Leasehold Improvements Paid by Tenant: Accounting and QIP Tax Rules

When a tenant pays to build out a leased space, the cost is capitalized as a fixed asset called leasehold improvements and then amortized on a straight-line basis over the shorter of the improvement’s useful life or the remaining lease term under ASC 842-20-35-12.¹ For federal income tax, most interior work qualifies as Qualified Improvement Property with a 15-year recovery period and is eligible for full first-year expensing, which usually produces a large timing gap between the book and tax numbers.

What Qualifies as a Leasehold Improvement

A leasehold improvement is a permanent alteration a tenant makes to a leased space that cannot be removed without causing real damage. Custom interior walls, specialized HVAC ductwork, built-in reception counters, and laboratory plumbing all fit. Routine maintenance like repainting or patching drywall does not; those costs are expensed as incurred.

To be capitalized, the expenditure has to add meaningful value, significantly extend the property’s useful life, or adapt the space for a new purpose. A $75,000 clean-room build-out clearly qualifies. A $900 door repair does not.

Trade Fixtures Are a Different Category

Removable business equipment the tenant installs (freestanding shelving, display cases, specialized machinery) is a trade fixture, not a leasehold improvement. Trade fixtures stay the tenant’s personal property and can be taken when the lease ends. Built-in shelving bolted into the walls goes the other way: it’s a leasehold improvement that reverts to the landlord. The test is whether removal would cause meaningful damage. If yes, capitalize as a leasehold improvement. If no, depreciate under the rules for that asset category.

Recording the Initial Cost

The full cost lands on the balance sheet as a non-current asset within Property, Plant, and Equipment, recorded separately from the right-of-use asset you recognize for the lease itself.¹ The entry debits Leasehold Improvements and credits Cash or Accounts Payable for the total construction cost.

The capitalized amount includes everything needed to get the improvement ready for use: materials, labor, architectural and engineering fees, and permits. Professional design fees on commercial build-outs commonly run 5% to 20% of total project cost, so this can be a meaningful piece of the number sitting on your books.

Tenant Improvement Allowances

Landlords often offer a tenant improvement allowance (TIA) to offset build-out costs. When the tenant owns and controls the resulting improvement, you still capitalize the full cost of the build-out. The TIA is treated as a lease incentive and is not netted against the leasehold improvement on the balance sheet. It’s recorded separately and amortized as a reduction to lease expense over the lease term. That keeps the true cost of the asset visible instead of buried in a net figure.

If the landlord retains ownership of the improvements and simply lets the tenant use them, the tenant records nothing as a leasehold improvement. The landlord capitalizes and depreciates the asset on its own books.

How Long to Amortize

ASC 842-20-35-12 requires amortization over the shorter of the improvement’s useful life or the remaining lease term.¹ The lease term for this purpose includes any renewal periods the tenant is “reasonably certain” to exercise.²

“Reasonably certain” is a high bar. You need real economic reasons pointing toward renewal: high relocation costs, expensive specialized improvements that only work in the current space, or contractual penalties for walking away. A vague intention to probably stay does not clear the threshold.

Two examples show the mechanics:

Useful life longer than the lease. An improvement has a 20-year useful life but only 5 years remain on the lease with no reasonably certain renewals. The amortization period is 5 years.
Lease longer than the useful life. A specialized exhaust system has an 8-year useful life and 10 years remain on the lease. The amortization period is 8 years, because the asset will be used up before the lease ends.

One exception: if the lease transfers ownership of the building to the tenant, or the tenant is reasonably certain to exercise a purchase option, the improvement is amortized over its full useful life regardless of the lease term.¹

For improvements installed partway through a lease, most companies apply the shorter-of rule to the useful life or the remaining lease term (including reasonably certain renewals) measured from the date the improvement is placed in service.³

Booking the Amortization

Straight-line amortization is used in nearly all cases for financial reporting. Divide the capitalized cost by the amortization period. Salvage value is zero, because the improvements revert to the landlord at lease end.

A tenant capitalizes $180,000 in improvements with a six-year amortization period. Annual amortization is $30,000. Each year, the entry debits Amortization Expense $30,000 and credits Accumulated Amortization–Leasehold Improvements $30,000. After two years the balance sheet shows the $180,000 cost against $60,000 in accumulated amortization, for a net book value of $120,000.

The amortization clock starts when the improvement is substantially complete and ready for its intended use, not when construction begins. The expense is non-cash and typically shows up in selling, general, and administrative costs or in cost of goods sold, depending on the function of the space.

Tax Treatment: QIP, Bonus Depreciation, and Section 179

Tax rules diverge sharply from financial reporting, and the gap creates timing differences you need to track for deferred taxes.

