Capitalize a leasehold improvement whenever you, as the tenant, pay for a change that permanently attaches to the leased space and either betters the property, restores it, or adapts it to a new use. The cost then comes off your books through depreciation for tax purposes and amortization for financial reporting, on two different schedules that rarely match. Under current federal rules, most tenant build-outs to commercial interiors are qualified improvement property with a 15-year tax life, and improvements acquired after January 19, 2025 qualify for 100% bonus depreciation in the first year.
The Repair-or-Improvement Test
The threshold question is whether the work is an improvement at all. The IRS tangible property regulations require you to capitalize a cost only if it produces a betterment, a restoration, or an adaptation of the property. Fail all three, and the expenditure is a current-year repair deduction.1Internal Revenue Service. Tangible Property Final Regulations
- Betterment: fixing a pre-existing defect, adding to the property’s size or capacity, or materially increasing its productivity, efficiency, or output.
- Restoration: replacing a major component or substantial structural part, returning a non-functional property to working condition, or rebuilding it to like-new condition after its class life ends.
- Adaptation: converting the property to a use fundamentally different from its original purpose when first placed in service.
Building new interior walls, installing a dedicated HVAC system, or adding built-in cabinetry each satisfies at least one test and must be capitalized. Repainting an office, patching drywall, or replacing worn carpet generally does not, because those activities keep the property in its current condition without adding value or capacity. Capitalizing a true repair overstates your balance sheet; expensing a true improvement understates it and accelerates deductions you are not entitled to.
The De Minimis Safe Harbor
Even something that meets an improvement test can be deducted immediately if it falls under the de minimis dollar thresholds. A business with an applicable financial statement (an audited set of financials, an SEC filing, or certain other specified statements) can expense items costing up to $5,000 per invoice or per item. A business without one can expense items up to $2,500 per invoice or per item.1Internal Revenue Service. Tangible Property Final Regulations
You elect the safe harbor by attaching a statement to your return each year, and it then applies to every qualifying expenditure for that year. You cannot use it for some invoices and skip others. For a build-out with dozens of small line items, the election eliminates a significant amount of tracking and scheduling.
What Actually Counts as a Leasehold Improvement
A leasehold improvement is a modification to the leased space that permanently attaches to the building and reverts to the landlord when the lease ends. The simple test: anything you cannot take with you when you move out. Those items become fixtures and go on the tenant’s books as capitalized assets.
Movable property the tenant owns independently, such as freestanding furniture, computer equipment, or modular shelving, is not a leasehold improvement. Those assets are capitalized separately under their own MACRS class lives, typically five or seven years depending on the asset.2Internal Revenue Service. Publication 946 – How to Depreciate Property
When you total up the capitalized cost, include everything directly tied to the physical work: architectural and engineering fees, permit costs, construction labor, and materials. Soft costs are part of the basis and recover through depreciation alongside the hard construction costs.
How Capitalized Improvements Recover for Tax
Most tenant improvements to commercial interiors qualify as qualified improvement property. QIP is any improvement a taxpayer makes to the interior of a nonresidential building, placed in service after the building itself was first placed in service.3Legal Information Institute. 26 U.S. Code 168(e)(6) – Qualified Improvement Property Definition Four categories are excluded:
- Enlargement of the building’s footprint or volume
- Elevators and escalators
- The building’s internal structural framework (load-bearing walls, columns, girders, beams, and trusses)
- Improvements to residential rental property
QIP has a 15-year MACRS recovery period, well short of the 39 years that applies to nonresidential real property generally.4Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System Anything that falls outside the QIP definition still gets capitalized, but it recovers over 39 years straight-line.
Bonus Depreciation
The One Big Beautiful Bill Act permanently restored 100% first-year bonus depreciation for qualifying property acquired after January 19, 2025. Because QIP has a 15-year life, well under the 20-year ceiling for bonus-eligible property, a tenant placing qualifying improvements in service can deduct the entire capitalized cost in the first year.5Internal Revenue Service. Treasury, IRS Issue Guidance on the Additional First Year Depreciation Deduction The 100% rate is now permanent with no scheduled expiration.6Internal Revenue Service. One, Big, Beautiful Bill Provisions
Section 179
As an alternative, you can elect to expense QIP under Section 179. The OBBBA roughly doubled the prior ceilings: the base deduction limit is $2,500,000, with a phase-out beginning when total qualifying property placed in service during the year exceeds $4,000,000.7Office of the Law Revision Counsel. 26 U.S. Code 179 – Election to Expense Certain Depreciable Business Assets Both figures adjust annually for inflation after 2025; for 2026, the deduction limit is approximately $2,560,000 with a phase-out near $4,090,000.
