The term leasehold improvement refers to any changes made to customize a rental property to satisfy the particular needs of a specific tenant. Such changes may include painting, installing partitions, changing the flooring, or installing customized light fixtures. Improvements can be undertaken by either the landlord or the tenant, though they are often paid for by the tenant.
While the useful lifespan of most leasehold improvements typically ranges from five to ten years, the Internal Revenue Code (IRC) requires that depreciation for such improvements occur over the economic life of the building.
Key Takeaways
- A leasehold improvement customizes a rental property to meet a tenant’s specific needs.
- Landlords may consent to these improvements for both existing and new tenants.
- Improvements may include painting, installing partitions, changing flooring, or adding customized light fixtures.
- Structural enlargements, elevators, roofs, and HVAC systems do not qualify as leasehold improvements.
How Leasehold Improvements Work
Leasehold improvements, often termed as tenant improvements or build-outs, are changes made by landlords of commercial properties. These improvements are tailored to meet the specific needs of a tenant, making the space more attractive and functional for them. Once the lease ends, the improvements generally belong to the landlord unless otherwise specified in the lease agreement. To be considered a leasehold improvement, modifications must meet the internal accommodation needs of the tenant.
Examples of Leasehold Improvements
Examples include:
- Structural modifications
- New drywall and flooring
- Updates to lighting and electrical systems
- Addition of rooms, cubicles, and partitions
- Shelving and countertops
Certain changes are not considered leasehold improvements, especially those that modify common areas or are exterior changes, like landscaping or parking lot repairs. Improvements that benefit multiple tenants or the building’s general functionality, such as HVAC upgrades, do not qualify.
Types of Leasehold Improvements
Tenant Improvement Allowance
This is where the tenant supervises the project. Provisions cover the budget usually listed as a lump sum or per-square-foot basis. Landlords either pay the construction company directly or reimburse the tenant. If the budget is exceeded, the tenant covers the balance.
Rent Discount
Tenants may receive rent discounts to compensate for the cost of improvements. This could manifest as one free month or reduced rent. The tenant still oversees the project and covers any excess cost.
Building Standard Allowance
The landlord offers an improvement package to the tenant who gets more time to focus on their business. Additional costs for extra modifications are borne by the tenant.
Turn Key
This type usually occurs at the beginning of a lease. Cost estimates and plans come from the tenant, while the landlord supervises and pays for the work.
Leasehold Improvements Rules and Regulations
Tax Considerations
In December 2015, the Protecting Americans from Tax Hikes (PATH) Act made permanent a tax-saving provision allowing for a 15-year straight-line cost recovery on qualified leasehold improvements. The Tax Cuts and Jobs Act (TCJA) of 2017 modified rules affecting leasehold improvements, making it easier for landlords and tenants to claim deductions. Qualified improvements must still be interior modifications but no longer require landlords and tenants to be unrelated or improvements to be made three years after the building’s initial occupancy.
CARES Act Adjustments
The CARES Act of 2020 allowed a 15-year recovery period for qualified improvement property (QIP) and provisioned for first-year depreciation of any QIP.
Accounting for Leasehold Improvements
The IRS treats improvements as part of the building, thus subject to depreciation rather than direct deductions. Depreciation deductions can be claimed by the party undertaking the work, be it the landlord or tenant. The maximum amortization amount was increased to $1 million by the new tax reforms.
Leasehold Improvement vs. Building Improvement
Leasehold improvements benefit a specific tenant, while building improvements benefit all tenants by enhancing the overall structure. Examples of building improvements include new roofs, parking lots, lobby renovations, and HVAC system upgrades.
Practical Example
Consider a landlord modifying a retail space for a new tenant, a disc golf shop. The landlord might add four walls to create built-in displays and storage areas for the equipment, all tailored for the tenant’s operational needs.
Who Pays for Leasehold Improvements?
Landlords often pay for such improvements either through a tenant improvement allowance or offering rent discounts. Tenants are responsible for additional costs beyond the agreed budget.
Are Leasehold Improvements Tax Deductible?
Direct deductions are not allowed for leasehold improvements; however, property owners can claim depreciation over time, as these outlays are considered capital improvements.
Conclusion
Leasehold improvements are integral for tenants and landlords to ready, maintain, or enhance rental units. While owners cannot immediately deduct these expenditures, depreciation allows for eventual financial recovery through the IRS guidelines.
Related Terms: tenant improvement, depreciation, lease agreement, tenant allowance, property enhancement.
References
- Loans Canada. “Everything You Need to Know About Leasehold Improvements”.
- HLB Gross Collins. “TAX ON TENANT IMPROVEMENTS”.
- University of Michigan. “Leasehold Improvements”.
- Internal Revenue Service. “New rules and limitations for depreciation and expensing under the Tax Cuts and Jobs Act”.
- Lease Query. “Tenant Improvement Allowance Accounting for Lessees under ASC 840”.
- F.E. Moran. “Who Pays for Tenant Improvements?”
- Finance.senate.gov. “SECTION-BY-SECTION SUMMARY OF THE PROPOSED ‘PROTECTING AMERICANS FROM TAX HIKES ACT OF 2015’”, Page 3.
- Docs.house.gov. “Protecting Americans from Tax Hikes Act of 2015”, Pages 58 and 59-61.
- BPM. “The CARES Act Adjusts Eligibility of Qualified Improvement Property”.
- Accounting Tools. “How to account for leasehold improvements”.
- Zacks. “Building Improvements Vs. Leasehold Improvements”.
