Do Leasehold Improvements Qualify for Bonus Depreciation?

Leasehold improvements can qualify for bonus depreciation, but only if they meet the tax code’s definition of Qualified Improvement Property (QIP). For QIP acquired after January 19, 2025, the One Big Beautiful Bill Act restored 100% first-year bonus depreciation.¹ Improvements acquired under a written binding contract signed before that date stay on the Tax Cuts and Jobs Act phase-down schedule, which drops to 20% for property placed in service in 2026.² Whether your build-out lands on the 100% track or the 20% track can move a six-figure deduction, so the details below deserve careful attention.

What Qualifies as Qualified Improvement Property

QIP is any improvement a taxpayer makes to the interior of an existing nonresidential building, placed in service after the building itself was first placed in service.³ That last piece is the one people miss. If a landlord builds out custom interiors as part of the original construction, before the building is first placed in service, those costs are part of the building itself and depreciate over 39 years. QIP is a 15-year asset, which is what makes it eligible for bonus depreciation in the first place. Bonus depreciation requires a MACRS recovery period of 20 years or less, and the 15-year classification clears that threshold.

Typical work that fits inside QIP: partition walls, dropped ceilings, interior lighting, flooring, and electrical or plumbing work tied to how the tenant will use the space.

What the Statute Excludes

Three categories are carved out of QIP even when the work happens inside the building:

Building enlargements. Adding square footage to the structure never qualifies.
Elevators and escalators. Vertical transportation equipment is out regardless of where it sits.
Internal structural framework. Load-bearing walls, columns, and similar elements holding the building up don’t count.

Costs pushed into these buckets default to 39-year straight-line depreciation. On a $200,000 structural addition, that works out to roughly $5,128 a year, which offers little help in the early years of a project.²

The Two Rates in Play for 2026

OBBBA, signed in 2025, permanently restored the 100% bonus depreciation rate for qualifying business property acquired after January 19, 2025.¹ Everything acquired on or before that date stays on the TCJA phase-down: 80% for 2023, 60% for 2024, 40% for 2025, and 20% for 2026.²

Acquisition is measured by the written binding contract date, not the placed-in-service date. If you signed a construction contract in late 2024 and the improvements are finished in 2026, you get the 20% phase-down rate, not the restored 100%. If the contract is signed in 2025 after January 19 and the work wraps in 2026, you get 100%.

The IRS has issued interim guidance letting taxpayers rely on the existing depreciation framework with updated dates and percentages under the new law.⁴ Proposed regulations are expected but not yet final, so the rules on eligible property types, used-property purchases, and election mechanics carry forward.

When the Improvement Is Placed in Service

Property is placed in service on the date it’s ready and available for its intended use. For a build-out, that’s when the space is finished and the tenant can operate in it, not when the lease is signed and not when construction begins. Keep the paperwork that fixes the date in your permanent records: certificate of occupancy, contractor completion letter, or inspection sign-off.⁵

The placed-in-service date determines the tax year of the deduction. The acquisition date determines the rate. Both matter.

Used Property and Related-Party Rules

Bonus depreciation applies to both new improvements you construct and used property you acquire, with one condition: the property cannot have been previously used by you or a related party. This blocks a business from shuffling improvements between affiliated entities and claiming a fresh deduction on the same asset.

Related parties under the tax code include family members, corporations sharing more than 50% common ownership, and partnerships where the same people control both the partnership and another entity.⁶ This trips up tenant-landlord arrangements where the same owners sit on both sides of the lease. If the tenant improves a building owned by a related landlord, the QIP is likely ineligible for bonus depreciation.

The Section 163(j) Trade-Off for Real Estate Businesses

Businesses with average annual gross receipts above an inflation-adjusted threshold face limits on business interest deductions. For 2025 that threshold is $31 million; the 2026 figure will be slightly higher based on inflation.⁷

Real property trades or businesses can elect out of the interest limitation. The cost of that election is high: it forces all nonresidential real property, residential rental property, and QIP onto the Alternative Depreciation System.⁸ Under ADS, QIP has a 20-year recovery period, nonresidential real property stretches to 40 years, and none of it qualifies for bonus depreciation. If you carry significant debt and are considering the election, run the numbers both ways before filing. The interest you preserve can be worth less than the bonus depreciation you give up.

Section 179 as an Alternative

QIP is also eligible for immediate expensing under Section 179.⁸ For tax years beginning in 2026, the maximum Section 179 deduction is $2,560,000, with a dollar-for-dollar phase-out once total qualifying property placed in service exceeds $4,090,000.

Section 179 comes with restrictions bonus depreciation doesn’t have. The deduction cannot exceed your taxable income from all active trades or businesses, so it cannot create or increase a net operating loss. The property must be purchased rather than received by gift or inheritance. And if the property is used for both business and personal purposes, business use must exceed 50% in the year it’s placed in service.

Section 179 is most useful in two situations: when you’re on the pre-January 20, 2025 acquisition track and want to accelerate more than the 20% bonus allows, or when you want to expense certain non-QIP improvements to a nonresidential building that Section 179 does allow, including roofs, HVAC systems, fire protection, and security systems.

Why a Cost Segregation Study Is Worth Considering

A typical build-out doesn’t split cleanly into QIP and non-QIP. A $500,000 project might include partition walls (QIP), an HVAC system (Section 179 eligible but not QIP), structural reinforcement (39-year), and fixtures that could fit into 5-year or 7-year classes rather than 15-year QIP.

A cost segregation study sorts the components into their correct categories. Specialized electrical wiring, removable partitions, task lighting, and plumbing connections tied to specific equipment often land in 5-year or 7-year buckets, which also qualify for bonus depreciation. Exterior site work like parking areas and landscaping frequently falls into 15-year land improvements. Reclassifying even 20% of a project’s cost out of 39-year property changes the first-year deduction materially. With 100% bonus depreciation restored for post-January 19, 2025 acquisitions, the payoff on a thorough study is stronger than it’s been since 2022. The study costs money, so the economics work best on projects above roughly $500,000 to $1,000,000, though the mix of components can justify a study at lower amounts.

State Conformity

A federal bonus depreciation deduction doesn’t automatically produce a state deduction. Many states decouple from federal bonus depreciation entirely or limit it to a fraction of the federal amount. In decoupled states, you add the bonus deduction back on your state return and then depreciate the property over its standard state recovery period, sometimes with the disallowed amount spread over future state returns. A $1 million federal QIP deduction can produce zero state benefit in the current year. Conformity rules change often, and states may respond further to OBBBA, so check your state’s current position before filing.

Leaving the Space Before the Improvements Are Fully Depreciated

If you terminate the lease and abandon improvements with basis still on the books, the remaining amount isn’t lost.³ Improvements abandoned at lease termination are treated as disposed of, and the tenant who built them can claim the remaining adjusted basis as a loss, provided the abandonment is genuine and you can’t remove the improvements. A lease buyout where the landlord compensates you for the build-out reduces or eliminates the loss by the amount received. And if you fully deducted the improvements through bonus depreciation the year they were placed in service, there’s no remaining basis to claim, which is one more argument for taking the deduction as early as the rules allow.

1
Internal Revenue Service. One, Big, Beautiful Bill Provisions
2
Internal Revenue Service. Tax Cuts and Jobs Act: A Comparison for Businesses
3
Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System
4
Internal Revenue Service. Treasury, IRS Issue Guidance on Special Depreciation Allowance for Qualified Production Property
5
Internal Revenue Service. Instructions for Form 4562
6
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
7
Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
8
Internal Revenue Service. Publication 946 (2025), How To Depreciate Property