Leasehold Improvements: Depreciation Life and Who Deducts

Leasehold improvements are alterations a tenant or landlord makes to leased commercial space — walls, flooring, lighting, fixtures. For tax, their depreciation life follows the property's MACRS class, not the lease term: interior improvements meeting the qualified improvement property definition are 15-year property, and everything else attached to the building is 39-year. Whoever owns the improvement depreciates it.

On this page

1. How long are leasehold improvements depreciated?
2. Who depreciates — tenant or landlord?
3. What happens to unrecovered basis when the lease ends?
4. What about repairs versus improvements?
5. Worked example
6. Frequently asked questions
7. Related guides
8. Official sources
9. Next step

How long are leasehold improvements depreciated?

The lease term does not control tax depreciation — a common misunderstanding carried over from financial accounting, where improvements are amortized over the shorter of their useful life or the lease. For tax, the improvement is classified like any other asset:

Because most tenant build-outs are interior, most of the cost lands in the 15-year QIP class and can be written off in the first year (the QIP guide).

Who depreciates — tenant or landlord?

The owner of the improvement does. Three arrangements:

The tenant pays and owns: the tenant capitalizes the improvements, depreciates them under their MACRS class (or expenses them under bonus or section 179), and — when the lease ends and the improvements stay with the building — writes off any remaining adjusted basis as a loss in the year of termination. The tenant's depreciation is not shortened to the lease term; the unrecovered cost is recovered at the end instead.

The landlord pays and owns: the landlord capitalizes and depreciates them, and the tenant has nothing to depreciate. Rent may be higher to compensate.

The landlord pays a construction allowance to the tenant: the default rule treats the allowance as income to the tenant, with the tenant owning and depreciating the improvements. The section 110 exception for short-term leases (fifteen years or less) of retail space — which includes space used to sell services to the general public, such as a medical or professional office — lets the tenant exclude the allowance from income if the lease expressly provides that it is for qualified long-term real property and it is spent on that property — with the landlord then treated as the owner who depreciates them. The lease language and the parties' consistent reporting decide which path applies.

What happens to unrecovered basis when the lease ends?

A tenant who leaves improvements behind at the end of the lease has an abandonment: the remaining adjusted basis is deducted as an ordinary loss in that year. A tenant who is paid by the landlord for the improvements on exit has a sale, with gain or loss (with bonus or section 179 taken on the improvements recaptured largely as ordinary income). A landlord who receives improvements from a departing tenant generally recognizes no income on receipt — improvements made by a tenant are excluded from the landlord's income unless they were made in lieu of rent.

What about repairs versus improvements?

Not everything done to leased space is capitalized. Under the tangible property regulations, work that keeps the space in ordinary operating condition — repainting, patching, replacing a few floor tiles — is a repair, deducted currently. Work that betters the property, restores it, or adapts it to a new use is an improvement, capitalized and depreciated. The de minimis safe harbor (the de minimis guide) expenses small items regardless, and the small-taxpayer safe harbor for buildings lets a business with modest gross receipts and a building under the unadjusted-basis threshold deduct repairs and improvements up to an annual cap without the analysis (average annual gross receipts of US$10 million or less, a building with an unadjusted basis of US$1 million or less, and total repairs, maintenance, and improvements on it for the year no more than the lesser of 2 percent of that basis or US$10,000, elected each year by a statement with the return).

Worked example

A dental practice signs a ten-year lease and spends US$310,000 building out the suite: US$240,000 of interior walls, cabinetry, lighting, and plumbing (QIP — 15-year, expensed under 100 percent bonus depreciation in year one); US$50,000 of dental chairs and equipment (7-year, also bonus); US$20,000 of structural work to relocate a load-bearing wall (39-year, straight line — about US$500 a year). The landlord contributed a US$60,000 allowance; because the lease does not expressly provide that the allowance is for long-term improvements that revert to the landlord, the section 110 exclusion does not apply even though a dental suite serving the public can count as retail space — the allowance is income to the practice, which owns and depreciates the full US$310,000. At the end of year ten the practice moves out: the US$20,000 structural work has about US$15,000 of unrecovered basis, deducted as an abandonment loss that year; the QIP and equipment have zero basis, and nothing to recapture because nothing was sold.

Frequently asked questions

Official sources

Publication 946 defines qualified improvement property this way: “Generally, this is any improvement to an interior part of a building that is nonresidential real property, and the improvement is section 1250 property, is made by you, and is placed in service by you after 2017 and after the date the building was first placed in service by any person.” — Internal Revenue Service, Publication 946, How To Depreciate Property, https://www.irs.gov/publications/p946

The IRS tangible property regulations guidance states: “You are not required to capitalize as an improvement, and therefore may be permitted to deduct, the costs of work performed on owned or leased buildings, e.g., repairs, maintenance, improvements or similar costs, that fall into the safe harbor election for small taxpayers.” — Internal Revenue Service, Tangible property final regulations, https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations

Next step

Fairlight Accounting is a cross-border accounting and tax practice with a U.S. Tax Desk and a Canadian Tax Desk. Our U.S. Tax Desk handles tenant and landlord improvement classification, construction allowance treatment, repair-versus-improvement analysis, and lease-end basis recovery. See pricing or book a call.