What Is a Leasehold Improvement?
Leasehold improvements are any changes made to a rental property in order to customize it for the particular needs of a tenant. These can include alterations such as painting, installing partitions, changing the flooring, or putting in customized light fixtures. Leasehold improvements can be undertaken either by the landlord—who may offer to do so to increase the marketability of their rental unit—or by the tenants themselves.
While the useful economic life of most leasehold improvements is five-to-10 years, the Internal Revenue Code requires that depreciation for such improvements to occur over the economic life of the building.
How Leasehold Improvements Work
Leasehold improvements are also known as tenant improvements or build-outs and are generally made by landlords of commercial properties. Landlords may provide these improvements for existing or new tenants. The modifications are tailored to suit the needs of a specific tenant and their needs.
What are leasehold improvements depends on the application of changes to a structure owned by a landlord in order to accommodate a tenant. Making changes to one tenant's space, however, does not qualify as a leasehold improvement to any of those tenant's neighbors. Changes to the exterior of a building or its landscape also don't apply. If a landlord replaces the roof of the building, upgrades the elevator, or paves the parking lot—none of these changes are considered leasehold improvements, as they don't benefit a specific tenant.
Only improvements made to the interior of a specific tenant's space are considered leasehold improvements.
Once the lease ends, the improvements generally belong to the landlord, unless otherwise specified in the agreement. If the tenant is able to take them, they must remove them without any damage to the property.
Leasehold Improvements Examples
Landlords may pay for leasehold improvements to encourage tenants to rent spaces for longer periods of time, especially in the retail industry. For example, a business owner leases a building for their disc golf shop. The landlord may choose to add four walls to the leased area to create built-in displays and storage areas for the discs. These alterations are considered leasehold improvements.
Let's take another example from the retail sector. The owner of Store A decides to lease space through Company B. The store only has four walls and no other amenities. Through the lease negotiation, Company B—the landlord—agrees to install shelving, a service counter for cash registers, and a display unit with special lighting before Store A opens its doors.
- A leasehold improvement is a change made to a rental property to customize it for the particular needs of a tenant.
- Landlords may agree with these improvements for existing or new tenants.
- Leasehold improvements may be done by the landlord or tenant.
- Painting, installing partitions or customized light fixtures, and changing flooring are all leasehold improvements.
- Enlargements to buildings, elevators and escalators, roofs, fire protection, alarm and security systems, and HVAC systems do not qualify as leasehold improvements.
Types of Leasehold Improvements
A landlord may pay for commercial leasehold improvements through a tenant improvement allowance (TIA). In this case, the landlord allows a set budget for improvements, typically $5 to $15 per square foot, and oversees the project. Meanwhile, the tenant controls the renovation process, which may be time-consuming. If project budgets are exceeded, the tenant covers the balance.
Rent discounts may be offered for leasehold improvements as well. The landlord offers the tenant free or reduced rent for a set number of months, such as one free month per year on the lease, as a means for the tenant to save on space alterations. The tenant typically oversees the project and has control over the lease improvements. The tenant is also responsible if costs exceed the budgeted amounts. In addition, rent may be raised at a later date, causing the tenant to pay more for the space long term.
Another type of leasehold improvement is a building standard allowance. The tenant may decide among various selections the landlord provides, such as one of four colors of paint. These items may not meet the tenant’s needs, and he may not be satisfied with the results. Additional improvements are covered by the tenant. The landlord oversees the project.
Leasehold Improvements Rules
Changes have been made to the way landlords and tenants can claim deductions following the new Tax Cuts and Jobs Act in 2017.
In December 2015, the United States Congress passed the Protecting Americans from Tax Hikes (PATH) Act, which modified and extended many tax provisions related to depreciation, including leasehold improvements. The act made permanent a tax-savings provision that allows for 15-year straight-line cost recovery on qualified leasehold improvements.
Under those guidelines, landlords and tenants were not allowed to be related, improvements only qualified if they were made to the interior of the building with only that tenant occupying the space, and leasehold improvements were required to be completed after three years of the building first being occupied for service.
The new tax act in 2017 modified some of the requirements. Improvements must still be made to the interior of the building, which means enlargements to buildings, elevators and escalators, roofs, fire protection, alarm, and security systems, and HVAC systems still don't qualify. The qualified improvement property no longer requires both parties—landlord and tenant—to be unrelated. It also got rid of the three-year requirement, stating that all improvements may be made "after the date when the property was first placed in service," according to the Internal Revenue Service (IRS).
Claiming Leasehold Improvements
The Internal Revenue Service (IRS) does not allow deductions for improvements. But because improvements are considered part of the building, they are prone to depreciation. The IRS allows for depreciation deductions, as long as the conditions noted above are satisfied. Whoever does the work is allowed to make the depreciation deduction—whether it's the landlord or the tenant. The new tax act increased the maximum amount allowed to $1 million from $500,000.