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    Majority of Costs to Remodel or Refresh Restaurants and Retail Stores Are Deductible Under New Safe Harbor


    Confronting complaints about the complexity of the “repair regs”, the IRS announced that restaurants and retail stores may now deduct 75% of remodeling costs and capitalize the other 25% under a “safe harbor” rule. The new remodeling cost rule also has a retroactive effective date, allowing taxpayers to apply it for taxable years beginning on or after January 1, 2014. Why did the IRS make the change? The application of the existing capital improvement rules “can be complex because remodel/refresh projects vary so much in frequency, quality, and degree,” the IRS noted. As a result, the IRS and taxpayers are spending too much time trying to sort out whether the costs for upgrading a building should be characterized as repairs, maintenance, or an improvement.

    Deduction v. Capitalization
    Taxpayers may deduct amounts paid for repair and maintenance of business property but must capitalize amounts paid to “improve” a unit of property, such as walls, floors, partitions, and ceilings. The repair regulations define “improvement” as a betterment, restoration, or adaptation of the property to a new or different use. Specifically, the regulations distinguish between refreshing property, which is deductible, versus remodeling property, which must be capitalized and depreciated over time. For example, cosmetic and layout changes to a store’s interiors, relocating lighting, moving walls, repainting and cleaning would be deductible repairs. On the other hand, rebuilding interior and exterior facades, replacing vinyl floors with ceramic flooring, rebuilding walls, and installing new lighting fixtures would be considered capital improvements.

    How the Remodel-Refresh Safe Harbor Works

    The safe harbor rule is pretty straightforward. The taxpayer files a change in method of accounting to use this remodel-refresh method of accounting, and then deducts 75% of its yearly remodel-refresh costs and capitalizes the remaining 25% of costs. The capital expenditure portion is depreciated as a separate asset, generally over 15 years (although up to a 39-year recovery period could apply to some property). Taxpayers get to deduct a substantial portion of their costs, and disputes with the IRS are minimized.

    Who is Eligible for Safe Harbor?
    Restaurants and retail establishments frequently undertake projects to change their appearance and update and refresh their displays and themes. In recognition of this practice, the IRS has limited the 75/25 safe harbor to restaurants, retailers, and those who lease a building to these businesses. Some businesses are specifically excluded from the new safe harbor, including automobile dealers, gas stations, non-store retailers, amusement parks, hotels, and casinos.

    Eligible and Non-Eligible Costs, Documentation Standards

    The IRS’s very detailed remodel-refresh rules are contained in Revenue Procedure 2015-56, which identifies 18 separate items considered eligible remodel-refresh costs and 12 items that do not qualify for safe harbor treatment. The IRS also offers detailed examples of how to elect and apply the safe harbor. Finally, the Revenue Procedure contains documentation standards which taxpayers must follow to keep track of their remodel-refresh expenditures.

    Certainty is a good thing in tax policy, and the new remodel-refresh safe harbor goes a long way toward helping business taxpayers plan effectively for their construction projects.

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