Section 179 caps the deduction at your taxable income from active trades or businesses for the year, with any excess carried forward. Bonus depreciation has no such cap and can generate or increase a net operating loss, which is what typically makes it the more flexible choice for a business with thin margins.
The Different Schedule for GAAP
Financial reporting uses a separate clock. Under ASC 842, leasehold improvements are amortized over the shorter of the improvement’s useful life or the remaining lease term. If the lease transfers ownership to you, or you are reasonably certain to exercise a purchase option, you amortize over the full useful life instead.
“Remaining lease term” is not just the years left on the current contract. ASC 842 defines the lease term as the noncancelable period plus any renewal option periods the tenant is reasonably certain to exercise.8Deloitte Accounting Research Tool. Deloitte’s Roadmap: Leases – 5.2 Lease Term Reasonable certainty is a high bar: it takes a strong economic incentive to renew, not just the contractual right. Significant leasehold improvements, favorable below-market renewal rates, or a location critical to the business all push toward reasonable certainty. Making a substantial investment in improvements can itself be evidence supporting reasonable certainty, because walking away from that investment would be economically irrational.
The practical result is that the tax and GAAP numbers rarely match. A $200,000 improvement on a seven-year lease with no reasonably certain renewal amortizes over seven years for GAAP, but recovers over 15 years for tax (unless you elect bonus or Section 179 to accelerate it). The gap creates a book-tax difference you have to track.9Internal Revenue Service. About Form 4562, Depreciation and Amortization
When the Landlord Pays: Tenant Improvement Allowances
If the landlord funds the build-out through a construction allowance, the capitalization analysis can flip entirely. Under IRC Section 110, a tenant excludes a construction allowance from gross income if three conditions are met: the lease is for retail space, the lease term is 15 years or less, and the allowance funds permanent real property improvements that revert to the landlord at lease end.10Office of the Law Revision Counsel. 26 U.S. Code 110 – Qualified Lessee Construction Allowances for Short-Term Leases
When Section 110 applies, the landlord is treated as the tax owner of the improvements. You do not report the allowance as income, and you have no depreciable basis in the improvements it funded. The exclusion is limited to what you actually spend on qualifying work, so any excess allowance is taxable income. The lease itself must explicitly state that the allowance is for constructing or improving qualified long-term real property at the leased space; vague language does not qualify. If Section 110 does not apply, such as when the space is office rather than retail or the lease exceeds 15 years, the allowance is generally treated as taxable rent, and you capitalize and depreciate the improvements yourself under the standard QIP rules.
What Happens When the Lease Ends or Changes
Early Termination
Vacate before the lease expires and any unamortized balance has to be written off at that point. For financial reporting, the remaining book value hits the income statement as a disposal loss in the period the lease ends. For tax, Treasury regulations on MACRS dispositions let you deduct the remaining tax basis as an ordinary loss in the year of disposition, reported on Form 4562.11eCFR. 26 CFR 1.168(i)-8 – Dispositions of MACRS Property
Renewal or Extension
Extending the lease does not reset the clock. The remaining unamortized balance is spread over the new remaining period, using the shorter of the improvement’s remaining useful life or the new extended term. The adjustment is prospective, so prior periods are not restated. Annual expense drops because the same unamortized cost is now divided across a longer timeline.
The Cost of Getting It Wrong
Misclassifying an improvement as a repair (or a repair as an improvement) produces a tax underpayment or overpayment the IRS can flag on audit. The accuracy-related penalty under IRC Section 6662 is 20% of the underpayment when the error results from negligence or a substantial understatement of income, and 40% for gross valuation misstatements. The penalty does not apply if you can show reasonable cause and good faith, and the practical way to do that is contemporaneous documentation: invoices, the contractor’s scope of work, and a written analysis applying the betterment, restoration, and adaptation tests at the time the money is spent rather than years later when an examiner asks.