New Safe Harbor: 75% Remodeling Expense Deduction for Restaurant and Retail Industries and Property Owners Who Rent to These Sectors

A recently created safe harbor permits taxpayers in the retail and restaurant sectors to deduct 75% of qualifying expenditures paid or incurred to remodel qualified buildings and requires only 25% to be capitalized. Not only is the safe harbor available to operators in these sectors, the safe harbor is also available to real property owners that lease their property to the retail and restaurant industries. Simply stated, this is a pro-taxpayer incentive that will impact the retail and restaurant operating population.

The safe harbor, effective for tax years beginning on or after January 1, 2014, is detailed in Rev. Proc. 2015-56.

To appeal to consumers and achieve operational efficiency, retailers and restauranteurs must frequently remodel or update their facilities.  Rev. Proc. 2015-56 provides details on how these expenditures may be expensed up to 75%.

Expenditures such as remodeling and renovation costs are governed by the final tangible property regulations which provide authority on when costs associated with tangible property (e.g., acquisition, production, maintenance) must be capitalized or expensed. The tangible property regulations, generally effective for tax years beginning on or after January 1, 2014, have promoted the capitalization of expenditures incurred by taxpayers. Hence, any relief such as this new safe harbor is welcome relief and a departure from the overall theme of the final tangible property regulations.

A “qualified taxpayer” is able to treat 75% of qualified costs incurred during the year as deductible repair expenses under § 162 and the balance of 25% as capitalized improvements costs under § 263(a) and § 263A. These capitalized costs are subsequently subject to depreciation under § 168.

To be deemed a qualified taxpayer, the taxpayer must first have an “applicable financial statement” (as defined under the relevant regulation).  Hence, taxpayers whose financial statements have not been audited are generally ineligible for the safe harbor.  Second, in general, qualified taxpayers must also be part of the restaurant and retail industry (NAICS codes beginning with 44 or 45, excluding automotive dealiers, motor vehicle dealer, gas stations, manufactured home dealers, and nonstore retailers and those with NAICS codes 722), but this also encompasses taxpayers who own qualified buildings that are leased to those involved in these aforementioned activities.  Hence, this is a broad spectrum of taxpayers that may avail themselves of this generous incentive.

Eligible costs must be expended on a qualified building, which the safe harbor describes as a building primarily used to sell merchandise to retail customers or for preparing and selling food or beverages. Under the revenue procedure, eligible costs include: painting; relocating departments, nonstructural exterior modifications, adding and replacing walls, doors and windows.

There is interplay between this safe harbor and other facets of the Internal Revenue Code that impacts the former’s implementation.  For example, taxpayers utilizing the safe harbor are not permitted to make a partial disposition election under § 1.168(i)-8(d)(2) or the late partial disposition election under Rev. Proc. 2015-14 for any portion or improvement to the original building.  To use the safe harbor, a taxpayer would have to revoke these elections beforehand if they are in place. Rev. Proc. 2015-56 contains automatic consent to change to revoke the aforementioned partial disposition election(s) and/or to use the appropriate asset for disposition purposes.

Further, as mentioned above, 25% of expenditures are required to be capitalized under the safe harbor. The taxpayer is subsequently required to include these amounts in general asset accounts and must make retroactive asset elections to include the building’s original basis and improvements before the safe harbor. Also, taxpayers who wish to utilize the safe harbor should note that they are afforded an automatic consent by the IRS for the change in method of accounting.

In sum, this safe harbor is generous and eradicates significant controversy that naturally arises between retailers and restaurant operators and the IRS regarding remodel/refresh projects. Notably, the safe harbor is filled with nuances and Rev. Proc. 2015-56 must be navigated with care. Accordingly, we encourage taxpayers in the retail and restaurant sector, including those who lease buildings to this sector, to contact their tax advisors to determine how they can benefit from this new measure.