Remodeling or refreshing a building? New safe harbor may allow accelerated deductions.
Remodel-refresh costs can be difficult to classify for tax purposes. Almost any project will involve both expenditures that can be classified as currently-deductible repair expenses and others that would more properly be considered improvements that must be capitalized and depreciated. In 2014, the IRS released regulations that provided specific guidance on capitalizing improvements made to all types of property. However, this guidance did little to clarify the distinction between repair expenses and capitalizable improvements for businesses that refresh or remodel buildings frequently in order to maintain an attractive and contemporary environment or conform to industry standards. As a result, taxpayers have been required to engage in a complex and expensive analysis of remodel-refresh costs that often result in significant capitalization and have been the subject of IRS scrutiny.
To provide relief to these businesses, the IRS has created a safe harbor that provides more certainty around classifying remodel-refresh costs, reduces the administrative burden, and potentially accelerates taxpayer deductions. To the extent a business has audited financial statements and meets the other criteria described below, it may use the safe harbor to expense 75 percent of the costs related to the remodel project and capitalize and depreciate the remaining 25 percent.
The safe harbor was created for remodels-refreshes of certain restaurant and retail establishments, including costs incurred by lessors who are leasing to qualifying businesses. In order to qualify for the safe harbor, the building user must be either:
- In the business of selling merchandise to customers at retail, with the exception of automotive dealers, gas stations, manufactured home dealers, and nonstore retailers, or
- In the business of preparing and selling meals, snacks, or beverages for immediate consumption, with the exception of hotels, civic organizations, amusement parks, theaters, casinos, country clubs, and similar facilities.
In addition, only businesses that have audited financial statements are able to adopt this safe harbor. As a result, many businesses may not qualify to utilize this safe harbor.
Taxpayers that adopt the safe harbor are generally required to apply it to all existing buildings, requiring analysis of all remodel-refresh projects undertaken in prior years.
What projects qualify?
A remodel-refresh is a planned undertaking by a qualified taxpayer on a qualified building to alter its physical appearance and/or layout, for one or more of the following purposes:
- Maintain a contemporary and attractive appearance.
- Conform to current industry or building standards.
- Efficiently locate retail or restaurant functions and products.
- Standardize consumer experience if the qualified taxpayer operates more than one qualified building.
- To offer the most relevant and popular goods within the industry.
- Address demographic changes by varying product/service offerings or display.
What costs qualify?
Generally, the costs of an eligible remodel-refresh project qualify for the safe harbor. However, certain costs are excluded from the safe harbor, such as:
- Personal property and land improvements.
- The initial build-out of a retail/restaurant by a tenant, landlord, or building owner, or a refresh done by a landlord for a new lessee.
- “Rebranding” of an acquired building if done within two years of the acquisition or lease of the building.
- Enlargement, expansion, or extension of the building’s square footage.
- Adaptation of more than 20 percent of the square footage to a new or different use.
- Repair activities that result in closing the building during normal business hours for more than 21 consecutive calendar days.
How to adopt the safe harbor
Taxpayers that adopt the safe harbor are generally required to apply it to all existing buildings, requiring analysis of all remodel-refresh projects undertaken in prior years. Therefore, there may be additional work required in the year a taxpayer adopts the safe harbor, which may include an accounting method change filed with the IRS.
Bonus depreciation and the safe harbor
In past years, certain leasehold improvements qualified for bonus depreciation. Effective in 2016, Congress expanded the types of real property improvements that qualify for bonus depreciation. Under these provisions, up to 50 percent of the refresh-remodel costs that are capitalized under the safe harbor would be eligible for immediate expensing. Careful tracking may be required to determine which costs are eligible for bonus depreciation.
The remodel-refresh safe harbor offers two significant benefits to qualifying taxpayers. First, it provides a rather generous amount of current deductions while reducing the time and expense involved in an analysis of remodel-refresh costs. Second, it brings some certainty to an area that frequently generated controversy between taxpayers and the IRS.
For more information about how the safe harbor and/or expanded bonus depreciation provisions could affect your business, contact your Plante Moran engagement team.