Tenant Improvements: Considering the Tax Implications

Improvements to a rental property on behalf of a tenant are often key issues when negotiating a lease. Who pays for the modifications can have significant tax implications in terms of which party can take depreciation deductions or expense the costs of the improvements, can create taxable income, or an intangible asset. With this in mind, tenants and landlords should understand the tax treatment of tenant improvements and consider how different lease structures could minimize the tax impact.

Tenant Improvements

Tenant improvements, also known as leasehold improvements, are changes to a rental property made for a specific tenant. These changes can include such things as painting, carpeting, and interior build-outs. For tax purposes, tenant improvements on nonresidential property placed in service in 2018 or later are considered “qualified improvement property” (QIP) subject to 15-year depreciation under MACRS and eligible for first-year bonus depreciation.

In order to take a deduction for depreciation, a taxpayer must own a depreciable interest in the property. In determining who has this interest, the IRS considers several factors, including the intension of the parties, who holds legal title, who paid for the improvements, the right of possession, who pays the property taxes and insurance, and who has the risk of loss. Depending on these factors, both a tenant and a landlord could have a depreciable interest in the property and be entitled to cost recovery for the improvements.

Tenant Improvement Funding Options

In the simplest situation, a landlord pays for tenant improvements and receives a depreciable interest in the property. Likewise, a tenant could also pay for the improvements and receive a depreciable interest. This becomes more complicated, however, when the parties fund the improvements through different lease structures that bring varied tax consequences. Some ways in which parties could structure a lease around tenant improvements include:

• Landlord pays tenant: A landlord could provide a tenant with cash to pay for the improvements.
• Rent concessions: In this funding model, a tenant could pay for the improvements and then reduce its rent payments to the landlord by the amount of the tenant’s expenditures.
• Reimbursement: In the reversal of a rent concession, a tenant could reimburse the landlord for the improvements in lieu of paying rent.
• Funding limits: A landlord could also pay for a certain amount of improvements and require the tenant to pay for improvements in excess of that limit.

Each option has differing tax implications to the landlord and tenant. There is also a statutory exclusion under IRC Section 110 in instances where the tenant would have taxable income under the arrangement if certain provisions are met.

Disposal or Abandoned

There are also tax implications when tenant improvements are disposed of or abandoned at the expiration of the lease. This usually occurs when the improvements are specific to the tenant and do not have any residual value.

Structuring the Lease

When both the landlord and the tenant are paying for the improvements, both parties have tax consequences, and the parties should agree to which party has the depreciable interest in which items. To do this, they should consider the various ways in which parties could structure the lease around funding these improvements and understand the tax consequences of each option. This analysis could help optimize the tax impact of the lease for both parties.

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