Real Estate Tax Calc
| Also called | Tenant improvement; build-out; fit-out |
| IRS statutory definition | IRC §168(e)(6): any interior improvement to an existing nonresidential building placed in service after the building's placed-in-service date |
| Four required criteria | Interior only · Permanent · Nonresidential real property · Existing building (not new construction) |
| Tax classification | Qualified improvement property (QIP) — 15-year MACRS GDS (20-year ADS) |
| Bonus depreciation (2026) | 20% first-year write-off; 0% in 2027 under current law |
| Who depreciates it | The economic owner — typically whoever paid for the work without reimbursement |
| What it is NOT | Repairs (§162 expense); trade fixtures (personal property); building structural components (39-year); residential rental improvements (27.5-year) |
Leasehold improvement: exact definition and 4-part IRS test
A leasehold improvement is a physical alteration or addition made to the interior of a leased building to adapt it for a tenant's specific use. These are permanent changes — items that are attached to and become part of the building's structure — as distinguished from furniture, movable equipment, and trade fixtures that the tenant installs and removes when the lease ends.
Four criteria determine whether a change qualifies:
- Interior only — the alteration must be within the leased space, not the building's exterior, structural frame, or common areas.
- Permanent — it attaches to and becomes part of the building structure rather than remaining a removable trade fixture.
- Nonresidential leased space — the building must be commercial real property; improvements to residential rental buildings do not qualify as QIP.
- Existing building — new construction and building enlargements are excluded; the improvement must be to a building already placed in service.
Common examples of leasehold improvements include:
- Interior partition walls and demising walls
- Dropped ceilings and acoustical ceiling tiles
- Hardwood, tile, or carpet flooring
- Built-in millwork, cabinetry, and reception desks
- Interior lighting systems and electrical distribution within the leased space
- Plumbing and restroom facilities
- HVAC ductwork and distribution within the tenant's space
- Sprinkler modifications and fire protection improvements within the space
- Security systems and access control built into the walls or structure
Notice that all of these examples are interior. The building's exterior — its roof, windows, facade, and structural frame — is not a leasehold improvement regardless of who pays for the work.
- Leasehold improvement / Tenant improvement / Build-out — permanent interior alteration to leased nonresidential space. 15-year QIP (MACRS), eligible for bonus depreciation.
- Trade fixture — tenant-installed item removable at lease end (commercial kitchen equipment, shelving, salon chairs). 5- or 7-year personal property; eligible for §179 and bonus.
- Building structural component — roof, exterior walls, columns, elevators, building-wide HVAC. 39-year property regardless of who pays for the work.
- Repair — keeps property in current condition without bettering, restoring, or adapting it. Deducted immediately under §162; not capitalized or depreciated.
- Building improvement (non-QIP) — capital work to the building's structure or exterior (roof replacement, adding a floor). 39-year nonresidential real property; not QIP, ineligible for bonus depreciation.
What does not count as a leasehold improvement?
Several categories are outside the leasehold-improvement classification and are treated differently for depreciation:
Trade fixtures and personal property. A restaurant tenant's commercial kitchen equipment, a salon's styling chairs, or a retail tenant's shelving units that can be unbolted and removed at lease end are personal property, not leasehold improvements. These are 5- or 7-year MACRS property, generally eligible for both bonus depreciation and Section 179.
Building structural components. Columns, exterior walls, the building shell, elevators, escalators, and load-bearing elements are structural components of the building itself. They are 39-year property even when a tenant funds the work.
Building enlargements. Adding floor area or a new wing changes the building's external dimensions and is not a leasehold improvement. These additions are capitalized as 39-year structural improvements.
Residential rental property improvements. Renovations to apartment interiors do not qualify as QIP because the building must be nonresidential real property. Those improvements are treated as 27.5-year structural additions.
Land improvements. Parking lots, driveways, fencing, and landscaping around the leased building are 15-year MACRS land improvements — a different category from QIP, also eligible for bonus depreciation, but classified under §168(e)(3)(C) rather than §168(e)(6).
Leasehold improvements vs. tenant improvements: same thing, different names
The terms leasehold improvement and tenant improvement are used interchangeably in the industry and in the tax code, and the difference is essentially stylistic. "Leasehold improvement" emphasizes the relationship to the leasehold interest — the tenant's right to use the space under the lease. "Tenant improvement" emphasizes who commissioned and paid for the work. Some practitioners also use "build-out" or "fit-out" for the same concept. All three terms refer to the same type of work — permanent interior alterations to adapt leased commercial space for a tenant's specific use — and the same QIP tax treatment applies regardless of which label you use.
