When reviewing commercial property leases, the term "leasehold improvements" often appears without much context or explanation. Many tenants and landlords alike would agree that the specifics of what constitutes leasehold improvements, who pays for them, and how they are treated financially remain unclear.
In this article, we will clearly define leasehold improvements, provide common examples, outline ownership and responsibilities between landlord and tenant, and detail the accounting treatment and tax implications in plain terms.
You will learn the key criteria that distinguish leasehold improvements from other tenant improvements, discover who typically pays for these enhancements, and review the capitalization, depreciation, amortization, and potential deductions related to leasehold improvements.
Introduction to Leasehold Improvements
A leasehold improvement refers to any additions or alterations made to a rental property by the tenant to suit their business needs. Common examples include installing walls, flooring, lighting, plumbing, or electrical wiring.
Tenants typically make leasehold improvements to customize the space for their operations. These improvements allow them to effectively use the property and conduct business activities.
Understanding Leasehold Improvements in Commercial Real Estate
In commercial real estate, leasehold improvements are commonly negotiated into lease agreements between tenants and building owners.
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For tenants, leasehold improvements allow customizing retail, office, or industrial spaces to meet specific business requirements. This enables optimal usage of the rented space.
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For building owners, allowing tenants to make leasehold improvements can demand higher rents and attract high-quality tenants. Owners may offer tenants an improvement allowance or agree to reimburse certain renovation costs.
Leasehold improvements permanently alter the property and often cannot be reversed if the tenant vacates. The lease agreement specifies what happens to improvements when the lease expires.
Leasehold Improvements Examples in Retail and Business
Common leasehold improvements in retail, restaurants, and other business sectors include:
- Retail: Display fixtures, racks, flooring, painting, lighting, signage
- Restaurants: Kitchen equipment, cabinetry, counters, flooring, bathroom remodeling
- Offices: Wall partitions, cabling, phone/internet systems, flooring, painting
- Industrial: Conveyor systems, racking, floor coating, lighting, drive-in doors
These examples illustrate how tenants customize spaces to enable their business activities, brand, and operations.
Accounting for Leasehold Improvements: Capitalization and Depreciation
Under GAAP accounting, if a leasehold improvement's useful life exceeds the lease term, its cost must be capitalized and depreciated over the shorter of its useful life or lease term.
- For example, a $50,000 renovation with a 10-year useful life but 5-year lease would be depreciated over 5 years.
Additionally, under the Tax Cuts and Jobs Act (TCJA), leasehold improvements are:
- Eligible for 100% bonus depreciation deductions
- Subject to reduced depreciation terms (15 years for qualified improvement property)
Properly accounting for capitalized costs and depreciation deductions allows reducing taxable income.
Tax Implications: Deductions and Amortization under the Tax Cuts and Jobs Act
The TCJA changed the tax treatment of leasehold improvements:
- 100% bonus depreciation allows immediately deducting the full cost
- Reduction to 15-year depreciation term if improvements made after December 31, 2017
- Classification as qualified improvement property (QIP) if improving interior of non-residential building after the date above
These changes allow faster recovery of costs through increased deductions. Amortizing improvements over 15 years rather than 39 years enables greater tax savings.
Consult a tax professional to utilize available deductions and optimize depreciation tax schedules.
What is a leasehold improvement example?
A leasehold improvement refers to any additions or alterations made to a rental property to customize it for a tenant. Here are some common examples:
- Installing walls or partitions to create additional rooms or divide up space
- Upgrading flooring by installing new carpeting, wood flooring, tile, etc.
- Painting or wallpapering to match the tenant's branding or aesthetic
- Installing specialized lighting fixtures like track lighting or accent lighting
- Upgrading bathrooms and kitchens with new sinks, cabinets, appliances, etc.
- Adding a security system, fire sprinklers, or HVAC system to meet the tenant's needs
- Building out a retail space with customized shelving, counters, dressing rooms, etc.
For retail tenants especially, leasehold improvements help transform generic retail shells into branded storefronts reflecting that tenant's image. A restaurant might upgrade ventilation, flooring, and lighting to suit their cuisine. An accountant might divide space into offices and install a server room.
The key is that leasehold improvements are specific to that tenant's needs and typically must be removed when their lease expires. The improvements often add real value for tenants in allowing ideal customization. But building owners retain control in requiring removal to prepare the space for future tenants.
What type of asset is a leasehold improvement?
