United States: IRS Issues Favorable Rules For Retail And Restaurant Remodeling Costs

Retail Did You Know?
Last Updated: December 2 2015
Article by Joshua T. Brady and James D. Bridgeman

Dear Retail Clients and Friends,

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).

Other Requirements

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.

This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions