Architect fees paid for a leasehold improvement have to be capitalized into the total project cost, not deducted in the year you pay them. Federal tax law treats design and engineering work the same as the drywall and flooring that follow: all of it is part of producing a long-lived asset. You recover the combined cost through depreciation, generally over 15 years, with the option to accelerate part of it using Section 179 or bonus depreciation in the first year the improvement is placed in service.
Why the Design Fees Get Folded Into the Project Cost
IRC Section 263 blocks an immediate deduction for any amount spent on “permanent improvements or betterments made to increase the value of any property.”1Office of the Law Revision Counsel. 26 U.S.C. 263 – Capital Expenditures The tangible property regulations reinforce this by requiring capitalization of any “betterment,” which includes any cost reasonably expected to increase the productivity, efficiency, or output of the property.2eCFR. 26 CFR 1.263(a)-3 – Amounts Paid to Improve Tangible Property Redesigning a commercial space for a new use clears that bar.
Section 263A then pulls in both the direct and allocable indirect costs of producing property.3Office of the Law Revision Counsel. 26 U.S. Code 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses Architect and engineering fees are direct production costs, so they get absorbed into the depreciable basis of the finished improvement. A $50,000 design fee on a $450,000 build-out creates one depreciable asset with a $500,000 basis. There is no separate schedule for the design work.
When the Clock Starts
Capitalization applies when the cost is incurred, but depreciation does not begin until the improvement is “placed in service,” meaning it is available and ready for its intended use. If you pay an architect $40,000 for plans in March and the build-out finishes in November, that $40,000 sits on your books as an asset-in-progress until construction wraps.
This gap matters when a project straddles two tax years. Design fees paid in December of one year yield no deduction that year if the space is not open for business until the next. Plan around the placed-in-service date, not the invoice date.
Does the Improvement Qualify as QIP?
The 15-year recovery period only applies if the work meets the statutory definition of Qualified Improvement Property. QIP is any improvement to the interior of nonresidential real property that is placed in service after the building itself was first placed in service.4Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System Most standard tenant build-outs fit: reconfigured layouts, new flooring, upgraded lighting, retail fit-outs.
Four categories of interior work are carved out of QIP:
- Enlargements that add square footage to the structure.
- Elevators and escalators, which are treated as separate building components.
- The building’s internal structural framework, including load-bearing walls and columns.
- Work done before the building is first placed in service, since there is no existing building to improve.
If the improvement falls outside QIP, it is classified as nonresidential real property with a 39-year recovery period. The difference between 15 and 39 years is large enough that it is worth confirming the classification with your tax advisor before finalizing the plans.
Recovery Options for 2026
QIP is assigned to the 15-year MACRS class by statute, and that period applies regardless of your actual lease term.4Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System A seven-year lease still produces a 15-year depreciable asset under the standard schedule. The architect fees ride along inside that single basis.
Bonus Depreciation
Bonus depreciation lets you deduct a percentage of the asset’s cost in the first year. It has been phasing down since 2023. For property placed in service in 2026, the first-year bonus is 20% of cost. Under current law, bonus depreciation drops to zero after 2026.
On a $500,000 QIP project placed in service in 2026, including $50,000 in capitalized architect fees, the 20% bonus produces a $100,000 first-year deduction. The remaining $400,000 depreciates over the 15-year MACRS schedule.
Section 179
With bonus depreciation this low, Section 179 has become the stronger first-year tool for many tenants. Section 179 lets you deduct the full cost of qualifying property in the year it is placed in service, subject to an annual cap. For 2025, the maximum Section 179 deduction is $1,250,000, with a phase-out that begins when total qualifying property placed in service exceeds $3,130,000.5Internal Revenue Service. Rev. Proc. 2024-40 The limits adjust for inflation, so 2026 thresholds will be modestly higher.
QIP is eligible for Section 179. A tenant with a $500,000 build-out (architect fees included) can potentially deduct the entire amount in year one, subject to the annual cap and to the rule that the deduction cannot exceed the business’s taxable income.
The two elections can be combined: apply Section 179 to part of the cost, take bonus depreciation on some of the remainder, and depreciate the rest over 15 years. For a larger project, working through the split with a tax advisor is worth the time.
If the Landlord Pays for Part of the Build-Out
Many commercial leases include a tenant improvement allowance. The tax treatment depends on the type of tenancy and how the lease is written.
For retail tenants with a lease of 15 years or less, IRC Section 110 provides a safe harbor. A cash allowance from the landlord for constructing or improving the retail space can be excluded from the tenant’s gross income, provided the funds are actually spent on qualified long-term real property that reverts to the landlord at lease end.6Office of the Law Revision Counsel. 26 USC 110 – Qualified Lessee Construction Allowances for Short-Term Leases The exclusion is capped at what you actually spend on qualifying property. A $200,000 allowance with only $150,000 spent on qualifying work yields a $150,000 exclusion.
The lease has to expressly state that the allowance is for constructing or improving qualified real property.7Internal Revenue Service. Revenue Ruling 2001-20 “Retail space” means property used for selling goods or services to the general public, and movable items like furniture or equipment do not count as qualified long-term real property.
Section 110 is narrow. If the lease runs longer than 15 years, or the space is not retail, the safe harbor does not apply, and the tax treatment turns on the economic substance of the arrangement. That is a separate analysis worth doing with counsel before signing, because the lease language can shift the outcome significantly.
If the Project Dies Before Construction
Sometimes you pay for plans and then cancel the project. In that case, the capitalization rule gives way to IRC Section 165, which allows a deduction for losses sustained in a trade or business.8Office of the Law Revision Counsel. 26 U.S. Code 165 – Losses
The IRS requires two things to claim an abandonment loss. You need a genuine intention to abandon the asset, and you need an affirmative act of abandonment, such as formally terminating the project and discarding the plans.9Internal Revenue Service. Rev. Rul. 2004-58 – Loss Deductions for Creative Property Holding the plans in case you revive the project later does not qualify. When both conditions are met, the capitalized architect fees come off the balance sheet as a loss in the year of abandonment.
If You Walk Away From the Improvement at Lease End
When the lease ends and you leave the improvements behind, the remaining undepreciated basis can be claimed as a deductible loss. The IRS instructions for Form 4797 direct taxpayers to report abandonment losses there.10Internal Revenue Service. Instructions for Form 4797 True abandonment means receiving nothing of value in exchange.
If you do receive compensation, whether cash, a rent credit, or any other consideration, it is a disposition rather than an abandonment. You calculate gain or loss against the remaining adjusted basis, and gain attributable to depreciation you previously claimed is subject to recapture. For QIP depreciated straight-line over 15 years, that recaptured gain is unrecaptured Section 1250 gain, taxed at a maximum federal rate of 25%.
The recapture exposure grows if you took bonus depreciation or Section 179 up front, because the accelerated deductions leave a lower adjusted basis and a larger potential gain on any buyout. Weigh the front-loaded deduction against how long you realistically expect to stay in the space and whether an early termination or landlord buyout is plausible.