Key Takeaways:
- What Leasehold Improvements Are: Leasehold improvements are modifications made to a rented space to fit the tenant’s needs. How they are depreciated depends on who made them and the current tax rules.
- Depreciation Life Has Changed: The Tax Cuts and Jobs Act of 2017 replaced the old 15-year leasehold improvement category with a broader category called Qualified Improvement Property, which also carries a 15-year life under current law.
- Cost Segregation Applies: For commercial property owners and tenants with significant improvement costs, a cost segregation study can identify components that qualify for even shorter depreciation lives, accelerating deductions further.
If you have ever built out a commercial space and installed new flooring, lighting, partitions, or custom fixtures to make it work for your business, those costs are leasehold improvements. How you depreciate them for tax purposes has changed significantly over the years, and getting it right can make a meaningful difference in your tax position.
At MVO Cost Segregation, we help commercial property owners and investors maximize depreciation through engineering-based cost segregation studies and detailed property analysis. Properly separating tenant improvements into the appropriate asset categories can help property owners understand applicable recovery periods and identify opportunities to accelerate depreciation where eligible.
In this article, we explain how leasehold improvements depreciation works, how the rules have changed, and how cost segregation fits in.
What Are Leasehold Improvements?
A leasehold improvement is any modification made to the interior of a rented commercial space by either the tenant or the landlord, typically to customize the space for a specific use. Common examples include interior walls and partitions, flooring upgrades, lighting systems, plumbing fixtures, HVAC modifications, and custom millwork or cabinetry.
These improvements are physically attached to the building but are often installed to serve the tenant’s needs rather than the building as a whole. That distinction matters for tax purposes because it affects how and over how long the improvement costs can be depreciated.
Leasehold Improvement Depreciation Life: What The Rules Say
The rules governing leasehold improvement depreciation have shifted significantly over the past decade. Researching where things stood before the Tax Cuts and Jobs Act, and what changed afterward, helps clarify how to classify and depreciate improvements made at different points in time.
How Depreciation Was Handled Before 2018
Before the Tax Cuts and Jobs Act of 2017 (TCJA), leasehold improvements made to nonresidential property had their own dedicated tax category with a 15-year depreciation life, provided they met specific requirements. This includes that the improvement was made more than three years after the building was first placed in service and that the tenant and landlord were not related parties.
What Changed In 2018
The TCJA eliminated the separate leasehold improvement category and replaced it with a broader category called Qualified Improvement Property (QIP). QIP covers most interior improvements to nonresidential buildings already in service, regardless of whether a lease is in place. A technical correction in 2020 confirmed that QIP carries a 15-year depreciation life and qualifies for bonus depreciation, meaning eligible improvements can potentially be deducted in full in the year they are placed in service rather than spread across 15 years. To understand the full scope of what qualifies under current rules, what is qualified improvement property covers the definition, eligibility criteria, and how QIP interacts with bonus depreciation in detail.
Qualified Improvement Property vs. Leasehold Improvements
The distinction between qualified improvement property and leasehold improvements matters because they are not the same thing, even though they often overlap. Leasehold improvements historically required a lease to exist and imposed additional conditions. Meanwhile, QIP is broader. Essentially, it applies to any interior improvement to a nonresidential building already in service, whether or not a lease is involved, as long as the improvement does not involve the building’s structural components, elevators, escalators, or enlargements.
In most practical scenarios involving tenant buildouts, the improvements will qualify as QIP. But knowing the difference helps property owners and tenants ensure their improvements are classified correctly and that they take advantage of the 15-year life and bonus depreciation eligibility, where applicable.
Leasehold Improvements Tax Treatment: Who Deducts What?
One of the most common sources of confusion around leasehold improvements is determining who actually gets to claim the depreciation deduction. The answer depends on who paid for the improvements and how the arrangement between landlord and tenant is structured.
Tenant-Paid Improvements
When a tenant pays for improvements, they generally capitalize those costs and depreciate them over the applicable recovery period, typically 15 years as QIP under current law. If the lease ends before the depreciation period is complete, the tenant may be able to claim a loss on the remaining undepreciated basis at that time, subject to applicable rules.
