# Leasehold Improvement: Definition, Accounting, and Examples

## What Is a Leasehold Improvement?

The term leasehold improvement refers to changes made to customize a rental [property](https://www.investopedia.com/terms/p/property.asp) to satisfy the particular needs of a specific tenant. These changes and alterations may include painting, installing partitions, changing the flooring, or putting in customized light fixtures. Improvements may be undertaken by the [landlord](https://www.investopedia.com/terms/l/landlord.asp) or the tenant and [may be paid by the tenant](https://www.investopedia.com/financial-edge/0411/7-homeowner-costs-renters-dont-pay.aspx).  

### Key Takeaways

*   A leasehold improvement is a change made to a rental property to customize it for the particular needs of a tenant.
*   Landlords may agree with these improvements for existing or new tenants.
*   Leasehold improvements may be done by the landlord or tenant.
*   Painting, installing partitions or customized light fixtures, and changing flooring are all leasehold improvements.
*   Enlargements to buildings, elevators and escalators, roofs, fire protection, alarm and security systems, and HVAC systems do not qualify as leasehold improvements.

![Leasehold Improvement](https://www.investopedia.com/thmb/lwF0mA--hfLL5HnKJdMKerxNSH8=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Leaseholdimprovement_final-8c173dabcc934342b2d2b1399b65675c.png)

*— Investopedia / Michela Buttignol*

## How Leasehold Improvements Work

Leasehold improvements are commonly referred to as tenant improvements or build-outs. These changes are generally made by landlords of [commercial properties](https://www.investopedia.com/terms/c/commercial-property.asp) and may be provided for an existing or new tenant. Any changes are tailored to the specific needs of a tenant and make the space more attractive and appealing to them.

Once the [lease](https://www.investopedia.com/terms/l/lease.asp) ends, the improvements generally belong to the landlord, unless otherwise specified in the agreement. If the tenant can take them, they must remove them without any damage to the property.

Certain criteria must be met for changes to qualify as leasehold improvements. Changes must be made to the interior to accommodate the specific needs of the [tenant](https://www.investopedia.com/terms/l/lessee.asp), including any of the following:

*   Structural modifications
*   New drywall and flooring
*   Updates to lighting, electrical, and technology systems
*   Addition of rooms, cubicles, partitions
*   Shelving and countertops

Not all changes are considered leasehold improvements. Modifications made for one tenant don't qualify for other tenants, including their neighbors. Exterior building [renovations](https://www.investopedia.com/renovations-4689700), such as landscaping, parking lot repairs, or roofing don't qualify either. Even interior alterations like upgrades made to a building's elevator or HVAC systems aren't considered leasehold improvements. That's because they don't benefit a specific tenant.  

> **Important**
>
> Leasehold improvements are considered qualified improvement property for tax purposes, along with building improvements, qualified restaurant property, and qualified retail improvements under the Tax Cuts and Jobs Act (TCJA) of 2017.

## Special Considerations

Leasehold improvements are meant to customize and change rental properties. Landlords do so to meet the needs of the lessees. But how do building owners treat the depreciation of these improvements? It depends entirely on the accounting method.

Owners can depreciate leasehold improvements over 15 years under the [Internal Revenue Code (IRC)](https://www.investopedia.com/terms/i/internal-revenue-code.asp) under certain conditions. These include making improvements:

*   As per the lease terms
*   More than three years after the building is placed into service
*   Doesn't enlarge the building, install elevators or escalators, or change the structural framework of its interior

Things are a little different according to [generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp). Under GAAP, leasehold improvements "are [amortized](https://www.investopedia.com/articles/investing/090213/explaining-amortization-balance-sheet.asp) over the shorter of the useful life of those leasehold improvements and the remaining lease term."

## Types of Leasehold Improvements

### Tenant Improvement Allowance

This type of leasehold improvement gives the tenant authority to oversee the project, taking the burden off the landlord especially if the process is time-consuming. The landlord normally puts provisions in place in the lease that cover the budget of the tenant allowance improvement.

This is usually listed as a [lump sum](https://www.investopedia.com/terms/l/lump-sum-payment.asp) or on a per-square-foot basis. Landlords may either pay the renovation/construction company directly or [reimburse](https://www.investopedia.com/terms/r/reimbursement.asp) the tenant directly. If project budgets are exceeded, the tenant covers the balance.

### Rent Discount

The landlord may offer the tenant [rent](https://www.investopedia.com/terms/r/rent-expense.asp) discounts for leasehold improvements. If this option is included in the lease, the tenant may get rent relief of some type, such as one free month or reduced rent for a certain period of the year.

Tenants can use this to save on space alterations. Just like with the TIA, the tenant oversees the project and controls the lease improvements. The tenant is also responsible if costs exceed the budget.

### Building Standard Allowance

This option is also called a build-out. In this case, the landlord presents an improvement package or other options to the tenant. The landlord is typically the one who manages the project, allowing the tenant more time to devote to their business.

In most cases, tenants may not end up with the modifications they actually want to help their [business](https://www.investopedia.com/terms/b/business.asp) grow. If they do choose to add on to the changes, they must cover the additional cost.

### Turn Key

This type of leasehold improvement is normally undertaken at the beginning of the lease. In most cases, cost estimates and plans are submitted by the tenant while the landlord is the one who supervises and pays for all of the work.

## Leasehold Improvements Rules

In December 2015, the U.S. Congress passed the [Protecting Americans From Tax Hikes (PATH) Act](https://www.investopedia.com/terms/p/path-act.asp), which modified and extended many tax provisions related to depreciation, including leasehold improvements. The bill made permanent a tax-savings provision that allowed for 15-year straight-line cost recovery on qualified leasehold improvements. Under those guidelines:

*   Landlords and tenants were not allowed to be related
*   Improvements only qualified if they were made to the interior of the building with only that tenant occupying the space
*   Leasehold improvements were required to be completed after three years of the building first being occupied for service

The passing of the TCJA in 2017 changed the way landlords and tenants can claim deductions involving leasehold improvements. The new law modified some of the requirements. Improvements must still be made to the interior of the building, which means enlargements to buildings, elevators and escalators, roofs, fire protection, alarm, and security systems, and HVAC systems still don't qualify.

The qualified improvement property no longer requires both parties (landlords and tenants) to be unrelated. It also eliminated the three-year requirement, stating that all improvements may be made "after the date when the property was first placed in service," according to the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp).

The [Coronavirus Aid, Relief, and Economic Security (CARES) Act](https://www.investopedia.com/coronavirus-aid-relief-and-economic-security-cares-act-4800707) made some tweaks to qualified improvement property when it was passed in 2020. The act put a 15-year recovery period for QIP and allowed filers to claim first-year depreciation for any QIP.

> **Fast Fact**
>
> Most lenders won't allow repayment terms beyond the life of the lease if financing is required to pay for any leasehold improvements.

## Accounting for Leasehold Improvements

The IRS does not allow [deductions](https://www.investopedia.com/terms/d/deduction.asp) for improvements. But, because improvements are considered part of the building, they are prone to depreciation. The IRS allows for [depreciation](https://www.investopedia.com/terms/d/depreciation.asp) deductions, as long as these conditions are satisfied. Whoever does the work is allowed to take the depreciation deduction, whether that's the landlord or the tenant. The TCJA increased the maximum amount allowed to $1 million from $500,000.

Accounting experts suggest expensing any improvements made that amount to less than the company's capitalization limit during the same period. If they exceed this amount, the total should be [capitalized](https://www.investopedia.com/terms/c/capitalize.asp) and [amortized](https://www.investopedia.com/terms/a/amortization.asp) over the term of the lease or over the shorter period of the life of the improvements.