One place where terminology diverges slightly: a tenant improvement allowance (TIA) specifically refers to cash paid by the landlord to fund a tenant's improvements, not the improvements themselves. The TIA is the financial arrangement; the resulting physical work is the leasehold or tenant improvement.
Leasehold improvements vs. repairs and maintenance
Not every dollar a tenant or landlord spends on leased space is a leasehold improvement. The tax rules under IRC §263 and the tangible property regulations (Reg. §1.263(a)-3) require distinguishing between capital improvements — which must be capitalized and depreciated — and repairs and maintenance — which are deducted immediately as ordinary business expenses.
An expenditure is a capital improvement (and therefore a leasehold improvement) if it:
- Betters the property by correcting a defect, adding capacity, or meaningfully increasing its quality, strength, or efficiency.
- Restores the property by returning a major component to like-new condition, replacing a structural component, or rebuilding after a casualty.
- Adapts the property to a new or different use that was not its use at acquisition.
A repair, by contrast, keeps the property in its current operating condition without materially adding to its value or meaningfully extending its useful life. Repainting walls, patching a floor, replacing a broken window, and fixing a leaking pipe are routine repairs — deductible in the year incurred under §162. Installing a new HVAC system, adding a partition wall to reconfigure the floor plan, or laying new flooring throughout the leased space are improvements — capitalized and depreciated as leasehold improvements under QIP rules.
From QLIP to QIP: the TCJA change
Before 2018, the tax code maintained three separate favorable categories for commercial interior improvements:
- Qualified leasehold improvement property (QLIP) — improvements under a lease between unrelated parties, more than three years after the building was placed in service, 15-year MACRS.
- Qualified retail improvement property — improvements to open-to-the-public retail space, 15-year MACRS.
- Qualified restaurant property — improvements and new construction of restaurant facilities, 15-year MACRS.
The TCJA, effective for property placed in service after December 31, 2017, eliminated these three categories and created a single, simpler category: QIP. The new definition dropped the "between unrelated parties" requirement of QLIP and the "three years after placed in service" rule, making it easier for some improvements to qualify. However, the TCJA inadvertently omitted QIP from the list of 15-year property in §168(e)(3)(E), causing QIP to default to 39 years — the so-called "retail glitch." The CARES Act retroactively corrected this in March 2020.
Taxpayers who placed qualifying improvements in service in 2018 or 2019 — when QIP was accidentally treated as 39-year property — could fix the error by filing a Form 3115 (change in accounting method) or, for certain taxpayers, an amended return, to claim the shorter 15-year life and any missed bonus depreciation. The IRS provided relief procedures in Rev. Proc. 2020-25.
Who owns leasehold improvements, and who depreciates them?
Ownership of leasehold improvements is a nuanced question that determines who claims the depreciation deduction. The general principle is that the economic owner — the party bearing the cost and economic risk of the improvements — depreciates them.
Tenant-funded improvements: When a tenant pays for improvements out of its own pocket without any landlord reimbursement, the tenant owns the improvements and depreciates them on its own return. This is true even though the improvements physically become part of the landlord's building.
Landlord-funded improvements: When the landlord builds out the space and leases it in improved condition, the landlord owns and depreciates the improvements. The tenant has no depreciable interest.
Tenant improvement allowances (TIA): A TIA is a cash payment or credit from the landlord to fund the tenant's build-out. The tax treatment depends on structure. If the landlord pays contractors directly and retains title, the landlord depreciates. If the landlord pays cash to the tenant and IRC §110's exclusion applies (nonresidential property, reversion to landlord, 15-year-or-less lease term), the tenant excludes the TIA from income but has zero basis in the improvements — no depreciation for the tenant. If the §110 exclusion does not apply, the tenant includes the TIA in gross income and takes a full cost basis in the improvements it built.
What happens at lease end? When a tenant leaves, improvements that revert to the landlord become the landlord's property. The tenant stops depreciating at that point. Any remaining undepreciated basis is a loss or a §1231 gain/loss depending on the circumstances. If the tenant is required to restore the property to its original condition, the restoration costs are a deductible expense in the year incurred.
