how leasehold improvements work
leasehold improvements are commonly referred to as tenant improvements or build outs these changes are generally made by landlords of commercial properties and may be provided for an existing or new tenant any changes are tailored to the specific needs of a tenant and make the space more attractive and appealing to them once the lease ends the improvements generally belong to the landlord unless otherwise specified in the agreement if the tenant can take them they must remove them without any damage to the property 1certain criteria must be met for changes to qualify as leasehold improvements changes must be made to the interior to accommodate the specific needs of the tenant including any of the following not all changes are considered leasehold improvements modifications made for one tenant don t qualify for other tenants including their neighbors exterior building renovations such as landscaping parking lot repairs or roofing don t qualify either even interior alterations like upgrades made to a building s elevator or hvac systems aren t considered leasehold improvements that s because they don t benefit a specific tenant 1leasehold improvements are considered qualified improvement property for tax purposes along with building improvements qualified restaurant property and qualified retail improvements under the tax cuts and jobs act tcja of 2017 2special considerationsleasehold improvements are meant to customize and change rental properties landlords do so to meet the needs of the lessors but how do building owners treat the depreciation of these improvements it depends entirely on the accounting method owners can depreciate leasehold improvements over 15 years under the internal revenue code irc under certain conditions these include making improvements things are a little different according to generally accepted accounting principles gaap under gaap leasehold improvements are amortized over the shorter of the useful life of those leasehold improvements and the remaining lease term 4types of leasehold improvementsthis type of leasehold improvement gives the tenant authority to oversee the project taking the burden off the landlord especially if the process is time consuming the landlord normally puts provisions in place in the lease that cover the budget of the tenant allowance improvement this is usually listed as a lump sum or on a per square foot basis landlords may either pay the renovation construction company directly or reimburse the tenant directly if project budgets are exceeded the tenant covers the balance 5the landlord may offer the tenant rent discounts for leasehold improvements if this option is included in the lease the tenant may get rent relief of some type such as one free month or reduced rent for certain periods per year tenants can use this to save on space alterations just like with the tia the tenant oversees the project and controls the lease improvements the tenant is also responsible if costs exceed the budget 6this option is also called a build out in this case the landlord presents an improvement package or other options to the tenant the landlord is typically the one who manages the project allowing the tenant more time to devote to their business in most cases tenants may not end up with the modifications they actually want to help their business grow if they do choose to add on to the changes they must cover the additional cost 6this type of leasehold improvement is normally undertaken at the beginning of the lease in most cases cost estimates and plans are submitted by the tenant while the landlord is the one who supervises and pays for all of the work 6leasehold improvements rulesin december 2015 the u s congress passed the protecting americans from tax hikes path act which modified and extended many tax provisions related to depreciation including leasehold improvements the bill made permanent a tax savings provision that allowed for 15 year straight line cost recovery on qualified leasehold improvements under those guidelines the passing of the tcja in 2017 changed the way landlords and tenants can claim deductions involving leasehold improvements the new law 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 8the qualified improvement property no longer requires both parties landlords and tenants to be unrelated it also eliminated 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 2the coronavirus aid relief and economic security cares act made some tweaks to qualified improvement property when it was passed in 2020 the act put a 15 year recovery period for qip and allowed filers to claim first year depreciation for any qip 910most lenders won t allow repayment terms beyond the life of the lease if financing is required to pay for any leasehold improvements accounting for leasehold improvementsthe 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 these conditions are satisfied whoever does the work is allowed to take the depreciation deduction whether that s the landlord or the tenant the tcja increased the maximum amount allowed to 1 million from 500 000 2accounting experts suggest expensing any improvements made that amount to less than the company s capitalization limit during the same period if they exceed this amount the total should be capitalized and amortized over the term of the lease or over the shorter period of the life of the improvements 11leasehold improvement vs building improvementwhile they may effectively be building improvements leasehold improvements are distinctly different that s because they only really make an impact on the space for a specific tenant building improvements on the other hand benefit everyone in the property and generally change the overall structure of the building itself 12examples of building improvements include putting up a new roof paving a driveway and or parking lot adding a parking lot renovating the lobby adding a new or repairing an existing elevator and updating the hvac system as such building improvements help extend the overall life of the structure 12examples of a leasehold improvementlandlords 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 