To account for leasehold improvements, capitalize the total cost as a long-term asset, then run two parallel schedules against it: a book amortization schedule over the shorter of the improvement’s useful life or the remaining lease term, and a separate tax depreciation schedule that usually treats interior improvements as 15-year Qualified Improvement Property eligible for 100% bonus depreciation. The two schedules almost never match, and the gap between them is a normal deferred tax item, not an error.
What Qualifies as a Capitalizable Improvement
A leasehold improvement is a modification a tenant makes to leased space that becomes a permanent part of the building and typically stays with the property when the lease ends. You capitalize the cost if the expenditure substantially extends the property’s useful life, increases its value, or boosts its capacity. If none of those apply, expense it.
Built-in cabinetry, permanent interior walls, and specialized HVAC systems are classic capitalizable improvements. Routine maintenance, minor repairs, and anything movable — standard office furniture, area rugs, decorative items — are not. Most companies set an internal capitalization threshold, often $5,000 or $10,000, below which everything is expensed regardless of character. The threshold is a practical policy choice rather than a GAAP requirement, but auditors expect consistent application.
Sales tax on construction materials, delivery charges, and installation fees directly tied to the improvement all get rolled into the capitalized cost. If it was a necessary cost of getting the asset ready for use, it belongs in the asset basis.
Building the Capitalized Cost
During construction, costs flow into a temporary balance sheet account called Construction in Progress (CIP). Raw materials, contractor invoices, and equipment rentals are the direct pieces. Architectural and engineering fees, building permits, and project management costs belong in CIP as well.
Interest is the piece companies miss. If you took a construction loan or drew on a line of credit to fund the project, the interest incurred during the construction period must be capitalized into the asset rather than expensed as a financing charge.1FASB. Summary of Statement No. 34 – Capitalization of Interest Cost Capitalization stops when the improvement is substantially complete. Small projects with immaterial interest can skip this step.
When the improvement is ready for use, transfer the CIP balance to a permanent Leasehold Improvements account. Debit Leasehold Improvements, credit CIP. That transfer date is the date book amortization begins and the placed-in-service date for tax.
Keep every contractor invoice, permit receipt, and change order. The IRS requires that the cost basis, recovery method, and placed-in-service date be maintained as part of your permanent records.2Internal Revenue Service. Instructions for Form 4562
Tenant Improvement Allowances
Many commercial leases include a tenant improvement allowance from the landlord. Under ASC 842, a TIA is a lease incentive, not income. The allowance reduces your right-of-use asset on the balance sheet, while the improvement itself is recorded separately in property, plant, and equipment at its full cost.
If the build-out costs $200,000 and the landlord provides a $75,000 TIA, record a $200,000 leasehold improvement asset and reduce the ROU asset by $75,000. If the landlord funds the improvements entirely, you have no capitalized cost and no amortization expense; the landlord owns the improvement from day one.
Book Amortization: The Shorter-Of Rule
Under ASC 842-20-35-12, you amortize a leasehold improvement over the shorter of its estimated useful life or the remaining lease term. There is no point spreading cost over 15 years if only 7 years of lease term remain and you have no right to stay beyond that.
Remaining lease term includes any renewal options you are reasonably certain to exercise. That phrase has real teeth. A renewal counts when the economic incentive is compelling: a below-market renewal rate, significant improvements that would be forfeited, or relocation costs that make leaving impractical. A vague intent to probably renew does not meet the threshold.
There is one exception. If the lease transfers ownership of the building to you, or you are reasonably certain to exercise a purchase option, amortize over the full useful life instead. This rarely applies to standard commercial leases.
Worked Example
Spend $150,000 on permanent interior buildout with a 15-year physical useful life. Your lease has 7 years remaining, no reasonably certain renewal. The amortization period is 7 years. Straight-line amortization is $21,429 per year ($150,000 ÷ 7), or $1,786 per month. Each month, debit amortization expense and credit accumulated amortization.
Flip it. Same improvement, but a 5-year useful life and 10 years left on the lease. The amortization period is 5 years. The physical life is a ceiling, even when the lease is longer.
Tax Depreciation Runs on Its Own Track
Book amortization and tax depreciation follow different rules, different timelines, and different recovery periods. Keeping them straight is tedious, and getting it wrong creates problems in both directions: overpaying tax, or misstating the tax provision.