Leasehold improvements in a sublease
When a tenant subleases part of its leased space to a subtenant, and the subtenant makes improvements, the same four-part test applies: the improvements must be interior, permanent, to nonresidential property, and to an existing building. The fact that the subtenant holds through a sublease rather than a direct lease does not disqualify the improvements. Courts and the IRS have confirmed that improvements made by a party who is not the building owner — including subtenants — can qualify as QIP.
Ownership and depreciation in a sublease follow the same economic-owner analysis. If the subtenant pays for and constructs the improvements, the subtenant claims the depreciation. If the master tenant provides an improvement allowance to the subtenant, the allowance mechanics mirror the TIA analysis above — the subtenant excludes it under §110 (if the sublease term is 15 years or fewer and improvements revert) or includes it as income and takes a basis. The master tenant is not affected by improvements the subtenant makes at the subtenant's expense.
One watch-out: subleases often have shorter terms than the master lease. When the sublease ends and improvements revert to the master tenant (and ultimately to the landlord), the subtenant may have a §1231 loss on undepreciated basis — which is deductible as an ordinary loss to the extent of prior §1231 gains, then a capital loss. Document the placed-in-service date and the sublease term to support basis and depreciation claims.
MACRS recovery period and method
Leasehold improvements that qualify as QIP are 15-year MACRS property under the GDS. The depreciation method is straight-line, and the applicable convention is the half-year convention (or mid-quarter if applicable). Using straight-line over 15 years with the half-year convention, the first-year deduction without any bonus is 3.33% of basis (half of the 6.67% annual rate). With bonus depreciation on top, the first-year deduction is substantially higher.
Under the Alternative Depreciation System (ADS), QIP has a 20-year straight-line recovery period. ADS is mandatory for certain taxpayers: those whose property is used predominantly outside the U.S., tax-exempt-use property, and businesses that elect out of the interest-expense limitation under IRC §163(j). Real property trades or businesses that make the §163(j)(7) election must use ADS for their nonresidential real property, residential rental property, and QIP — which means giving up bonus depreciation for QIP and spreading the deduction over 20 years instead of 15.
Bonus depreciation for leasehold improvements
Because QIP has a 15-year MACRS life (20 years or fewer under the bonus-depreciation eligibility threshold), it qualifies for bonus depreciation under IRC §168(k). The applicable bonus percentage depends on the year the improvement is placed in service:
- 100% for improvements placed in service after September 27, 2017, through December 31, 2022
- 80% for 2023
- 60% for 2024
- 40% for 2025
- 20% for 2026
- 0% after 2026 under current law
Bonus depreciation is the default — it applies automatically unless the taxpayer affirmatively elects out on a per-class basis. If you want to depreciate QIP over 15 years rather than take a large first-year deduction, you must make an election out of bonus depreciation on your timely filed return (including extensions).
Tax treatment of a tenant improvement allowance
The landlord–tenant relationship around TIAs creates a common source of confusion. When a landlord provides cash to a tenant specifically for building improvements, the tenant's tax treatment follows a two-step analysis.
First, is the TIA excludable from income under IRC §110? The exclusion applies when: (1) the allowance is for improvements to nonresidential real property, (2) the improvements revert to the landlord at the end of the lease, and (3) the lease term is 15 years or less including renewal options. When all three conditions are met, the tenant excludes the TIA from income but takes a zero cost basis in the improvements — no depreciation deduction for the tenant.
Second, if any condition fails, the entire TIA is ordinary income to the tenant, but the tenant also takes a cost basis equal to its actual expenditure on the improvements. The tenant then depreciates those improvements as QIP with a full basis. In practice, many commercial leases now exceed 15 years (with renewal options), which pushes TIAs outside the §110 exclusion and into ordinary income with a depreciable basis.
Worked numeric example
A medical practice signs a 12-year lease (including a five-year renewal option) on 3,000 square feet of nonresidential office space. The landlord pays a $180,000 TIA. The lease term including the renewal option exceeds 15 years, so IRC §110 does not apply. The medical practice includes $180,000 in gross income. It spends the full $180,000 on interior build-out (exam rooms, reception desk, flooring, lighting) placed in service in November 2026.