The default recovery period for nonresidential real property improvements is 39 years under MACRS.⁴ Almost no tenant uses it, because most interior work qualifies for much better treatment as Qualified Improvement Property.

Qualified Improvement Property

QIP is any improvement a taxpayer makes to the interior of an existing nonresidential building, with three exclusions: building enlargements, elevators and escalators, and changes to the internal structural framework.⁴ Most tenant build-outs involving new walls, flooring, ceilings, wiring, and plumbing meet this definition easily. QIP has a 15-year MACRS recovery period.

The Tax Cuts and Jobs Act of 2017 intended to create the 15-year QIP period but a drafting error left QIP classified as 39-year property. The CARES Act of 2020 corrected the mistake retroactively for improvements placed in service after 2017.⁴

100% Bonus Depreciation

QIP is eligible for bonus depreciation, which allows a business to deduct the entire cost in the year the property is placed in service. The One Big Beautiful Bill restored permanent 100% bonus depreciation for qualifying property acquired after January 19, 2025.⁵ A tenant that spends $500,000 on qualifying interior work in 2026 can deduct the full amount that year rather than spreading it over 15.

Section 179 Expensing

QIP is also eligible for Section 179 expensing.⁶ For 2026, the maximum Section 179 deduction is $2,560,000, with the phase-out beginning when total qualifying property placed in service exceeds $4,090,000.⁷ With permanent 100% bonus depreciation back, the two options overlap for most tenants, though Section 179 remains useful in specific situations. Depreciation and Section 179 amounts are reported on Form 4562.⁸

The Book-Tax Gap

Amortizing an improvement over six years for financial reporting while deducting 100% in year one for tax creates a large temporary book-tax difference. It’s tracked as a deferred tax liability and reverses gradually as book amortization continues in years when no tax deduction remains.

When Things Change: Impairment, Early Exit, and Restoration

Impairment

Leasehold improvements are long-lived assets under the impairment framework in ASC 360-10-35. There’s no fixed schedule; a recoverability test is triggered by events suggesting the carrying value may not be recoverable. Common triggers include a sharp drop in the asset’s market value, a significant change in how the space is used, physical damage, sustained operating losses at the location, or a decision to vacate or sublease well before the lease expires. When a trigger is present, compare the carrying value to undiscounted future cash flows. If carrying value is higher, write the asset down to fair value and recognize the difference as an impairment loss.

Lease Termination and Disposal

When a lease ends or the tenant vacates early, any remaining unamortized balance comes off the balance sheet immediately. You cannot keep amortizing an improvement for a space you no longer occupy.

Take the earlier $180,000 improvement. After four years of a six-year schedule, accumulated amortization is $120,000 and unamortized book value is $60,000. The write-off entry debits Loss on Abandonment $60,000, debits Accumulated Amortization $120,000, and credits Leasehold Improvements $180,000. The $60,000 loss hits the income statement in the period the lease ends.

If the improvement is sold to the landlord or an incoming tenant, the gain or loss equals sale proceeds minus net book value. Selling that $60,000 asset for $15,000 produces a $45,000 loss; selling it for $80,000 produces a $20,000 gain. For tax, claiming an abandonment loss requires permanent relinquishment, usually shown by the lease formally ending and the premises being surrendered.

Restoration Obligations

Many commercial leases require the tenant to remove improvements and return the space to its original condition. When that clause exists, the tenant has an asset retirement obligation under ASC 410-20, and it must be recognized at the start of the lease rather than when the bill comes due.

To record the ARO, estimate the future removal and restoration cost, discount it to present value, and book a liability. The offsetting debit increases the carrying value of the leasehold improvement asset. Over the life of the lease, the liability accretes toward its undiscounted amount through periodic interest expense, and the added asset cost is amortized alongside the rest of the improvement. Restoration costs then hit the income statement gradually instead of landing all at once at lease end.

1
Deloitte Accounting Research Tool. Deloitte Roadmap Leases – Chapter 8 Lessee Accounting
2
Deloitte Accounting Research Tool. Deloitte Roadmap Leases – Section 5.4 Reassessment of Lease Term
3
Financial Accounting Standards Board. EITF Issue No. 05-6 – Determining the Amortization Period for Leasehold Improvements
4
Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System
5
Internal Revenue Service. Treasury, IRS Issue Guidance on the Additional First Year Depreciation Deduction Amended as Part of the One Big Beautiful Bill
6
Internal Revenue Service. Publication 946 – How To Depreciate Property
7
Office of the Law Revision Counsel. 26 USC 179 – Election To Expense Certain Depreciable Business Assets
8
Internal Revenue Service. About Form 4562, Depreciation and Amortization