Leasehold improvements are the permanent alterations made to leased premises to fit them to the tenant’s use, the partition walls, wiring and fit-out that turn a shell into a working space. They are capitalized as a fixed asset of whoever owns the improvement rather than deducted as rent or as a repair, and the cost comes back through depreciation over later years instead of in the year it is paid. A taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property, including leasehold improvements (26 CFR 1.263(a)-2(d)(1)).
That default, and the two routes back off it, are worked through in opex versus capex and capitalised expenditure.
Who Owns the Improvement, and Who Paid for It
Ownership decides whose books the asset sits on. Who wrote the check does not.
A lessee must capitalize what it pays to improve a leased property, and it must also capitalize what the lessor pays to improve that property if the lessee is the owner of the improvement (26 CFR 1.263(a)-3(f)(2)(i)). A lessor must capitalize what it pays directly, or indirectly through a construction allowance to the lessee, when the lessor is the owner of the improvement, and must also capitalize what the lessee pays when the lessee’s improvement constitutes a substitute for rent (26 CFR 1.263(a)-3(f)(3)(i)). So a landlord-funded build-out can still be the tenant’s asset, and a tenant-funded one can still be the landlord’s.
One statutory carve-out sits inside that rule, and it is narrower than it looks. Gross income of a lessee does not include an amount received in cash, or treated as a rent reduction, from a lessor under a short-term lease of retail space for the purpose of constructing or improving qualified long-term real property, and then only up to what the lessee actually spent on the work (26 U.S.C. 110(a)). Short-term lease there means a lease of retail space for 15 years or less, and qualified long-term real property has to revert to the lessor at the termination of the lease (26 U.S.C. 110(c)). Property built with an allowance that clears those conditions is then treated as nonresidential real property of the lessor (26 U.S.C. 110(b)). An office or warehouse allowance does not reach it, because the space is not retail.
On the financial statements the allowance is treated differently again. Lease incentives include payments made to or on behalf of the lessee (FASB, Accounting Standards Update 2016-02, paragraph 842-10-55-30), and an incentive received reduces the tenant’s right-of-use asset rather than the improvement, which right-of-use asset sets out. The funding source moves the entries. It does not move the definition.
Where It Lands in a Firm’s Work
The improvement opens a line on the fixed asset register under its own category, one of the groups the capitalization regulation names and capital items examples lists.
On the depreciation schedule the period does not follow the lease. Capital expenditures made by either a lessee or lessor for the erection of a building or for other permanent improvements on leased property are recovered under the Code provisions applicable to the building or improvements, without regard to the period of the lease (26 CFR 1.167(a)-4(a)). The deduction is computed in the same manner as it would be for the underlying property had that property been placed in service at the same time as the improvement, and the recovery period begins on the later of the date the improvement is placed in service and the date the underlying property was (26 U.S.C. 168(i)(6)).
Interior work usually lands in one class. Qualified improvement property means an improvement made by the taxpayer to an interior portion of a building which is nonresidential real property, if the improvement is placed in service after the date the building was first placed in service (26 U.S.C. 168(e)(6)). The statute makes it 15-year property, so its applicable recovery period is 15 years, its method is straight line, and its convention is the half-year one unless the mid-quarter rule takes the year (26 U.S.C. 168(b)(3), (c), (d) and (e)(3)(E)(vii)).
Work outside that definition takes its own class rather than that one. An improvement to the building itself follows the building, at 39 years for nonresidential real property (26 U.S.C. 168(c)), while a component that qualifies on its own follows its own class, which is what a cost segregation study exists to establish. That work, and what the interior class excludes, are in commercial real estate accounting; the recovery mechanics themselves are in MACRS and straight line depreciation, and whether a first-year allowance reaches the class is in bonus depreciation.
At the book close the clock is different. Leasehold improvements are amortized over the shorter of the useful life of those improvements and the remaining lease term, unless the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise a purchase option, in which case they run to the end of their useful life (FASB, Accounting Standards Update 2016-02, paragraph 842-20-35-12). Improvements under a common control lease are the exception, and that one is covered in ASC 842 lease accounting.
