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March 29, 2022

Tax Impacts of Leasehold Improvements: What Landlords And Tenants Need To Be Aware Of

Landlords and tenants entering into lease agreements need to be mindful of who will be paying for any leasehold improvements to the property. Leasehold improvements are improvements to a rental property to fit the needs of a specific tenant. The improvements can be paid for by either the landlord or tenant, but how the improvements are paid for can impact the after-tax cash flow of the landlord and tenant.

Typically, leasehold improvements are to be depreciated over the remaining economic life of the building. However, the CARES Act introduced100% depreciation for Qualified Improvement Property (QIP) if placed in service from 2018 through 2022. Read more on eligibility for QIP.

Tailoring Lease Terms for Improvement Payments

The party managing the construction of the leasehold improvement does not affect who can deduct its cost. Only how the improvement is paid for determines who receives the tax benefit of the deduction. Below are the different scenarios of how the landlord and the tenant could structure their lease terms for paying for the improvements.

  • Landlord pays for the improvements: The landlord depreciates the improvements over the applicable depreciable life and there is no tax impact to the tenant.
  • Tenant pays for the improvements: There is no tax impact to the landlord as the tenant is the owner of the leasehold improvements. The tenant depreciates the improvements over the applicable depreciable life. Any remaining basis in the improvements upon departure can be written off by the tenant.
  • Landlord provides an allowance to the tenant: The landlord amortizes the allowance over the life of the lease with the lease term typically being shorter than the depreciable life of the improvements. The tenant reports the allowance as taxable income. The tenant is the owner of the improvements and depreciates the costs over the applicable depreciable life as well as writes off any remaining basis upon departure.
  • Tenant pays for the improvements and transfers ownership to the landlord at completion: The costs of the improvements become taxable income for the landlord upon transfer and the landlord depreciates the improvements over the applicable depreciable life. The tenant amortizes the improvement costs over the life of the lease.
  • Landlord reduces rent for the cost of the improvements paid by the tenant: The landlord receives benefit through a reduction of taxable rental income. The tenant is not allowed to deduct the cost of rent that is not paid to the landlord and is the owner of the improvements. The tenant depreciates the improvements over the applicable depreciable life as well as writes off any remaining basis upon departure. If the lease agreement is written to stipulate that the rent is being reduced in consideration for the tenant’s expenditures for improvements, then the landlord would have taxable income and a depreciable asset for the reduced rents.
  • Landlord loans the tenant money to pay for improvements: The landlord must report any interest income from the loan. The tenant is the owner of the improvements and depreciates the improvements over the applicable depreciable life as well as writes off any remaining basis upon departure. The tenant also deducts any interest paid to the landlord on the loan.

It is important for both tenants and landlords to understand how the terms of their lease and the payment for leasehold improvements will impact their tax situation. For more information on leasehold improvements, contact an Anders real estate advisor below.

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