Qualified vs. Non-Qualified Leasehold Improvements
The financial impact of a commercial leasehold improvement hinges on its tax classification, which governs its depreciation and eligibility for accelerated deductions.
When a business leases a property, it often needs to make changes to the space to fit its operational requirements. These modifications, known as leasehold improvements, can range from simple cosmetic updates to significant structural alterations. The tax classification of these expenditures determines how they are depreciated, which directly impacts a company’s taxable income. Understanding the distinction between “qualified” and “non-qualified” improvements has significant financial consequences, as the proper classification dictates the timeline over which the cost can be recovered through tax deductions.
Defining Qualified Improvement Property
Qualified Improvement Property (QIP) has a specific definition under the tax code. To be considered QIP, an improvement must be made to the interior portion of a commercial building that is nonresidential real property. The improvement must also be placed in service after the date the building was first placed in service by any taxpayer, meaning the building cannot be brand new.
This classification encompasses a wide range of common interior upgrades, including the installation of new drywall, ceilings, interior doors, and flooring. It also extends to the addition or modification of interior systems such as fire protection, security systems, and plumbing. The Tax Cuts and Jobs Act of 2017 (TCJA) intended to simplify various improvement categories into the single QIP classification but contained a drafting error that assigned it a 39-year recovery period. The Coronavirus Aid, Relief, and Economic Security (CARES) Act corrected this retroactively, assigning QIP the intended 15-year recovery period.
Identifying Non-Qualified Improvements
The tax code also carves out certain types of work that do not meet the definition of Qualified Improvement Property. These non-qualified improvements are treated differently for tax purposes and fall into three distinct categories. The first major exclusion is any improvement that results in the enlargement of the building, such as adding a new wing or another floor to the existing building. A second category of non-qualified improvements involves elevators or escalators. The final exclusion pertains to any improvement that affects the internal structural framework of the building, including modifications to load-bearing walls, columns, or beams.
Tax Treatment and Depreciation
The financial distinction between qualified and non-qualified improvements becomes clear in their tax treatments. Qualified Improvement Property (QIP) is assigned a 15-year recovery period under the Modified Accelerated Cost Recovery System (MACRS). This classification also makes QIP eligible for bonus depreciation, allowing a business to deduct a significant portion of the cost in the year it is placed in service. For property placed in service in 2025, the bonus depreciation rate is 40%, with the rate set to drop to 20% in 2026 before being eliminated.
In addition to bonus depreciation, QIP is eligible for expensing under Section 179. This provision allows for an immediate deduction, subject to annual limits. For 2025, the maximum deduction is $1,250,000, and this deduction begins to phase out for businesses that place more than $3,130,000 of qualifying property in service during the year.
Non-qualified improvements, on the other hand, are treated as part of the building itself. This means they are classified as nonresidential real property and must be depreciated over a much longer 39-year recovery period using the straight-line method. This extended timeline results in a much smaller annual deduction compared to QIP. Furthermore, these non-qualified assets are not eligible for bonus depreciation or Section 179 expensing. The consequence is a significantly slower cost recovery, reducing the immediate tax savings available from the investment.
Landlord vs Tenant Considerations
The tax implications of leasehold improvements are also shaped by who owns them, as this determines which party is entitled to claim depreciation deductions. When a tenant pays for and owns the improvements, the tenant is the party that depreciates the asset. The depreciation method depends on whether the improvement is classified as QIP or non-qualified, and the length of the lease does not affect the depreciation period. If the lease ends and the tenant vacates the property, they can claim a deduction for the remaining undepreciated basis of the improvements.
If the landlord pays for the improvements, the landlord depreciates the cost and receives the associated tax benefits. A landlord may provide a tenant with a cash payment, known as a construction allowance, to build out the space. Under Internal Revenue Code Section 110, a tenant may be able to exclude this cash allowance from its gross income if certain conditions are met. These conditions require the payment to be used for improvements to a retail space under a short-term lease; otherwise, the tenant must report it as income.