Qualified Improvement Property
Most interior improvements to nonresidential buildings qualify as Qualified Improvement Property. QIP covers any improvement to the interior of a nonresidential building placed in service after the building itself was originally placed in service.3Internal Revenue Service. Publication 946 (2025), How To Depreciate Property The MACRS recovery period for QIP is 15 years.
Three categories are excluded from QIP and instead depreciate over 39 years straight-line as nonresidential real property:3Internal Revenue Service. Publication 946 (2025), How To Depreciate Property
- Building enlargements that increase total square footage.
- Elevators and escalators.
- Internal structural framework: load-bearing walls, columns, floors, and ceilings that define the building’s skeleton.
Mixed projects require allocation. A $500,000 renovation that includes $80,000 in structural steel modifications means $420,000 on a 15-year schedule and $80,000 on a 39-year schedule.
The Mid-Month Convention
Nonresidential real property uses the mid-month convention under MACRS. Regardless of the actual day placed in service, the IRS treats it as placed in service at the midpoint of that month.3Internal Revenue Service. Publication 946 (2025), How To Depreciate Property An improvement placed in service on March 3 gets the same first-year depreciation as one placed in service on March 28.
Bonus Depreciation
The One Big Beautiful Bill Act restored 100% first-year bonus depreciation permanently for qualifying property acquired after January 19, 2025.4Internal Revenue Service. Treasury, IRS Issue Guidance on the Additional First Year Depreciation Deduction Amended as Part of the One Big Beautiful Bill QIP with a 15-year recovery period qualifies, meaning you can deduct the entire cost of eligible interior improvements in the year they are placed in service.5Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System
A $300,000 improvement placed in service during 2026 can be deducted in full for tax purposes in year one while still amortizing over the lease term for book purposes. The result is a temporary difference that generates a deferred tax liability.
Section 179 as an Alternative
The Section 179 election lets you expense qualifying property immediately. For 2026, the maximum deduction is $2,560,000, phasing out dollar-for-dollar once total qualifying property placed in service exceeds $4,090,000.6Internal Revenue Service. Revenue Procedure 2025-32 Certain nonresidential real property improvements qualify, including roofs, HVAC systems, fire protection, and security systems. With 100% bonus back, Section 179 is less critical for most QIP, but it stays useful for property that does not qualify for bonus depreciation.
All tax depreciation for leasehold improvements is reported on IRS Form 4562.7IRS. 2025 Instructions for Form 4562 – Depreciation and Amortization
Restoration Costs at Lease End
Many leases require the tenant to remove improvements and restore the space at lease expiration. That obligation creates an asset retirement obligation under ASC 410-20, not a lease payment under ASC 842.
At lease signing, estimate the future cost of removal, discount it to present value, and record it as both a liability and an addition to the improvement’s capitalized cost. The added cost amortizes over the same shorter-of period as the rest of the improvement. Each period, accrete the liability toward the undiscounted amount by recognizing accretion expense. Record the ARO when you make the improvement, not when you tear it out.
Adjustments After the Initial Setup
Early Termination
When a lease ends before its scheduled expiration, any remaining book value of the improvement must be written off immediately as a loss on disposal. Spent $100,000, amortized $60,000, and the lease terminates? The remaining $40,000 hits the income statement in that period. There is no option to spread it.
Renewal
A formal renewal changes the denominator. Once the renewal is exercised, spread the improvement’s current book value over the new remaining term, still subject to the shorter-of test against remaining useful life. Book value of $40,000 with a 5-year renewal (and asset life beyond 5 years) means $8,000 per year going forward. This is a prospective change in accounting estimate; prior periods stay untouched.
Impairment
Leasehold improvements are long-lived assets subject to impairment testing under ASC 360-10. There is no annual schedule. Testing is triggered by events or changes in circumstances that suggest the carrying amount may not be recoverable: a decision to relocate before lease end, a significant decline in the business operating from that space, or a broader restructuring that calls the space’s continued use into question.
When a trigger occurs, compare undiscounted future cash flows expected from the asset to its carrying amount. If cash flows fall short, write the asset down to fair value and recognize the difference as an impairment loss. The triggering event is the decision or indication of vacating, not the eventual termination itself. Waiting until you hand back the keys means prior financial statements carried an overstated asset.