Landlord-Paid Improvements and Tenant Allowances
When a landlord pays for improvements, those costs are typically treated as part of the building’s depreciable basis and depreciated accordingly. When a landlord provides a tenant improvement allowance, which is a cash payment or rent credit given to the tenant to fund buildout costs, the tax treatment can vary depending on how the arrangement is structured. In some cases, the allowance is treated as income to the tenant, which then offsets the capitalized improvement costs. In others, the landlord retains the depreciable interest. The specific treatment depends on the terms of the lease and applicable tax rules, making it worth reviewing with a CPA.
Commercial Tenant Improvements Depreciation And Cost Segregation
Commercial tenant improvements depreciation is an area where cost segregation can add meaningful value, particularly for significant buildouts. Even though QIP improvements already qualify for a 15-year life, a cost segregation study can identify individual components within the improvement that qualify for even shorter recovery periods (5 or 7 years) based on their specific function.
Which Components Can Qualify For Even Shorter Lives
For example, within a commercial buildout, specialty electrical systems, dedicated plumbing, certain flooring systems, and removable fixtures may qualify for shorter Modified Accelerated Cost Recovery System (MACRS) lives rather than being grouped into the 15-year QIP bucket. Separating those components accelerates their depreciation further and can increase first-year deductions beyond what the standard QIP treatment provides.
Where To Learn More
For a deeper look at how depreciation schedules are structured and how to read the applicable IRS tables, our MACRS depreciation table article explains how recovery periods and annual rates work in practice. For commercial property owners evaluating cost segregation on tenant improvements and broader building components, our commercial cost segregation services post covers how the analysis is structured for specific commercial asset types.
How MVO Can Help
Overall, if you own or manage commercial real estate with significant tenant improvement histories, understanding how those costs are depreciated is one part of a broader depreciation strategy. Check out our services to see how MVO Cost Segregation approaches commercial engagements, including properties with complex improvement schedules.
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Final Thoughts
Leasehold improvements depreciation has evolved significantly over the past decade, and the shift to Qualified Improvement Property under current law has simplified some of the older rules while creating new planning opportunities. For commercial tenants and landlords alike, understanding how improvements are classified, who holds the depreciable interest, and whether cost segregation can identify shorter-lived components within those improvements is worth the conversation before filing season.
Frequently Asked Questions About Leasehold Improvements Depreciation
How are leasehold improvements depreciated?
Leasehold improvements are depreciated according to their tax classification rather than simply according to the length of the lease. Eligible improvements may qualify as QIP, while other components may be treated as longer-lived building property or separate asset categories.
What is the depreciation life for leasehold improvements?
Under current law, most interior improvements to nonresidential buildings qualify as Qualified Improvement Property and carry a 15-year depreciation life. They also qualify for bonus depreciation, which may allow the full cost to be deducted in the year the improvement is placed in service.
Are leasehold improvements the same as Qualified Improvement Property?
Not exactly. QIP is a broader category that replaced the old leasehold improvement category under the Tax Cuts and Jobs Act. Most tenant buildouts will qualify as QIP, but the two categories have different eligibility requirements. Your CPA can confirm how specific improvements should be classified.
Who depreciates leasehold improvements, the tenant or the landlord?
It depends on who paid for them. Tenants generally depreciate improvements they fund. Landlords depreciate improvements they pay for directly. Tenant improvement allowances involve additional considerations depending on how the arrangement is structured.
Can a cost segregation study help with leasehold improvements?
Yes. Even for improvements that already qualify as 15-year QIP, a cost segregation study can identify components within the buildout that qualify for 5- or 7-year treatment, further accelerating depreciation on those specific assets.
What happens to undepreciated leasehold improvements when a lease ends?
If a tenant has undepreciated improvement costs when a lease terminates, they may be able to claim a loss on the remaining basis, subject to applicable tax rules. The specific treatment depends on the circumstances and should be reviewed with a qualified tax advisor.