By Mandi Raneri 

It’s no question that restaurants are fast-paced businesses with increased growth year after year. The National Restaurant Association projects that restaurant industry sales will reach $782.7 billion in 2016, with more than nine in 10 restaurants employing fewer than 50 employees.

These small businesses are severely impacted by the heavy traffic they see each day. What happens when this increased activity begins to take a toll on the buildings and expensive equipment that restaurant owners have invested their limited capital in?

Restaurant owners and operators typically remodel, renovate, or replace their stores every six to eight years. From the necessity to remain competitive to quick service restaurants hoping to transition to fast-casual, the number of reasons to make a significant change are almost as numerous as they are expensive.

These expenditures can cost hundreds of thousands and franchisees are recommended to begin saving several years in advance. Preferential tax treatment for qualified restaurant property and qualified leasehold improvements, the special restaurant depreciation allowance, and remodel-refresh guidance significantly reduce the impact on cash flow and encourage restaurant owners to invest more in their businesses.

Qualified Restaurant Property and Qualified Leasehold Property

As defined in IRS Publication 946, qualified restaurant property is any Section 1250 property that is a building or an improvement to a building placed in service during the tax year. More than 50% of the building’s square footage must be devoted to the preparation of meals and seating for on-premise consumption of prepared meals. Qualified leasehold improvement property is generally considered to be any improvement to an interior part of a building that is nonresidential real property, regardless of square footage devoted to meal preparation and consumption.

The IRS has provided industry specific guidance regarding the depreciable lives of restaurant assets in the Cost Segregation Guide issued in 2004. Generally, all Section 1245 tangible personal property should have a useful life of 5 years, with Section 1250 property placed in service at either 39 years or 15 years, in the case of qualified leasehold improvements and qualified restaurant property.

Restaurant operators can elect to treat qualified restaurant property or qualified leasehold improvement property placed in service during the tax year as Section 179 property up to a maximum of $250,000 of the $500,000 allowed for the 2015 tax year. The PATH Act of 2015 eliminated the $250,000 Section 179 expensing limit on qualified real property beginning in the tax year 2016. Section 179 allows a taxpayer to elect to deduct the cost of certain types of property on their income tax return as an expense, rather than requiring the cost of the property to be capitalized and depreciated. This can be extremely beneficial as it will allow for automatic expensing of $250,000 to $500,000 of Section 1250 property that would otherwise be required to be depreciated over 39 years.

A special restaurant depreciation allowance has been established to recover part of the cost of qualified property placed in service during the tax year. For qualified property placed in service during 2015, 2016, and 2017, an additional 50% depreciation allowance is available after any Section 179 deduction and before regular depreciation is figured under MACRS for the year property is placed in service. The special restaurant depreciation allowance is applicable to both qualified restaurant property that is also a leasehold and qualified leasehold property, as well as additional items specifically addressed by the IRS.

Remodel-Refresh Treatment

What is a remodel-refresh project? Applicable projects include projects to maintain a contemporary and attractive appearance; address changes in demographics; confirm the space to current industry standards; locate retail or restaurant functions more efficiently; offer more relevant goods within the industry, or address changes in demographics. Costs strictly to repaint or clean the building are not included.

In Rev. Proc. 2015-56, the IRS addresses the frequency and intensity of remodel and refresh projects that are undertaken by retail and restaurant establishments. For taxable years beginning on or after January 1, 2014, the IRS permits retail establishments and restaurants to use a safe-harbor method of determining whether expenditures incurred to remodel or refresh a qualified building are deductible under Sec. 162(a) or must be capitalized under Sec. 263(a) or 263A.

How Restaurant Operators Use this Method

Under this safe harbor, the qualified taxpayer may treat 75% of qualified costs paid during the tax year as deductible under Section 162 and the remainder of capitalized costs for improvements to a qualified building (263(a)) and as costs for the production of property used in the taxpayer’s trade or business (263A). A qualifying taxpayer must have an applicable financial statement and is subject to certain restrictions on the businesses of retail and restaurant operation.

To take advantage of this safe harbor, taxpayers must file Form 3115, Application for Change in Accounting Method. Taxpayers who adopt this method must use it for all qualifying costs and cannot change without IRS consent to use another method. Additionally, the revenue procedure has special rules for taxpayers who wish to adopt the safe harbor and have elected partial disposition treatment for the same qualifying property.

Restaurant operators interested in taking advantage of this revenue procedure or have more questions about depreciation are strongly encouraged to discuss this opportunity with their tax advisor.