To help avoid disputes in this area, the IRS issued Rev. Proc. 2015-56, which provides a safe harbor method for treating refresh and remodeling costs of certain retail and restaurant businesses. Under this safe harbor, 25 percent of qualifying costs must be capitalized and depreciated, and the remaining 75 percent of qualifying costs are currently deducted.
Only certain business types (and landlords that lease to these businesses) qualify to elect the new safe harbor. Most retail businesses are eligible, but certain businesses are excluded, such as car dealers and gas stations. Most restaurants are eligible, but there are exceptions here as well, including hotels, country clubs, casinos, and "special food services" such as caterers and food truck businesses.
Certain types of expenditures are excluded, including the initial acquisition and build-out costs of the building or leased space, costs to rebrand a building within two years of the initial acquisition, and costs to adapt more than 20 percent of the total square footage to a new and different use. Also, costs will not qualify for the safe harbor if the project requires the building to be closed during normal business hours for more than 21 consecutive calendar days.
Another requirement for the safe harbor is that the taxpayer must have an "applicable financial statement" in order to qualify. Generally speaking, this means audited financials. While this is probably not an issue for large retailers, many smaller businesses may be prevented from utilizing the safe harbor due to this requirement. Unlike some provisions of the "Tangible Property Regs," there is no requirement that the tax treatment under the safe harbor conform to the treatment in the applicable financial statements.
The remodel/refresh safe harbor is a method of accounting, so utilizing the safe harbor requires the filing of Form 3115 – "Application for Change in Accounting Method." A general asset account election must also be made for the property, to ensure that the 25 percent capitalized portion is not prematurely deducted with a partial disposition election.
The decision to make use of the remodel/refresh safe harbor is not a "no-brainer." Under the "Tangible Property Regs," many refresh projects may be completely deductible or require less capitalization than the safe harbor’s 25 percent. But that determination requires a detailed and potentially complex analysis under the regulations, and there is always the possibility of disagreement from the IRS. The certainty offered by the remodel/refresh safe harbor may outweigh the negatives.
To learn more about the retail and restaurant remodeling safe harbor, contact a Boulay advisor at 952-893-9320 or learnmore@BoulayGroup.com.
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