Cost Segregation Across a Multi-Location Restaurant Group

A restaurant buildout typically reclassifies 30 to 45 percent of its cost into five, seven, and fifteen-year property, and qualified improvement property under IRC Sec. 168(e)(6) carries a 15-year recovery period eligible for bonus depreciation. Across a multi-location group, the compounding effect of applying this consistently is far larger than the sum of individual studies.

Restaurant groups are among the best cost segregation candidates in commercial real estate, and among the most consistently under-optimized. The reason is structural: each location gets built, opened, and handed to the accountant as its own project, usually inside its own LLC, and the depreciation treatment gets decided location by location by whoever is preparing that entity's return.

Treat the group as a portfolio instead and the numbers change materially.

Why Restaurant Buildouts Reclassify So Heavily

Very little of a restaurant buildout is structural. The kitchen is equipment and equipment-serving infrastructure. The dining room is finishes. The exterior is signage, lighting, and site work. On a typical full-service buildout, the reclassification profile looks something like this:

• Five-year IRC Sec. 1245 property: walk-in coolers and freezers as equipment rather than structure, hood and exhaust systems, dedicated kitchen electrical and plumbing, POS cabling and low-voltage, decorative lighting, millwork, booth seating, bar buildout, and specialty wall and floor finishes
• Fifteen-year land improvements: parking, drive-through lanes and menu board foundations, patio hardscape, site lighting, landscaping, and pylon sign foundations
• Fifteen-year qualified improvement property: interior improvements to the nonresidential building made after it was first placed in service, excluding enlargement, elevators and escalators, and internal structural framework

Qualified improvement property is the category that most often gets mishandled. QIP is defined at IRC Sec. 168(e)(6) and assigned a 15-year recovery period, which makes it eligible for bonus depreciation under IRC Sec. 168(k). Buildouts of leased space frequently qualify in full. When QIP gets defaulted onto a 39-year schedule, which happens routinely, the entire improvement is depreciating over more than twice its correct life and is losing bonus eligibility on top of that.

The Portfolio Effect

Three things compound once you look at the group rather than the location.

Consistency of method. A group with eleven locations built over nine years often has four different depreciation approaches on the books, because four different preparers made four different calls. Standardizing the method across the portfolio, and filing Form 3115 to correct the locations that were set up wrong, produces a single IRC Sec. 481(a) catch-up adjustment in the current year covering every location at once.

Partial asset disposition. Restaurants remodel. When you tear out a hood system, a bar, or a dining room and replace it, the removed component still sits on the depreciation schedule being depreciated as though it existed. A partial asset disposition election under Treas. Reg. 1.168(i)-8 lets you write off the remaining basis of the retired component in the year of the remodel, and it removes the demolished asset from the schedule so you stop depreciating something that is in a dumpster. Without a cost segregation study identifying components separately, there is no basis figure to write off, so the election is unavailable. Groups on a five-to-seven-year refresh cycle leave large amounts here.

Loss placement. Where the deduction lands matters as much as its size. If the operating entities are S-Corps and the real estate sits in separate LLCs, the same passive activity questions that affect any owner-occupied structure apply. If locations are leased from third parties, the buildout depreciation sits in the operating entity and offsets operating income directly, which is the simpler case.

Sequencing a Group Study

The practical approach for a group of five or more locations:

1. Inventory the fixed asset schedules across every entity. This step alone usually surfaces two or three locations with QIP sitting on 39 years.
2. Identify the remodel history. Any location remodeled in an open year is a partial asset disposition candidate.
3. Study the largest and most recently placed-in-service locations first. Bonus depreciation is most valuable where basis is highest and the property is newest.
4. Batch the Form 3115. Method changes across multiple entities can generally be coordinated in the same filing year, producing one consolidated planning conversation instead of eleven.
5. Model taxable income before deducting. A group that generates more deduction than it has income to absorb creates a net operating loss with its own limitations. Deduction you cannot use this year is worth less than deduction timed to a year with income.

The Constraint Worth Knowing

Accelerated depreciation is timing, not forgiveness. On sale, IRC Sec. 1245 recapture applies to the personal property component at ordinary rates, and IRC Sec. 1250 applies to the real property component. For a group that intends to hold and operate, this is a straightforward trade of tax now for tax later at a discount rate you control. For a group preparing for a sale inside two or three years, the recapture math needs to be run before the study, not after, because purchase price allocation under IRC Sec. 1060 in the eventual sale interacts directly with how the assets were classified going in.

Groups that are building, remodeling, and holding are the clearest candidates. Groups mid-way through an exit process should model the full cycle first.

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This article is for informational purposes only and does not constitute legal or tax advice. Consult a qualified tax professional regarding your specific circumstances. AE Tax Advisors, 935 Lake Elmo Dr, Suite B, Billings, MT 59105. Phone: (631) 614-5762.

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