Cost basis of QIP: $180,000
Bonus depreciation (2026 rate: 20% — the final year under current law): $180,000 × 20% = $36,000
Remaining basis after bonus: $180,000 − $36,000 = $144,000
Year-1 regular MACRS (half-year convention): $144,000 ÷ 15 × 0.5 = $4,800
Total year-1 depreciation: $36,000 + $4,800 = $40,800
The $180,000 TIA is income, but $40,800 is offset in year one by depreciation. Net taxable income from the TIA in year one: $180,000 − $40,800 = $139,200, with the remaining $139,200 of basis recovering at roughly $9,600 per year going forward.
Year comparison: The same build-out placed in service in 2025 (40% bonus) would yield $72,000 bonus + $3,600 regular MACRS = $75,600 year-1 deduction — almost double the 2026 amount. After 2026, bonus drops to 0% under current law: a build-out placed in service on January 1, 2027 recovers only $6,000 in year one ($180,000 ÷ 15 × 0.5).
| Year placed in service | Bonus % | Bonus amount | Year-1 MACRS | Total yr-1 deduction |
|---|---|---|---|---|
| 2024 | 60% | $108,000 | $2,400 | $110,400 |
| 2025 | 40% | $72,000 | $3,600 | $75,600 |
| 2026 | 20% | $36,000 | $4,800 | $40,800 |
| 2027 (current law) | 0% | $0 | $6,000 | $6,000 |
Based on $180,000 QIP cost basis. Year-1 MACRS: remaining basis after bonus ÷ 15 × 0.5 (half-year convention). Assumes no election out of bonus depreciation.
What happens to leasehold improvements when the lease ends?
When a tenant vacates — whether at lease expiration, early termination, or abandonment — any remaining undepreciated basis of tenant-owned leasehold improvements creates a tax event.
Reversion to landlord at lease end. When a lease expires and the improvements permanently pass to the landlord, the tenant is treated as having abandoned them. Under IRC §168(i)(1), the tenant may recognize an abandonment loss equal to the entire remaining adjusted basis in the year of departure. This loss is ordinary — not a §1231 capital loss — because the improvements are deemed to have zero value at that point. The tenant reports the loss on Form 4797. After the lease ends, depreciation stops and the remaining basis is claimed as a lump-sum ordinary deduction.
Early termination and lease-termination payments. If the landlord pays the tenant to exit early, that payment is typically ordinary income. If the payment is less than the remaining undepreciated basis, the shortfall is still an abandonment loss. If the payment exceeds the remaining basis, the excess is a §1231 gain — potentially taxed at capital rates after netting with other §1231 gains and losses for the year.
Restoration obligations. Some leases require the tenant to restore the space to original condition at exit. Those restoration costs — removing built-in millwork, restoring flooring — are deductible ordinary business expenses in the year the work is performed. Depreciation on the improvements stops when the space is vacated, and the remaining unrecovered basis flows into the abandonment loss.
Frequently asked questions
What is the definition of a leasehold improvement?
A leasehold improvement is a permanent interior alteration made to leased nonresidential space satisfying four IRS criteria: (1) interior only — inside the leased space, not the building shell; (2) permanent — physically attached rather than removable; (3) nonresidential real property — residential rental improvements do not qualify; and (4) existing building — new construction and enlargements are excluded. After the TCJA, most qualifying improvements are categorized as QIP with a 15-year MACRS life.
What is the difference between a leasehold improvement and a trade fixture?
A leasehold improvement becomes a permanent part of the building (partition walls, ceiling tiles, flooring). A trade fixture is installed by the tenant for business purposes and is removable without material damage to the property — the tenant can take it when the lease ends. Trade fixtures are personal property; leasehold improvements are real property.
Who depreciates leasehold improvements?
The party that economically owns them. If the tenant paid with its own funds and has an economic interest, the tenant depreciates. If the landlord funded and retains ownership, the landlord depreciates. If the tenant received a TIA that qualifies under IRC §110, the tenant excludes it from income but has zero basis — no depreciation for the tenant.
What recovery period applies to leasehold improvements after the TCJA?
15 years under MACRS GDS as qualified improvement property (QIP), corrected retroactively by the CARES Act. Under ADS the life is 20 years. Improvements to residential rentals or the building's structural shell remain 27.5 or 39 years.
Are leasehold improvements eligible for bonus depreciation?
Yes, if they qualify as QIP. Bonus depreciation was 100% for property placed in service through 2022, then phases down: 80% (2023), 60% (2024), 40% (2025), 20% (2026), and 0% afterward under current law.
What are the four defining criteria for a leasehold improvement?
