If you own or are looking to lease a commercial space, making changes to that property might be necessary for a variety of reasons. Whether you make structural or cosmetic improvements to the property, the work you have done will fit into one of two main categories: a building improvement or a leasehold improvement. Here is how you can differentiate each of these and the ways each type of improvement is treated for accounting and tax purposes.
What Are Building Improvements?
Building improvements can be major expenses for commercial property owners and private investors because they often require a significant amount added to a finance note, with not much in the way of tax savings. For this reason, it’s important to categorize building improvements properly.
A “building” is considered any structure that is attached to land, is not mobile, has a roof, and is completely surrounded by walls. Buildings are not any ancillary part of a state’s highway network, such as toll buildings or rest stops. These are considered “infrastructure” rather than buildings for classification purposes.
Building improvements are capital expenditures that increase the value of a building or materially extend its useful life. Some examples of building improvements include installing a new roof, elevator, or escalator or renovating a common lobby or bathroom.
Accounting for Building Improvements
The accounting for building improvements will depend on how they are classified. Certain building improvements must be capitalized. This means that the improvements are treated as fixed assets, meaning they add substantial value to the property and will last a long time. An example of a Capitalized Building Improvement is the addition of an elevator to a building.
Other building improvements can be treated as Expensed Building Improvements, meaning they are expensed as regular repairs and maintenance expenses on the Income Statement. For example, the replacement or repair of a building component that doesn’t significantly lengthen the life of the total asset would be considered an expense, not an improvement.
Tax Treatment for Building Improvements
According to the IRS, you must depreciate a capitalized building improvement over the same time period that you depreciate the building. There is typically a 39-year life assigned to commercial real estate, so building improvement depreciation would be spread out over nearly four decades. Knowing this, you will achieve more short-term tax savings if you can classify any improvements to your property as leasehold improvements or repairs.
What Are Leasehold Improvements?
Leasehold improvements are changes made to a commercial property that customize the property to satisfy the needs of a tenant or leaseholder. The improvement must be located within the four walls of the tenant’s space and made according to the terms of the tenant’s lease. Some previous restrictions on leasehold improvements were eliminated with the 2017 Tax Cuts and Jobs Act (TCJA).
Some examples of leasehold improvements include the following.
- Modifications to tenant’s structure
- New flooring and drywall
- Updates to electrical, light fixtures, and technology
- Addition of partitions and cubicles
- Countertops and shelving
There are several different types of leasehold improvements.
- Turn-Key — Turn-key projects generally happen at the beginning of the lease. Plans and costs estimates are submitted by the tenant, but the landlord supervises and pays for the work.
- Tenant Improvement Allowance — The landlord gives the tenant an allowance to cover leasehold improvements, either as a lump sum or on a per square foot basis. The tenant then supervises the project and pays anything that goes over budget.
- Building Standard Allowance — Also referred to as a “build-out” option, the landlord gives the tenant an improvement package. The landlord generally pays for and manages the work.
- Rent Discount — The landlord provides the tenant with a rent discount to cover leasehold improvements. With this option, the tenant controls the project and its costs.
Accounting for Leasehold Improvements
Accounting experts recommend that companies expense any improvements that they make that are equal to less than the company’s capitalization limit during the same period. If the total for the improvements exceeds this amount, the tenant can capitalize and amortize them for the term of the lease or over the life of the improvements if that is shorter.
Tax Treatment for Leasehold Improvements
Leasehold improvements aren’t tax-deductible. However, the IRS does allow building owners to account for the depreciation of any leasehold improvements because they are part of the building. The tax act has now raised the maximum allowable depreciation deduction from $500,000 to $1 million.
If the landlord gives a rent discount to the tenant to account for leasehold improvements, the landlord can still take the depreciation but must also recognize the rental income. Likewise, the landlord won’t recognize any taxable income or depreciation if the tenant paid for improvements but wasn’t reimbursed in some way by the property owner. The tenant becomes the owner of the improvements and can claim the depreciation.
Leasehold improvements made by a tenant may also qualify for special accelerated depreciation under several sections of the Internal Revenue Code, such as IRC §179 or IRC §168(k).
Leasehold improvements that qualify as a “qualified improvement property” (QIP) allow a dollar-for-dollar deduction when the taxpayer places more than $2,590,000 of qualified assets into service if both the IRC §179 and bonus depreciation applies. The IRC §179 is used first to reduce the cost basis of the qualified property. The bonus depreciation under IRC §168(k) allows the taxpayer to claim bonus depreciation on 100% of the property’s cost basis through 2022, after which the percentage reduces by 20% per year until reaching 0% in 2027.
Building Improvements vs. Leasehold Improvements
While there is considerable overlap between building improvements and leasehold improvements, the purpose of the improvement is what matters. If the changes to the property are being done to suit the needs of a tenant, they are considered leasehold improvements. If they are being done to improve the building’s overall functionality or suit the owner’s needs, they are classified as building improvements.
Read this article if you would like to learn more about commercial building depreciation!