Do Leasehold Improvements Qualify for Bonus Depreciation?

Improvements made by a tenant to a rented property, called leasehold improvements, can qualify for a tax deduction known as bonus depreciation. This allows a business to deduct a large portion of an asset’s cost in the year it is placed in service rather than spreading the deduction over many years. Recent changes in tax law have shifted the rules governing the depreciation of improvements to leased business spaces. Navigating these rules is important for any tenant making significant investments to customize their commercial space for their operational needs.

Defining Qualified Improvement Property

The Internal Revenue Code provides a classification for most interior upgrades to commercial buildings called Qualified Improvement Property (QIP). For an expenditure to be considered QIP, it must be an improvement made by the taxpayer to the inside of a nonresidential building that has already been placed in service.

This definition covers a range of projects undertaken by tenants. For example, installing new interior walls to create offices, updating internal plumbing or electrical systems, and replacing flooring fall under the QIP umbrella. The improvements must be made by the taxpayer, meaning a business cannot purchase a building with existing improvements and classify them as QIP.

Exclusions from Qualified Improvement Property

The definition of Qualified Improvement Property also specifically excludes certain types of work. Any improvement that results in the enlargement of the building, such as expanding the total square footage, does not qualify.

Additionally, the installation of any new elevator or escalator is not considered QIP. Improvements to the internal structural framework of the building are also excluded. This final exclusion prevents taxpayers from classifying major structural renovations, such as replacing internal support columns or load-bearing walls, as QIP, and these expenditures are subject to different, longer depreciation schedules.

Bonus Depreciation Eligibility for Leasehold Improvements

Bonus depreciation allows businesses to immediately deduct a percentage of the cost of eligible assets. This tax provision applies to business property with a recovery period, or tax life, of 20 years or less. For leasehold improvements to qualify, they must fit into a property class with such a recovery period.

The Tax Cuts and Jobs Act of 2017 (TCJA) intended to assign QIP a 15-year recovery period, making it eligible for bonus depreciation. However, a drafting error in the legislation, often called the “retail glitch,” defaulted QIP to the standard 39-year recovery period, making it ineligible.

This was corrected retroactively by the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The CARES Act assigned QIP the intended 15-year recovery period for any property placed in service after December 31, 2017. This correction officially makes QIP eligible for bonus depreciation, and as a result, businesses can now deduct the full cost of qualifying interior improvements in the year they are completed and put to use.

The 100% bonus depreciation rate was temporary and is being phased down. For property placed in service in 2025, the rate is 40%. This rate will decrease to 20% in 2026 before being eliminated for most property in 2027.

Considering the Section 179 Deduction

Businesses have another option for deducting costs associated with QIP: the Section 179 deduction. This provision also allows for the immediate expensing of the cost of qualifying property in the year it is placed in service. Both Section 179 and bonus depreciation can apply to QIP, but they operate under different rules.

The primary differences are the annual limitations. The Section 179 deduction is subject to an annual dollar limit on the total amount that can be expensed. For 2025, the maximum deduction is $1,250,000, and this begins to phase out if the total cost of property placed in service during the year exceeds $3,130,000. The deduction is also limited by the taxpayer’s business taxable income and cannot be used to create a net operating loss.

In contrast, bonus depreciation has no annual investment limit and is not capped by taxable income. A business can claim bonus depreciation on any amount of qualifying property, and it can be used to generate a business loss, which could then be used to offset other income or be carried forward to future tax years. A business might elect out of bonus depreciation and use Section 179 if state tax law does not conform to the federal bonus depreciation rules.

How to Claim Depreciation on Tax Returns

Claiming these deductions is handled on IRS Form 4562, Depreciation and Amortization, which is filed with the business’s annual income tax return. Taxpayers use this form to report QIP and elect to take either the Section 179 deduction or bonus depreciation.

For businesses that placed QIP in service during 2018 or later but depreciated it over 39 years due to the TCJA’s drafting error, there are methods to correct the treatment. One option is to file an amended tax return for the year the property was placed in service to claim the missed bonus depreciation. This can result in a tax refund.

An alternative to amending a return is to file Form 3115, Application for Change in Accounting Method. This form allows a taxpayer to make a “catch-up” adjustment on their current year’s tax return to account for the depreciation that was not claimed in prior years.