Leasehold improvements, commonly referred to as tenant improvements, are structural modifications or permanent fixtures placed in the interior of a rented space. Examples include changes made to ceilings, flooring, and interior walls. Alterations to the exterior of the building or modifications that benefit other tenants, such as new roof, upgraded elevators, and repaved walkways, are not leasehold improvements.
Generally, leasehold improvements are capitalized and depreciated over the life of the asset as determined by Revenue Procedure 87-56. Because most leasehold improvements become part of the building, they are depreciated using the straight-line method over 39 years. An exception exists for “qualified leasehold improvements”. Qualified leasehold improvements (“QLI”) are depreciated using the straight-line method over 15 years. In addition, qualified leasehold improvements placed in service after 2015 may be eligible for bonus depreciation and §179 deduction. For an improvement to be a qualified leasehold improvement, the following requirements must be met:
- The improvement has to be made to the interior of the building;
- The landlord and tenant must not be related;
- The improvement must not impact any other tenants, including any common areas; and
- The improvement is placed into service more than three years after the date that the building was first placed into service.
For assets placed in service on or after January 1, 2016 the category of bonus depreciation for qualified leasehold improvements is replaced with “qualified improvement property”. Qualified Improvement Property (“QIP”) is defined similarly to QLI except that QIP does not need to be placed in service pursuant to the terms of the lease or more than three years after the improved building was placed in service by any person. Lastly, QIP may include assets that are structural components that benefit an internal common area.
In general, there are three main options for structuring leasehold improvements. The landlord can pay, the tenant can pay, or the landlord can offer an improvement allowance. Each of these options has different tax benefits and detriments.
Landlord Pays
If the landlord pays for the improvements, they will capitalize and depreciate the improvements per the discussion above (straight-line 39 years; straight-line 15 years with possibility for bonus and §179 deductions if QLI or QIP).
Landlords that dispose or abandon leasehold improvements upon termination of a lease after June 12, 1996, may take the adjusted basis of the improvement into account for purposes of determining gain or loss on disposal. Prior to June 13, 1996, landlords were required to continue to depreciate leasehold improvements in the same manner as the underlying real property, even if the improvements were retired at the end of the lease term.
Tenant Pays
If the tenant pays for the improvement, they will capitalize the improvement and depreciate the improvement per the discussion above (straight-line 39 years; straight-line 15 years with possibility for bonus and §179 deductions if QLI or QIP).
Upon termination of the lease, any unrecovered basis in the leasehold improvement may be deducted as a loss if the improvement is not retained by the tenant. If the lessee is paid to terminate the lease and forfeits the improvements, the unrecovered basis is used to reduce the gain associated with the termination payments.
Improvement Allowance
The landlord can offer the tenant an improvement allowance. Section 110(a) protects the tenant from income recognition if the following requirements are met:
- The tenant is under a short term lease (15 years or less); and
- The amount received is for the purpose of constructing or improving qualified long-term real property for use in the tenant’s trade or business.
When Section 110(a) does apply the allowance is not income to the lessee and the lessee does not own the property. The landlord would capitalize the improvement and depreciate it for 39 years or 15 if the improvement meets the qualified leasehold improvement or qualified improvement property definition.
In the case that Section 110(a) does not apply the allowance would be considered a cost to acquire the lease and the landlord would amortize the cost over the life of the lease. The allowance is taken into income by the tenant and the improvement is capitalized by the tenant and depreciated as applicable.
For more information on leasehold improvements and how they can affect your business, contact a member of our Real estate Team.