Accounting for tenant improvements starts with one question that decides everything downstream: who is the accounting owner of the improvements? Once you answer that, ASC 842 tells you how to record the construction costs, any tenant improvement allowance, and any free rent, and the Internal Revenue Code tells you how to depreciate the resulting assets for tax. The two answers are not the same, and the gap between book and tax has widened since the One Big Beautiful Bill Act restored 100% bonus depreciation.
Who Owns the Improvements for Accounting Purposes
Legal ownership under the lease is not the test. Under ASC 842, you look at the substance of the arrangement to decide whether a landlord-funded buildout is the landlord acquiring property that happens to sit inside a leased space, or simply a financial inducement to sign the tenant.
Several factors point to the landlord as the accounting owner:
- The lease treats the tenant’s failure to make specified improvements as an event of default.
- The tenant must provide evidence of actual construction costs before receiving payment.
- The landlord is obligated to fund cost overruns above the original allowance.
- The tenant cannot alter or remove the improvements without the landlord’s consent.
- The improvements have significant useful life remaining at lease expiration.
- The improvements have general utility to a future tenant.
When none of those are present, the payment is a lease incentive rather than a property acquisition. If the tenant has full discretion over the funds, doesn’t have to produce receipts, and can pocket any unused portion, the landlord is providing an incentive, not buying an asset.
One boundary before going further. Tenant improvements are permanent modifications that become part of the building: interior walls, upgraded electrical, HVAC ductwork, built-out conference rooms. Trade fixtures are different. Shelving, display cases, and removable equipment stay with the tenant as personal property, get depreciated on the tenant’s books, and go with the tenant when the lease ends. If pulling the item out would damage the structure, it’s an improvement, not a fixture.
Tenant Accounting Under ASC 842
The Right-of-Use Asset and Lease Liability
At lease commencement, a tenant with an operating lease records a lease liability equal to the present value of remaining lease payments, discounted at the rate implicit in the lease or the tenant’s incremental borrowing rate. The right-of-use asset starts at the same amount, adjusted up for any prepaid rent and initial direct costs, and adjusted down for any lease incentives received.
ASC 842 eliminated the deferred rent liability that tenants used to record under the prior standard. Incentives no longer sit in their own balance sheet account. They fold directly into the right-of-use asset, reducing its carrying value from day one.
Recording a Tenant Improvement Allowance
When a TIA is classified as a lease incentive rather than landlord-owned property, it reduces the right-of-use asset at commencement. A tenant with a $500,000 lease liability who receives a $75,000 TIA (and has no prepaid rent or initial direct costs) starts the right-of-use asset at $425,000. The lease liability stays at $500,000. The difference amortizes over the lease term through straight-line lease expense.
If the tenant also pays for leasehold improvements out of its own pocket, those go on the balance sheet as a separate long-term asset. The TIA does not offset that asset directly. It runs through the right-of-use asset, and the leasehold improvements stand alone on their own amortization schedule.
Total lease expense for the operating lease still lands at a straight-line amount each period, regardless of how cash payments are structured. Rent escalations, abatement months, and incentive timing all get smoothed. The mechanics are more involved than under the prior standard, but the income statement result is the same figure: total payments minus total incentives, spread evenly.
Amortization Period for the Leasehold Improvement Asset
ASC 842-20-35-12 sets the amortization period at the shorter of the improvements’ useful life or the remaining lease term. A 15-year improvement inside a 7-year lease amortizes over 7 years.
Two exceptions extend the period to the full useful life: the lease transfers ownership of the underlying space to the tenant, or the tenant is reasonably certain to exercise a purchase option. Renewal options can also stretch the amortization period, but only if exercise is reasonably certain. That is a high bar under ASC 842. The mere existence of the option is not enough. Economic incentives, whether the improvements themselves would have meaningful remaining value in the renewal period, and the tenant’s historical pattern of renewing all factor in.
Landlord Accounting
When the Landlord Owns the Improvements
If the ownership factors point to the landlord, construction costs go onto the landlord’s balance sheet as property, plant, and equipment. For GAAP, depreciation runs over the shorter of the asset’s estimated useful life or the lease term. For tax, MACRS governs the recovery period, discussed below.
When the Allowance Is a Lease Incentive
When the arrangement is a financial incentive rather than a property acquisition, the landlord does not capitalize a physical asset. The allowance reduces rental revenue on a straight-line basis over the lease term. Each period’s recognized rent is lower than the cash suggests, because the upfront payment is being spread across the whole lease.
Free rent works the same way. The landlord adds up all cash rent to be received over the full term, divides by the number of periods, and recognizes that straight-line figure each period. During abatement months, revenue still gets recognized, producing a receivable that unwinds as the tenant begins paying full cash rent.
Initial Direct Costs
Costs to execute the lease itself, such as broker commissions and legal fees tied to finalizing the agreement, can be capitalized only if they are truly incremental to executing the lease. Legal fees for negotiating terms are not incremental and get expensed as incurred. Qualifying costs on an operating lease are recognized as expense over the lease term on the same basis as lease income.
