Tax Treatment of Leasehold Improvements

Leasehold improvements are enhancements made to rental properties to fit a specific need of a tenant. These enhancements, such as interior walls, carpeting, built-in cabinetry and plumbing additions, can be paid by the tenant or landlord. Previously, these leasehold improvements would depreciate over the tax life of the building (39 years for a nonresidential building). However, in March 2020, the CARES Act was signed which allowed for 100% bonus depreciation for Qualified Improvement Property (QIP) placed in service between the years 2018 and 2022.

What are Landlord and Tenant Options?

The way a lease agreement is structured can produce significant tax savings. In the agreement, there should be a provision on whether the landlord or the tenant is responsible to pay for improvements, as well as which party retains ownership of them. Depending on how an improvement is paid for determines who receives the deduction and tax benefit. Landlords and tenants both have options on how to handle who should make improvements.

If the landlord decides to:

Pay for the improvements, there is no tax impact on the tenant. The landlord depreciates the improvements over the applicable depreciable life and is the owner of the improvements. If the leased space will be used by future tenants, this is the most straightforward solution.
Provide an allowance to the tenant, the landlord will amortize the allowance over the life of the lease with the lease term being shorter than the depreciable life of the improvements. The costs will depreciate over the applicable depreciable life as well. This means the tenant is the owner of the improvements, reports the allowance as taxable income and can write off any remaining basis upon lease termination.
Reduce rent for the cost of the improvements paid by the tenant, then the tenant is the owner of the improvements and cannot deduct the cost of rent that is not paid to the landlord. The tenant can also write off any remaining basis upon lease termination along with deprecating the improvements over the applicable depreciable life. The landlord would benefit through a reduction of taxable rental income and a depreciable asset for the reduced rents. If the lease agreement states that rent is being reduced in consideration of the tenant’s spending on improvements.
Loan the tenant money to pay for improvements, the landlord must report any interest income from the loan. The tenant would deduct any interest paid to the landlord on the loan, is the owner of the improvements, depreciates the improvements over the applicable depreciable life and can write off any remaining basis upon lease termination.

If improvements paid by the landlord are tenant specific and cannot be changed or used for future tenants, landlords are entitled to deduct the remaining tax basis in capitalized leasehold improvements made by tenant upon lease termination.

If the tenant decides to:

Pay for the improvements, there is no tax impact to the landlord and the tenant depreciates the improvements over the applicable depreciable life. The tenant can write off any remaining basis in the improvements upon lease termination.
Pay for improvements and transfers ownership to landlord at completion, they amortize the improvement costs over the life of the lease. Upon transfer of ownership, the landlord depreciates the improvements over the applicable depreciable life and the costs of the improvements become taxable income.

Landlords and tenants should have a full understanding on the terms of their lease agreement on paying for leasehold improvements due to the implications it can have on each of their tax situations. If you have any questions on leasehold improvements, contact your BSSF tax advisor today!