In Revenue Procedure 2015-56 the IRS provided a safe-harbor method that may be used by certain taxpayers operating a retail establishment or restaurant for remodel-refresh costs.
One key restriction is that this safe harbor may only be used by taxpayers that have applicable financial statements (AFP) as referred to in the tangible property regulations that took effect in 2014. Such statements are defined at Reg. §1.263(a)-1(f)(4)—and many small businesses will not have a statement.
Generally to have an AFP a taxpayer must have a financial statement that is either:
- Filed with the SEC
- Audited by an outside CPA
- Filed with a non-tax governmental agency
Reviewed financial statements do not count for this purpose.
The procedure explains the need for the procedure as follows:
Although § 1.263(a)-3 provides several examples that apply the improvement criteria and the unit of property rules to remodel or refresh costs, many remodel-refresh projects are more complicated and diverse than the scenarios included in the examples. Because remodel-refresh projects frequently involve work performed on building structures and a variety of building systems, the final tangible property regulations generally require taxpayers performing remodel-refresh projects to apply separate legal analyses to many different components of the building. These analyses become especially difficult in situations where, as part of their remodel-refresh projects, taxpayers adapt portions of space to a new and different use. Moreover, the application of the improvement rules to particular buildings can be complex because remodel-refresh projects vary so much in frequency, quality, and degree. Consequently, taxpayers and the IRS frequently encounter questions regarding whether the costs for a particular remodel-refresh project should be characterized as repairs, maintenance, or an improvement of the taxpayers' property, causing taxpayers and the IRS to expend significant resources on this factually intensive issue.
A taxpayer using this method will capitalize and depreciate 25% of the costs as an improvement to the building and treat the remaining 75% of the costs as currently deductible.
One thing to note—if a taxpayer elects this method, the taxpayer may not make a partial disposition election related to the claimed disposition of a portion of the building in the year in which the remodel-refresh covered by this procedure takes place or in any prior year. Thus if a taxpayer has made use of such an election previously, the taxpayer must undergo a revocation of that prior late partial disposition election when this method is elected and may not use a partial disposition election in future years.
The IRS justifies this by stating that they arrived at the 75% expense number by taking into account the expected amount of any partial disposition that would have taken place under the application of the specific rules found in the tangible property regulations.
A taxpayer using the safe harbor method may not elect to apply the safe harbor for small taxpayers under § 1.263(a)-3(h) to amounts paid for repair, maintenance, improvement, or similar activities related to a remodel-refresh project during the taxable year. Similarly, the routine maintenance safe harbor cannot be used for any expenses includable in a remodel-refresh per this safe harbor.
As well, changing to this method is a change in a method of accounting and, because of this, a Form 3115 requesting permission to change will generally be required for a taxpayer adopting this method. The revenue procedure provides for obtaining automatic consent to change the accounting method.
There are some items to which this procedure does not apply. Those include:
- Excluded remodel-refresh costs which are defined at Section 4.06 of the procedure as:
- §1245 property
- Intangible property, including creation or maintenance of computer software
- Initial acquisition costs of the building
- Activities to rebrand a building performed within two years of
- An acquisition or initial lease of the building
- Acquisition of a controlling interest in the qualified building
- Activities that ameliorate a material condition or defect that existed prior to acquisition or lease of the building
- A material addition to the building (which is defined as enlarging, expanding, or extending the square footage of the qualified building, or enlarging, expanding, or extending the building systems in conjunction with enlarging, expanding, or extending the square footage of the qualified building.)
- Restoration costs caused by damage to the building for which the taxpayer is required to make an adjustment as a casualty loss
- Adapting more than 20% of the square footage (prior to the remodel) of the building to a a new or different use
- Remodel-refresh costs incurred during a temporary closing
- Cost of any property for which the taxpayer claims a deduction under §§179, 179D or 190.
- De minimus costs
- Remodel-refresh costs that, if capitalized, are not depreciated by the taxpayer
- Qualified lease construction allowances (under IRC §110)
- Direct or indirect costs of acquiring property for resale subject to capitalization under the UNICAP rules of §263A
Remodel, refresh, maintenance or similar activities covered by this procedure include the following:
- Painting, polishing, or finishing interior walls;
- Adding, replacing, repairing, maintaining, or relocating permanent floor, ceiling, or wall coverings, including millwork;
- Adding, replacing, repairing, maintaining, or relocating 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 a room or rooms (for example, dressing rooms, "private" dining space, front office space, or break 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, replacing, or re-lamping lighting fixtures, or adding reflectors, mirrors, or other similar devices to existing lighting fixtures;
- Repairing, maintaining, retrofitting, relocating, adding, or replacing building systems defined in the tangible property regulations within the existing footprint of the qualified building;
- Making non-structural changes to exterior facades;
- Relocating, replacing, or adding windows or doors (including replacing a manual door with an automatic door) 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, other than demolition subject to § 280B, 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.
The regulation contains 11 examples of the application of this rule by a taxpayer. A taxpayer considering whether or not to elect this method should review those examples to gain a clear understanding of exactly what is being agreed to by switching to this method.
A taxpayer changing to this method that has previously used the partial disposition election must elect out of that method in the first or second taxable year beginning after December 31, 2013. The election out is added to Revenue Procedure 2015-14 as new section 6.43 with an automatic change number of 221.
The change to the Remodel-refresh safe harbor method is added to Revenue Procedure 2015-14 as new section 10.13 and the automatic change number is 222.