Leasehold improvements are considered a type of fixed asset that is made to a leased commercial property in order to improve its functionality or appearance. Some examples of common leasehold improvements include:
- Installing new flooring
- Upgrading lighting fixtures
- Adding partitions to create new office spaces
- Renovating bathrooms
- Upgrading HVAC systems
- Painting/wallpaper
Leasehold improvements are a unique category of assets because although the business makes the capital expenditures and investments into the improvements, they do not own the actual property. This means that leasehold improvements must be handled differently for accounting and tax purposes.
Specifically, leasehold improvements are accounted for according to ASC 360 guidelines regarding property, plant and equipment. This means that:
- Leasehold improvements are capitalized on the balance sheet as a fixed asset
- They are depreciated over the shorter of the useful life of the asset or the remaining lease term
- Depreciation expense for the improvements is recorded on the income statement
If the lease expires and is not renewed, the remaining net book value of the leasehold improvements would then be written off as an expense.
So in summary, leasehold improvements are a unique type of fixed asset that businesses invest in to customize their rented commercial space, which must be properly capitalized and depreciated over time. Proper accounting treatment is important to ensure accurate financial reporting.
What is not a leasehold improvement?
Alterations to the exterior of a building or modifications that benefit other tenants in the building are not considered leasehold improvements.
Examples of non-leasehold improvements
- Elevator upgrades
- Roof construction
- Paving of walkways
These types of alterations generally benefit the overall building or other tenants, rather than being specific to the needs of an individual tenant.
Some other examples of non-leasehold improvements include:
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Landscaping - Improving the grounds around the building would benefit all tenants and visitors.
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Parking lot repairs - Fixing potholes or repaving the parking lot serves all tenants who use that parking area.
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Lobby renovations - Upgrading the lobby décor makes the building more attractive but does not directly improve an individual tenant's space.
In summary, leasehold improvements must be specific to a tenant's leased space to qualify. Anything that benefits the building overall or other tenants would not count. The key determining factor is whether the alteration or upgrade is integral to the tenant's particular business operations within their designated rental area.
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What is considered a qualified leasehold improvement?
According to the IRS, qualified leasehold improvements include renovations or alterations made to the interior of a building by either the landlord or the tenant. However, there are some exceptions:
What Qualifies
Some examples of qualified leasehold improvements include:
- Installation or upgrades of walls, floors, ceilings
- Lighting, plumbing, HVAC systems
- Retail store remodeling like display counters, walls, floors
Essentially, any non-structural upgrade made to the building's interior can potentially qualify.
What Does NOT Qualify
However, the following do not qualify as leasehold improvements according to the IRS:
- Any enlargement or expansion that increases the total square footage of the building itself
- Elevators, escalators, and other structural reinforcements
- Facilities related to internal structural framework of the building
So expansions like adding a new wing or floor to the building would not qualify. But upgrades made within the existing interior spaces can qualify.
How Are Leasehold Improvements Treated?
For tax purposes, qualified leasehold improvements made after December 31, 2017 are:
- Eligible for bonus depreciation deductions
- Subject to a 15-year depreciation period instead of 39 years
This makes it very advantageous for tenants or landlords to classify any interior upgrades as leasehold improvements for better tax treatment.
Qualifying Criteria for Leasehold Improvements
For alterations to a rented building to qualify as leasehold improvements, they must meet certain criteria set by accounting standards and the IRS Tax Code.
Distinguishing Leasehold Improvements from Tenant Improvements
Leasehold improvements are alterations made to a rented property in order to adapt the space for the lessee's use. Tenant improvements are a broader category that includes any construction or upgrades done to prepare the space for occupancy.
The key differences between leasehold improvements and tenant improvements are:
- Ownership: Leasehold improvements are owned by the lessor, while tenant improvements may be owned by the tenant or lessor depending on the lease terms.
- Useful life: Leasehold improvements must have a useful life that does not extend substantially beyond the lease term to be capitalized. Tenant improvements do not have this constraint.
- Removability: Tenant improvements are often removable at the end of the lease, while leasehold improvements generally cannot be removed without substantial damage.
So in summary, all leasehold improvements are tenant improvements, but not all tenant improvements qualify as leasehold improvements for accounting and tax purposes.
Building Improvements Vs. Leasehold Improvements: Understanding the Difference
There is an important distinction between improvements made to the actual building structure owned by the lessor, and improvements made specifically to adapt the rented space for the lessee's use:
- Building improvements upgrade the building itself, like replacing the roof, renovating common areas, or upgrading HVAC systems. These are permanent improvements that benefit the building over the long term.
- Leasehold improvements adapt the tenant's rented space for their specific business needs, like installing partitions, flooring, plumbing, or electrical wiring. These have a shorter useful life tied to the tenant's occupancy.