Tax Depreciation of Tenant Improvements
Tax depreciation follows entirely different rules than GAAP amortization, and the gap has widened.
The 39-Year Baseline for Structural Work
Nonresidential real property depreciates over 39 years using straight-line under MACRS.1Internal Revenue Service. Publication 946 – How To Depreciate Property Structural work integral to the building, such as a new roof, foundation work, or exterior walls, falls here. Structural tenant improvements owned by the landlord depreciate over 39 years regardless of the lease term.
Qualified Improvement Property
Most interior, non-structural improvements to commercial space qualify as qualified improvement property. QIP is any improvement to the interior of a nonresidential building placed in service after the building itself was placed in service. Expenditures for enlarging the building, elevators, escalators, and the internal structural framework are excluded.2Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System
QIP is 15-year property under MACRS.2Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System Interior walls, ceilings, lighting, flooring, plumbing, and fire protection systems inside an existing commercial building all typically qualify. The classification applies whether the landlord or the tenant funds the work, provided the other requirements are met.
100% Bonus Depreciation Under the OBBBA
The One Big Beautiful Bill Act, signed July 4, 2025, permanently reinstated 100% bonus depreciation for qualified property acquired and placed in service after January 19, 2025.3Internal Revenue Service. Treasury, IRS Issue Guidance on the Additional First Year Depreciation Deduction Amended as Part of the One Big Beautiful Bill Both conditions matter: acquired after that date and placed in service after that date. There is no annual dollar cap, and bonus depreciation can generate a net operating loss.
For QIP placed in service in 2026, a tenant or landlord can expense the entire cost of qualifying interior work in year one. A $200,000 buildout of interior walls, lighting, and flooring could produce a $200,000 deduction on the 2026 return.
Section 179 as an Alternative
Section 179 lets a business immediately expense qualifying property, and QIP is eligible. For tax years beginning in 2026, the maximum Section 179 deduction is $2,560,000, phasing out once total qualifying property placed in service in the year passes $4,090,000. Section 179 cannot create a net operating loss; the deduction is capped at the business’s taxable income. Bonus depreciation is usually the more flexible choice for tenant improvement projects, but Section 179 remains useful for assets that don’t qualify for bonus.
Section 110 Safe Harbor for Retail Tenants
A tenant who receives a construction allowance faces a real risk that the IRS treats the payment as taxable income. Section 110 provides a safe harbor to exclude a qualifying allowance from gross income, but the boundaries are strict.4Office of the Law Revision Counsel. 26 U.S. Code 110 – Qualified Lessee Construction Allowances for Short-Term Leases
The lease must be a short-term lease of 15 years or less, and the space must be used in the tenant’s trade or business of selling tangible goods or services to the general public.4Office of the Law Revision Counsel. 26 U.S. Code 110 – Qualified Lessee Construction Allowances for Short-Term Leases Office tenants, warehouse operators, and other non-retail occupants cannot use the exclusion.
Even inside retail, the exclusion covers only the portion of the allowance actually spent on qualified long-term real property, meaning nonresidential real property that is part of the retail space and reverts to the landlord at lease termination.5Internal Revenue Service. Rev. Rul. 2001-20 – Qualified Lessee Construction Allowances For Short-Term Leases Movable fixtures and equipment don’t count. A tenant who receives $100,000 but spends only $70,000 on qualifying real property can exclude only $70,000.
The lease itself must expressly state that the allowance is for constructing or improving qualified long-term real property. That language is not a formality. It forces both parties to take consistent tax positions: the landlord depreciates the improved property as its own asset, and the tenant excludes the allowance from income.5Internal Revenue Service. Rev. Rul. 2001-20 – Qualified Lessee Construction Allowances For Short-Term Leases No separate IRS form is required. Miss the lease language and the tenant cannot claim the exclusion, even if every other condition is met.
Book-Tax Differences
A single asset can produce two very different depreciation schedules. A tenant might amortize a $150,000 leasehold improvement over a 10-year lease term for GAAP, giving $15,000 of annual book expense. That same asset, if it qualifies as QIP placed in service after January 19, 2025, could generate a $150,000 bonus depreciation deduction in year one on the tax return.
Year one taxable income is $135,000 lower than book income. Over the next nine years the pattern reverses: GAAP keeps recognizing $15,000 while the tax return shows zero depreciation, since the whole cost was already taken. The temporary difference produces a deferred tax liability that unwinds over the remaining book life.
Landlords face the same problem from the opposite side. A landlord who capitalizes tenant improvements and takes bonus depreciation for tax while depreciating the same asset over the lease term for GAAP carries a deferred tax liability that reverses over the book life. Both parties need parallel depreciation schedules, one for financial reporting and one for tax, reconciled each period. Errors here don’t just create audit friction; they can produce material misstatements in the deferred tax accounts that draw scrutiny from external auditors and tax authorities.