Four criteria must all be satisfied: (1) interior only — work inside the leased space, not the building's exterior or structural frame; (2) permanent — attaches to the building rather than remaining removable at lease end; (3) nonresidential real property — improvements to residential rental buildings do not qualify for QIP; and (4) existing building — new construction and enlargements are excluded from the QIP definition.
Are leasehold improvements real property or personal property?
Leasehold improvements are real property — specifically nonresidential real property under MACRS — not personal property. This means they are not eligible for Section 179 expensing (which is limited to personal property and certain §179 real property). QIP uses bonus depreciation under §168(k) instead. Improvements become part of the building's structure even if the tenant paid for them, and are classified as real property regardless of who owns or depreciates them.
Are leasehold improvements the same as tenant improvements?
Yes. "Leasehold improvement," "tenant improvement," and "build-out" are interchangeable terms for the same thing: a permanent interior alteration to leased nonresidential space made by or for a tenant. The tax code uses both phrases. The QIP rules apply identically regardless of which term is used. The only label that is slightly different is "tenant improvement allowance (TIA)," which refers to the cash payment a landlord makes to fund the tenant's work — the TIA funds the improvements, but it is not itself the improvement.
Can leasehold improvement costs be expensed rather than depreciated?
Sometimes. The tangible property regulations provide several safe harbors that allow immediate expensing: the de minimis safe harbor (up to $5,000 per invoice or item if you have an applicable financial statement, $2,500 if you don't), the small taxpayer safe harbor (amounts up to the lesser of $10,000 or 2% of the building's cost), and the routine maintenance safe harbor. Amounts that fall outside these safe harbors — most large build-outs — must be capitalized as QIP. Bonus depreciation on QIP (20% in 2026) can then accelerate the first-year deduction on the capitalized amount.
What is the difference between a leasehold improvement and a building improvement?
A leasehold improvement is an interior alteration within the leased tenant space — partition walls, flooring, lighting — and qualifies as 15-year QIP under MACRS. A building improvement is a capital expenditure to the building's structure, exterior, or common areas (roof replacement, adding square footage, building-wide HVAC) and is classified as 39-year nonresidential real property. The same physical work can land in either category: an HVAC system serving only one tenant's leased space may be a leasehold improvement; a building-wide system serving all tenants is a structural building improvement at 39 years.
Do leasehold improvements need to be related to a formal lease?
After the TCJA, the QIP definition (IRC §168(e)(6)) no longer requires the improvement to be made "under or pursuant to a lease" between unrelated parties — the pre-2018 "related lease" requirement was eliminated. Any interior improvement to an existing nonresidential building by any person can qualify as QIP, whether the work is done by the owner, a tenant, or a subtenant, as long as the four criteria (interior, permanent, nonresidential, existing building) are satisfied.
What happens to undepreciated leasehold improvements when the lease ends?
When a lease expires and tenant-owned improvements revert to the landlord, the tenant claims an ordinary abandonment loss equal to the remaining adjusted basis under IRC §168(i)(1), reported on Form 4797 in the year of departure. If the landlord pays a termination fee, that payment first offsets the remaining basis; any excess is a §1231 gain. Restoration costs required by the lease are deductible ordinary business expenses in the year performed. Missing this deduction is a costly mistake — it cannot be recovered in a later year.
What IRS code section and form cover leasehold improvements and QIP?
Qualified improvement property is defined in IRC §168(e)(6) and the depreciation deduction is computed under §168 (MACRS). The placed-in-service date and bonus depreciation election are reported on Form 4562 (Depreciation and Amortization), which flows to Schedule E or the applicable business return. When a tenant claims an abandonment loss on vacated leasehold improvements, the deduction is reported on Form 4797 (Sales of Business Property). The election out of bonus depreciation for a class of property is made on Form 4562 for the placed-in-service year.
What does leasehold improvement mean in plain language?
In plain terms, a leasehold improvement is any permanent change made to the inside of a leased commercial space — walls, flooring, ceilings, lighting, plumbing, built-in fixtures — installed to fit the space for a tenant's specific use. "Leasehold" refers to the tenant's right to use the space under the lease; "improvement" means a permanent physical change (not just moving furniture). The IRS's formal definition in IRC §168(e)(6) requires the improvement to be (1) interior, (2) permanent, (3) in a nonresidential building, and (4) in a building already in service. These are classified as "qualified improvement property" (QIP) for depreciation purposes, with a 15-year life under MACRS.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.