Leasehold Improvements vs. Building Improvements
Distinguishing between property alterations is critical for landlords and tenants to correctly assign costs and manage financial reporting.
When a business moves into a new commercial space, modifications are often necessary to make the property suitable for its operations. These changes fall into two distinct categories: leasehold improvements and building improvements. For both tenants and landlords, correctly identifying an alteration is important for accurate accounting and tax reporting. The financial implications for each type of improvement differ, influencing who pays for the work and how the costs are recovered over time.
Defining Leasehold Improvements
Leasehold improvements are modifications made to a leased property by or for a tenant to align the space with their specific business requirements. These enhancements are physically attached to the property and cannot be removed at the end of the lease term without causing damage. Because they are customized for a particular occupant, their utility may not extend to subsequent tenants. These improvements revert to the landlord upon the termination of the lease.
These changes are for the exclusive use and benefit of the tenant occupying that specific unit, not the building as a whole. Common examples of leasehold improvements include:
- Installation of interior walls and partitions to create offices
- Construction of custom-built cabinetry or shelving for a retail store
- Addition of specialized lighting systems
- New carpeting, unique plumbing additions, or other fixtures tailored to the tenant’s activities
Defining Building Improvements
Building improvements are capital expenditures initiated by the property owner that enhance the value of the building or extend its useful life. Unlike modifications made for a single tenant, these projects benefit the entire structure and all its occupants. The focus is on the building’s core, common areas, or operating systems to maintain or upgrade the overall functionality and marketability of the property.
Examples of building improvements include large-scale projects such as:
- Replacing the entire roof
- Upgrading the central heating, ventilation, and air conditioning (HVAC) system
- Installing a new elevator or escalator
- Renovating a common area like a lobby or shared restroom
These actions are considered long-term investments in the property itself.
Key Distinctions in Ownership and Responsibility
The tenant is responsible for financing and overseeing the installation of leasehold improvements. In contrast, the landlord funds and manages building improvements as part of their responsibility to maintain the overall property. This division of financial responsibility is a standard starting point for most commercial lease negotiations.
The lease agreement is the definitive document that outlines these responsibilities, specifying which party is accountable for alterations and who legally owns them during and after the lease term. While the tenant may pay for and use the leasehold improvements, the lease often stipulates that legal ownership transfers to the landlord because they are physically integrated into the property.
At the conclusion of the lease, the tenant surrenders the modified space, and the improvements become the property of the landlord. If the improvements are highly specialized and not useful to a future tenant, the landlord may require the departing tenant to remove them and restore the space to its original condition. If an improvement made for a specific tenant is abandoned, the landlord may be able to deduct the remaining cost basis of that asset.
Contrasting Tax and Depreciation Treatment
The tax treatment for building and leasehold improvements differs concerning depreciation. For building improvements, the property owner capitalizes the cost and depreciates it over the same period as the building itself. For nonresidential commercial property, this is a 39-year straight-line depreciation schedule.
The party that pays for leasehold improvements is the one who claims the depreciation deductions. If the tenant pays, they depreciate the cost, and if the landlord pays, they take the depreciation. A common scenario involves a landlord providing a tenant improvement allowance. In this case, the tenant may be considered the owner for tax purposes, report the allowance as income, and depreciate the full project cost.
A tax classification known as Qualified Improvement Property (QIP) can apply to these interior upgrades. QIP is defined as any improvement made to the interior portion of a nonresidential building after the building has been placed in service. This can include work paid for by either the landlord or the tenant. Exclusions from QIP are improvements that enlarge the building, relate to elevators or escalators, or alter the internal structural framework.
The benefit of QIP is its depreciation schedule. Under the CARES Act, QIP has a 15-year recovery period, a significant acceleration compared to the 39-year period for the building. QIP is also eligible for bonus depreciation, though the benefit is being phased out. For improvements placed in service in 2025, the bonus depreciation rate is 40%, allowing a business to deduct a significant portion of the cost in the first year. This accelerated deduction provides a substantial tax savings for the party that incurred the cost.