Leasehold Improvements: Types, Accounting, and Tax Implications

Leasehold improvements are essential for customizing leased spaces to meet business needs, impacting both financial statements and tax obligations. Businesses must understand these modifications as they influence accounting practices and tax strategies.

Types of Leasehold Improvements

Leasehold improvements involve modifications tenants make to leased properties to suit their operations. These can range from cosmetic changes to structural alterations. Common examples include interior remodeling, such as installing partitions, upgrading flooring, or enhancing lighting to create a conducive work environment or align the space with a brand identity.

Mechanical and electrical upgrades are often necessary for businesses requiring specialized equipment or systems. For instance, a tech company might install additional power outlets and data cabling to support IT infrastructure. These upgrades improve functionality and ensure compliance with safety standards.

Exterior modifications, though less common due to landlord restrictions, may include updating signage, improving the building facade, or adding accessibility features like ramps or automatic doors. These changes can enhance visibility and customer access.

Accounting for Leasehold Improvements

Accounting for leasehold improvements requires compliance with financial reporting standards. These improvements are capitalized as they provide future economic benefits and are expected to last beyond one year. Costs are added to the asset base and depreciated over the shorter of the asset’s useful life or the lease term, including reasonably assured renewal options, in accordance with Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

Determining the appropriate useful life for depreciation depends on factors such as the nature of the improvements and the likelihood of exercising lease renewal options. Significant structural changes in a long-term lease may be depreciated over a longer period compared to cosmetic updates in a short-term lease.

It’s critical to distinguish between leasehold improvements and repairs or maintenance. Improvements are capitalized, whereas repairs and maintenance are expensed in the period incurred. For example, constructing new walls or installing a new HVAC system is considered a leasehold improvement, while painting walls or fixing a leaky faucet is categorized as maintenance.

Tax Implications and Deductions

The tax treatment of leasehold improvements can significantly affect a company’s taxable income. Under the Internal Revenue Code (IRC), these improvements are capitalized and depreciated. The Tax Cuts and Jobs Act (TCJA) of 2017 introduced bonus depreciation for certain qualified improvement property (QIP), allowing businesses to immediately expense a percentage of the cost.

To qualify as QIP, improvements must be made to the interior of a nonresidential building and placed in service after the building’s original service date. However, improvements such as enlargements, elevators, or internal structural framework modifications are excluded. The current bonus depreciation rate is 100%, but this rate is scheduled to phase down, requiring strategic planning to optimize tax benefits.

IRC Section 179 provides an alternative option to expense certain improvements immediately, up to a limit of $1,160,000 for 2023. This deduction is subject to a phase-out threshold, making it important for businesses to assess their total capital expenditures. Additionally, state tax rules may differ from federal regulations, adding complexity to tax planning.