A Worked Example
Say a tenant capitalizes interior fit-out that meets the qualified improvement property definition, on premises where the lease has fewer years left to run than the statutory recovery period.
Cost capitalized 180,000
Tax
Recovery period, in years 15
Full year deduction 180,000 / 15 = 12,000
First year, half-year convention = 6,000
Book
Remaining lease term, in years 8
Amortization each full year 180,000 / 8 = 22,500One asset, two annual charges, and neither schedule is wrong. The gap between them is a timing difference the income tax provision has to carry, not a disagreement to resolve.
What Leasehold Improvements Get Confused With
A repair. The general improvement tests, betterment, restoration and adaptation to a new or different use, are the same ones an owner applies (26 CFR 1.263(a)-3(d)), and they are worked through in opex versus capex. What is specific to leased space is the unit those tests are applied to. Paragraph (f) provides the exclusive rules for determining whether amounts paid are for an improvement to a leased property (26 CFR 1.263(a)-3(f)(1)), and for a tenant leasing part of a building the unit of property is the portion of the building subject to the lease and the structural components associated with that portion (26 CFR 1.263(a)-3(e)(2)(v)(A)). The tests run against the leased portion, not the whole building.
The leasehold interest itself. The lease conveys a right; the improvement is a separate asset built on the premises that right covers. The right has a tax character of its own, because a leasehold of land or of section 1250 property is intangible real property and accordingly is itself section 1250 property, while a fee simple interest in land is not depreciable and so is not (26 CFR 1.1250-1(e)(3)(i)). What that class does at a disposition is set out in section 1250 property.
The right-of-use asset. A leasehold improvement is an owned, capitalized asset of the tenant. The right-of-use asset is the right to use the space for the lease term, measured off the lease liability, and the two are recognized separately (right-of-use asset). Which side of the contract a firm is working on is set out in lessee vs lessor.
What Happens to the Unamortized Balance
On the books the balance is already tied to the lease term, so a term that shortens shortens the amortization period with it (FASB, Accounting Standards Update 2016-02, paragraph 842-20-35-12).
For tax the trigger is the asset leaving service rather than the lease ending. A disposition occurs when ownership of the asset is transferred or when the asset is permanently withdrawn from use, and it includes the sale, exchange, retirement, physical abandonment or destruction of an asset (26 CFR 1.168(i)-8(b)(2)). Where the landlord is the owner, an improvement made by the lessor for the lessee which is irrevocably disposed of or abandoned by the lessor at the termination of the lease is treated as disposed of by the lessor when so disposed of or abandoned (26 U.S.C. 168(i)(8)(B)).
A promise to take the work back out is a third thing again. An obligation imposed by the lease to return the underlying asset to its original condition, such as a requirement to remove a lessee-installed leasehold improvement, generally would not meet the definition of lease payments and is accounted for under Subtopic 410-20 (FASB, Accounting Standards Update 2016-02, paragraph 842-10-55-37), which asset retirement obligation covers.
Common Questions
Partition walls, interior doors, flooring, dropped ceilings, lighting, wiring runs, plumbing serving the tenant’s space and built-in shelving or counters. Work attributable to the enlargement of the building, to any elevator or escalator, or to the internal structural framework of the building sits outside the qualified improvement property class and is treated differently (26 U.S.C. 168(e)(6)(B)).
Either side, and the lease negotiation settles it. A landlord commonly funds part of the work through an improvement allowance, and a tenant commonly funds anything specific to how it operates. Who funds the work does not decide who capitalizes it, because the regulation keys on who owns the improvement (26 CFR 1.263(a)-3(f)).
Not in the year they are paid, as a general matter. The default is capitalization, with the cost recovered through depreciation over the applicable recovery period. The safe harbor for small taxpayers and the de minimis safe harbor election are the named exceptions to the leased-property improvement rules (26 CFR 1.263(a)-3(f)(1)), and their conditions sit in expenditure. If the improvement is abandoned, the remaining basis is handled as a disposition instead (26 CFR 1.168(i)-8(b)(2)).
A firm carrying lease schedules and fixed asset registers into busy season can put a real block of that work through Accountably’s team and grade it first, with a trial task.