Building improvements are capitalized by the lessor, while leasehold improvements may be capitalized by the lessee if they meet certain criteria. A key factor is the improvement's useful life in relation to the lease term.
Assessing the Useful Life of Leasehold Improvements
For alterations to qualify as leasehold improvements, they must have a useful life that does not extend substantially beyond the lease term according to ASC 840-10-25-11. Specifically:
- If the lease term including renewals is 10 years or less, alterations with a useful life of 10 years or less can be capitalized as leasehold improvements.
- If the lease term including renewals is over 10 years, alterations with a useful life that does not exceed 75% of the lease term can be capitalized.
The reason for this useful life constraint is that leasehold improvements essentially have no value to the lessee beyond their occupancy since the assets revert to the lessor. Accurately assessing useful life is critical for calculating depreciation deductions.
Leasehold Improvements Paid by Tenant: Ownership and Expense Recognition
Sometimes the tenant bears the costs of alterations rather than the building owner. In this case:
- The lessor is still considered the legal owner of the leasehold improvements.
- The lessee can capitalize the costs on their balance sheet provided the useful life criteria is met.
- The lessee then depreciates the costs over the improvement's useful life and deducts this on their tax return.
- At the end of the lease, the improvements revert to the lessor at no cost.
If the improvements don't meet the capitalization criteria, the lessee cannot depreciate the costs but can deduct the entire expenditure as a rental expense in the year it was incurred.
So in summary, even though the tenant paid for the leasehold improvements, they still belong to the lessor from an accounting perspective. But the lessee does gain tax advantages from capitalizing and depreciating qualifying improvements over time.
Ownership and Responsibilities
Lease contracts typically specify who owns any leasehold improvements made, who is responsible for installation costs, and who must pay any removal or restoration fees when the lease expires.
Negotiating Lease Terms: Who Pays for Leasehold Improvements?
When negotiating a commercial property lease, tenants and landlords should discuss:
- Who will pay for any leasehold improvements or renovations needed to customize the space for the tenant's business
- Whether the landlord will offer a tenant improvement allowance or reimbursement to offset some renovation costs
- If the tenant pays, whether the landlord will amortize some costs into the rent over the lease term
Clearly documenting these agreed-upon terms in the final lease agreement reduces confusion down the road. Landlords may be more willing to invest if improvements increase the property's long-term value.
Tenant's Financial Responsibilities for Leasehold Improvements
Typically, tenants pay upfront to install their custom leasehold improvements like flooring, walls, lighting, or shelving. Other potential costs for tenants include:
- Permits or fees for construction, inspections, or remodeling
- Professional services like architects or contractors
- Removal and restoration fees when the lease expires
However, landlords sometimes offer a predetermined tenant improvement allowance, capped reimbursement, or rent amortization to offset major expenses.
What Happens to Leasehold Improvements When Lease Expires?
There are several potential outcomes for leasehold improvements when the lease ends:
- Removal: Tenants take fixtures with them and restore the space
- Abandonment: Improvements left behind become the landlord's property
- Transfer: Tenant sells improvements to the incoming tenant
- Further negotiation: Extensions allow tenants to utilize improvements longer
Lease agreements generally specify these terms about existing leasehold improvements to reduce uncertainty.
Leasehold Improvements Depreciation: Accounting for the End of the Lease
For tax and accounting purposes, leasehold improvements must be depreciated over the shorter of the useful life or the remaining lease term. This matches expenses to the business' ability to generate income from the assets.
So when a lease ends, the tenant's depreciation schedule impacts their net income and tax liability. Any improvements not yet fully depreciated must be accounted for as a loss or further expense. Proper planning helps avoid negative financial surprises.
Accounting Treatment of Leasehold Improvements
Leasehold improvements are additions and alterations made to rented commercial property in order to configure the space for the tenant's business operations. There are specific accounting guidelines under Generally Accepted Accounting Principles (GAAP) that dictate how businesses should treat leasehold improvement costs on their financial statements.
Leasehold Improvements Capitalization: The Initial Accounting Step
When a business invests in leasehold improvements for a rented commercial space, the costs associated with the improvements must be capitalized on the balance sheet rather than expensed on the income statement. This means the costs are recorded as a fixed asset and not immediately deducted as a business expense. The leasehold improvements are capitalized because they have future value that extends beyond the current accounting period.
