In order to lease their buildings, real estate companies make improvements to those buildings — either handling the modifications themselves, or allowing tenants to make improvements to the leased space. But who pays for these tenant improvements — and who owns them — not only affects the lease rates negotiated but also can have significant tax implications for both parties.
What are leasehold improvements, and how are they treated?
Tenant or leasehold improvements refer to improvements made to property owned by a landlord to attract tenants and allow them to lease space suitable for an intended use. The options for — and tax implications of — constructing and paying for leasehold improvements vary. Improvements may be made under the supervision of either the landlord or the tenant, paid for by either the landlord or the tenant, and owned by either party.
These facts, as well as whether the lease meets the requirements to be considered an IRC Section 110 short-term lease of retail space, will determine the income tax treatment of these tenant improvements.
Nonresidential real property is depreciated using the straight line method over 39 years. However, tenant improvements placed in service on or after January 1, 2018 that meet certain qualifications are classified as “qualified improvement property” (QIP). When the CARES act was signed into law in March 2020, it provided a retroactive correction to the Tax Cuts and Jobs Act error related to QIP. As a result, under current law qualified improvement property is assigned a 15-year life and is eligible for bonus depreciation. The phase-out of bonus depreciation for QIP has started in 2023 with a reduction to 80% bonus depreciation and a continued reduction of 20% each year resulting in a full phase-out by 2027.
In addition, if these improvements meet the requirements to be “qualified real property” under IRC Section 179, and the other requirements of Section 179 are met, they may be eligible to be immediately expensed.
Who should make improvements — landlord or tenant?
Tax considerations for leasehold improvements primarily focus on which party pays for the improvements and which party retains ownership them. Generally, the party who pays for and owns the improvements may take the depreciation deductions. But determining ownership isn't always obvious and depends on factors such as who retains the benefits and burdens of ownership, not only on who has legal title to the improvements.
Consequently, the parties to the lease should consider including a provision in the lease agreement to document their intent as to who retains ownership of improvements during the lease term. The options are as follows:
- When landlords construct and pay for improvements, they own and depreciate the improvements, and there are no tax consequences to the tenant. This is often the simplest solution when the improvements are likely to be used by future tenants once the current tenant vacates the leased space.
- Many leasehold improvements are tenant-specific and will be disposed of or abandoned when the tenant’s lease terminates. In cases like this, landlords are entitled to deduct the remaining tax basis in capitalized leasehold improvements made for a particular tenant upon termination of the lease if such improvements are irrevocably disposed of or abandoned and won’t be used by a subsequent tenant.
- If a landlord constructs and owns the improvements and is reimbursed by the tenant as a substitute for rent under the lease, then the landlord must recognize rental income for the amount of the reimbursement and depreciate the improvements as its own assets. The tenant may amortize the cash payment to the landlord over the life of the lease because it's a substitute for rent due under the lease. The same result occurs if the tenant makes and pays for the improvements if treated under the lease arrangement as a substitution for rent. But this is generally a poor tax situation for the landlord because rental income is recognized immediately, while the depreciation of the improvements is spread over many years.
- Conversely, if the tenant makes and owns the improvements it will use, isn’t reimbursed by the landlord, and the lease and other evidence doesn’t show the parties intended this as a substitute for rent, then the landlord has no taxable income. The tenant is treated as the owner of these improvements and may depreciate them. Upon the termination of the lease, the tenant may claim an abandonment loss for the remaining tax basis in these improvements if they’re left behind after the tenant vacates the space.
- If the landlord provides a cash allowance to the tenant for the tenant to construct improvements it will own and use, this cash payment will constitute immediately taxable income to the tenant. To the extent the tenant uses this improvement allowance to construct its improvements in its lease space, the tenant may depreciate these assets. The cash allowance for tenant improvements would be treated as a lease acquisition cost to the landlord, who would amortize this cost, along with other lease acquisition costs, ratably over the term of the lease.
- There’s a statutory exclusion to the rules discussed immediately above for cash payments made to, or rent reductions received by, a tenant if this rental arrangement meets the provisions to be considered an IRC Section 110 short-term lease (15 years or less) of retail space. If the Section 110 requirements are met, there’s no income recognized by the tenant to the extent the allowance is used to construct improvements, since these improvements will revert to the landlord when the lease terminates. In this case, for depreciation purposes, the landlord must treat these improvements as nonresidential real property.
Structuring lease transactions properly can produce significant tax savings, and landlords and tenants alike should carefully consider the options that best align with their respective tax positions and goals.
