Confusion over qualified leasehold improvements may create opportunity

However, improvement expenditures attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building are still considered 39 year property under MACRS, and excluded from bonus depreciation. For purposes of accounting, the costs of leasehold improvements are capitalized as a fixed asset and then amortized rather than depreciated, as the prior section mentioned. Qualified Improvement virtual cfo services Property is defined as any improvement made to the interior of a nonresidential building after the building is placed in service. Improvements must explicitly exclude expansion of the building, elevators and escalators, and changes made to a building’s internal structural framework. Any property that is subject to the rules of QIP and is leased by a single tenant now falls under the rules for QIP for tax accounting purposes.

Notably, the approval of a tenant’s request for a leasehold improvement increases the property value, which directly affects a landlord’s ability to raise future rents. Starting from tax years beginning after December 31, 2022, the 100% bonus depreciation deduction will gradually decrease by 20% each year until it reaches a complete phase-out by the end of the 2026 calendar year. This means that deductible amounts will be reduced to 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and finally 0% in 2027. As a general rule, it is better to expense an asset than depreciate it.

1. Leasehold improvements are amortized over the useful economic life of the improvements or over the remaining lease term, whichever is shorter.
2. Leasehold improvements, such as painting, installing partitions, changing the flooring, or putting in customized light fixtures can be undertaken either by the landlords—who may offer to do so to increase the marketability of their rental units—or by the tenants themselves.
3. Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London.
4. In simple terms, it is any modification that is made to commercial rental property to customize the property to the tenant’s specifications.
5. If an improvement qualifies under the rules of QIP, an entity must depreciate it over the 15-year prescribed recovery period for tax purposes.

The TCJA made QIP eligible for section 179 expensing, subject to the $1,000,000 expensing and $2,500,000 spending limitation starting on Jan. 1, 2018. On the surface, one of the bullet points under the “does not qualify” section above (structural components benefitting a common area) would seem to disqualify many leasehold improvements from utilizing the shorter 15-year life. Section 1.168(k)-1(c)(3)(ii) reveals that the restriction is less strict than one might assume. Other factors which could affect the assurance of the exercise of a renewal option are penalties in the contract for termination and optional bargain buyouts after the next lease period.

This would also impact any other 15-year property, such as land improvements, that was placed in service by the taxpayer in the same year as the leasehold improvements. Failure to properly depreciate QLHI over 15 years puts other 15-year property at risk for reclassification to longer recovery periods. Unfortunately, there was an oversight in drafting the Tax Cuts and Job Act, and QIP was not included in the 15-year depreciation list, even though it was supposed to be. This means that leasehold improvements made after 2017 will have the regular 39-year depreciation period that applies to all commercial buildings. This is an unsatisfactory position for tenants, because most leases will not last this long.

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It may be possible to spread the cost of these improvements over an extended time period, but only if the amount expended is more than the lessee’s capitalization limit. If the amount expended is less than the capitalization limit, the amount is charged to expense as incurred. Otherwise, the lessee can record the expenditure in the leasehold improvements asset account. When the expenditure is recorded as an asset, it must be charged to expense over time; the rules for doing so are noted below. Under the TCJA, leasehold improvements made on or after January 1, 2018, are reclassified for tax purposes as “qualified improvement property,” or QIP.

However, there was an opportunity for smaller taxpayers to take immediate deductions on QIP. The TCJA added QIP as a category of property under section 179 that is eligible for immediate deduction, when a taxpayer elects to include QIP costs in its section 179 deduction calculation. So, even though there was no bonus depreciation eligibility for QIP, there was still an opportunity to deduct costs related to QIP for smaller taxpayers. The confusion of different qualifying property and different years enacted may be a reason taxpayers have missed this opportunity to accelerate depreciation by 24 years. Taxpayers may have assumed that their leasehold improvements would not qualify for the shorter life because the expenditures weren’t related to restaurant or retail property improvements.

However, taxpayers who only claimed impermissible depreciation on QIP for a single year can include such depreciation in their accounting method change. Or they can correct the depreciation for such “one-year property” by filing an amended return. Qualified improvement property (QIP) is any improvement that is Sec. 1250 property made by the taxpayer to an interior portion of a nonresidential building placed in service after the date the building was placed in service. However, expenditures attributable to the enlargement of the building, elevators or escalators, or the internal structural framework of the building are excluded (Sec. 168(e)(6) and Regs. The requirement that the improvement be made by the taxpayer means that taxpayers cannot acquire a building and treat any cost assigned to improvements made by a previous owner as QIP.

The addition of a leasehold improvement could make any penalty economically detrimental for the lessee to incur because of the increased value the improvement provides. It could also make the buyout at the end of the lease more attractive since the leased property is already customized for the entity’s business purposes. For GAAP accounting, amortization of qualified improvement property follows the guidelines of ASC 842.

What is the Accounting Treatment of Leasehold Improvements?

Leasehold improvements are also known as tenant improvements or build-outs and are generally made by landlords of commercial properties. The modifications are tailored to suit the needs of a specific tenant and their needs. Only https://www.kelleysbookkeeping.com/analyzing-a-bank-s-financial-statements/ improvements made to the interior of a specific tenant’s space are considered leasehold improvements. Leasehold improvements are tenant specific, which means the improvement must make the space more usable for the tenant.

If the modification is going to benefit multiple tenants, then it is not a leasehold improvement. Examples include elevators and escalators that serve several offices, or a new roof on a multi-unit building. To qualify as a leasehold improvement, the alteration must make a permanent modification to the structure of the space that is being rented to the tenant, or permanently fix something to the inside of that space. If all you are doing is fixing something that is broken, then you would deduct the repair cost in the same way you would with any other business expense.

Definition of Leasehold Improvements

These sorts of modifications can occur in many commercial real estate locations, like offices, retail, and industrial spaces, mostly entailing changes to walls, ceilings, and flooring. Once implemented, the improvements are owned by the landlord on paper, even if the one benefiting directly is the renter, i.e. the asset is an intangible “right” of ownership. You can set the default content filter to expand search across territories.

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While bonus depreciation diminishes, alternative avenues such as Section 179 deductions offer opportunities to mitigate tax liabilities and optimize cash flow. The salvage value is assumed to be zero because ownership of the improvements returns to the lessor, not the lessee. Once the lease ends, the improvements generally belong to the landlord, unless otherwise specified in the agreement. If the tenant is able to take them, they must remove them without any damage to the property. This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.

This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. The accounting rules that pertain to leasehold improvements are as follows. In some cases, the lessee may have a high expectation of renewing a lease, such as when a bargain lease rate is being offered by the lessor. In this case, where extension of the lease is reasonably assured, the lessee can extend the depreciation period to cover the additional term of the lease, capped at the useful life of the asset.

This information is brought to you by Checkpoint Edge, the award-winning, AI-powered tax and accounting research tool from Thomson Reuters. Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a business writer. Her articles have appeared on numerous business sites including Typefinder, Women in Business, Startwire and Indeed.com. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory. These materials were downloaded from PwC’s Viewpoint (viewpoint.pwc.com) under license.

But until the legislative glitch is fixed, you have to assume a recovery period of 39 years unless a tax professional advises otherwise. Technically, leasehold improvements are amortized, rather than being depreciated. This is because the actual ownership of the improvements is by the lessor, not the lessee. The lessee only has an intangible right to use the asset during the lease term. However, there is no real effect on the income statement of using one term over the other, especially if the amortization and depreciation expenses are combined for presentation purposes. A leasehold improvement is created when a lessee pays for enhancements to building space, such as carpeting and interior walls.