There are specific criteria that must be met for leasehold improvement costs to qualify for capitalization:
- The improvements must be permanent in nature (not temporary fixtures or fittings)
- They must add demonstrable value enhancement to the commercial property
- The useful life of the improvements must extend past the current accounting period
If these criteria are met, the leasehold improvement costs can be capitalized on the balance sheet and then systematically depreciated or amortized over time as a fixed asset.
Depreciation of Leasehold Improvements: Methodologies and Schedules
For the capitalized leasehold improvements asset on the balance sheet, an annual depreciation expense must be recorded on the income statement. This systematically allocates the costs over the estimated useful lifespan of the improvements.
There are two main methods for depreciating leasehold improvements:
Straight-line depreciation: With this simple method, the cost of the improvements is divided by its useful life to calculate a fixed annual depreciation expense. For example, if leasehold improvements cost $100,000 and have a 10-year lifespan, the annual straight-line depreciation would be $10,000 ($100,000/10 years).
Accelerated depreciation: This method records higher depreciation expenses in the earlier years of an asset's lifespan, assuming greater usefulness and value from the improvements in the beginning. Accelerated methods include double-declining balance and sum-of-years digits.
In addition to depreciation methodology, businesses must also determine an appropriate depreciation schedule for leasehold improvements based on factors like:
- Useful lifespan estimates
- Lease contract terms
- Renewal options
- Removal requirements
For example, a 5-year lease term would warrant a shorter depreciation schedule than a 10 or 20-year lease.
Leasehold Improvement Amortization: Spreading Costs Over Time
In accounting, amortization is the process of allocating costs associated with intangible assets over a specific time period. This applies to certain aspects of leasehold improvements such as permits, licenses, fees, architectural designs, and other expenditures related to the configuration of the rented space itself (as opposed to physical fixtures and fittings).
The costs associated with these intangible components of leasehold improvements may be amortized over the life of the lease, rather than depreciated over the lifespan of the physical improvements. Amortization allows these costs to be incrementally expensed on the income statement in line with the business benefits expected from the enhancements over the lease term.
How to Account for Leasehold Improvements: A Step-by-Step Guide
Here is a summary of the key steps businesses should follow to properly account for leasehold improvements:
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Identify costs - Compile all expenditures related to alterations of the rented commercial space. Segregate between tangible and intangible costs.
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Capitalize - Record the total leasehold improvement costs on the balance sheet as a fixed asset.
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Classify improvements - Categorize between tangible assets subject to depreciation and intangible assets subject to amortization.
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Establish useful life - Estimate or align with the useful lifespan of improvements or lease contract term.
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Calculate depreciation/amortization - Determine appropriate methodology (straight-line or accelerated) and schedule.
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Record depreciation/amortization - Systematically expense costs on the income statement over useful life of leasehold improvements.
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Review and adjust - Re-evaluate useful lifespan estimates and depreciation/amortization approach periodically and make adjustments.
Properly accounting for leasehold improvements requires understanding the unique categorization, capitalization, depreciation, and amortization treatments under GAAP. Businesses should follow best practices to accurately reflect these assets on their financial statements.
Conclusion: Key Takeaways on Leasehold Improvements
Leasehold improvements are an important consideration for businesses operating in leased commercial spaces. As summarized in this article, key takeaways include:
Review of Leasehold Improvements and Commercial Property Enhancements
- Leasehold improvements are alterations and additions made by a tenant to a leased commercial property in order to customize or improve the space for their business operations and needs.
- Common examples include renovations like demolition/construction, HVAC, electrical systems, flooring, walls, lighting, plumbing, built-in cabinetry, etc.
- These improvements become part of the real property and often revert to the landlord at lease expiration, so accounting treatment and tax implications are important to understand upfront.
Final Thoughts on Accounting and Depreciation Practices
- Businesses should follow GAAP standards to capitalize qualifying leasehold improvements and amortize them over the shorter of useful life or lease term.
- Under the Tax Cuts and Jobs Act, leasehold improvements now have a 15-year cost recovery period, allowing for greater tax deduction benefits.
- Careful record keeping and negotiations with landlords can optimize depreciation deductions and cost reimbursements for tenants.
Navigating Lease Agreements and Tenant Improvements
- Clearly outline responsibilities for improvement costs and ownership rights in the lease agreement upfront between landlord and tenant.
- Understand depreciation impacts when negotiating tenant improvement allowances.
- Consult tax and accounting advisors to ensure proper treatment per latest regulations.
Future Considerations for Leasehold Improvements and Tax Legislation
- Tax policies related to asset capitalization and depreciation are complex areas that see occasional updates and changes.
- Businesses should monitor new tax legislation proposals that could impact leasehold improvement deductions going forward.