## Leasehold Improvement vs. Building Improvement

While they may effectively be building improvements, leasehold improvements are distinctly different. That's because they only really make an impact on the space for a specific tenant. Building improvements, on the other hand, benefit everyone in the property and generally change the overall structure of the building itself.

Examples of building improvements include putting up a new roof, paving a driveway and/or parking lot, adding a parking lot, renovating the lobby, adding a new or repairing an existing elevator, and updating the HVAC system. As such, building improvements help extend the overall life of the structure.

## Examples of a Leasehold Improvement

Landlords may pay for leasehold improvements to encourage tenants to rent spaces for longer periods of time, especially in the [retail industry](https://www.investopedia.com/articles/stocks/10/the-four-rs-of-retail.asp). For example, a business owner leases a building for their disc golf shop. The landlord may choose to add four walls to the leased area to create built-in displays and storage areas for the discs. These alterations are considered leasehold improvements.

Let's take another example from the retail sector. The owner of Store A decides to lease space through Company B. The store only has four walls and no other amenities. Through the lease [negotiation](https://www.investopedia.com/terms/n/negotiation.asp), Company B—the landlord—agrees to install shelving, a service counter for cash registers, and a display unit with special lighting before Store A opens its doors.

## What Are Examples of Leasehold Improvements?

There are many [examples of leasehold improvements](https://www.investopedia.com/ask/answers/071315/what-are-examples-typical-leasehold-improvements.asp). A leasehold improvement is anything that benefits one specific tenant, usually in a commercial property. This includes painting, adding new walls, putting up display shelves, changing flooring and lighting, and the addition of offices, walls, and partitions.

## Who Pays for Leasehold Improvements?

Landlords budget and pay for improvements by offering a tenant improvement allowance or through rent discounts. They may also pay by offering the tenant a package of modifications from which they can choose. The tenant is normally responsible for any additional costs that go over the budget.

## Are Leasehold Improvements Tax Deductible?

You can't deduct leasehold improvements. But the IRS does allow building owners to account for their depreciation because any improvements made are considered to be part of the building.

## The Bottom Line

Leasehold improvements are changes made by landlords, property owners, or tenants to ready, maintain, or fix rental units for the benefit of a specific tenant. These can include painting, repairs, updates, and replacements of fixtures and appliances. Owners cannot deduct these outlays from their taxes directly because they are considered to be capital improvements, but the IRS does afford them depreciation expense over time.

> **Article Sources**
>
> 1.  Internal Revenue Service. “[New Rules and Limitations for Depreciation and Expensing Under the Tax Cuts and Jobs Act](https://www.irs.gov/newsroom/new-rules-and-limitations-for-depreciation-and-expensing-under-the-tax-cuts-and-jobs-act).”
>     
> 2.  Congressional Research Service. “[Tax Depreciation of Qualified Improvement Property: Current Status and Legislative History](https://crsreports.congress.gov/product/pdf/IF/IF11187)." Page 1.
>     
> 3.  PwC. “[6.19 Leasehold Improvements—Useful Life](https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/ifrs_and_us_gaap_sim/ifrs_and_us_gaap_sim_US/chapter_6_assetsnonf_US/619_leasehold.html).”
>     
> 4.  Congress.gov. “[Division Q—Protecting Americans From Tax Hikes Act of 2015](https://www.congress.gov/114/plaws/publ113/PLAW-114publ113.pdf).” Pages 129 Stat. 3040, 3063-3064.
>     
> 5.  Congress.gov. “[H.R.1 — 115th Congress (2017-2018)](https://www.congress.gov/bill/115th-congress/house-bill/1/text).“ Pages 131 Stat. 2110-2111.
>     
> 6.  Congress.gov. “[H.R.748 - CARES Act](https://www.congress.gov/bill/116th-congress/house-bill/748).” Page 134 Stat. 359.
>     
> 7.  Internal Revenue Service. “[Rev. Proc. 2020-25](https://www.irs.gov/pub/irs-drop/rp-20-25.pdf).” Page 3.
>     
> 8.  Internal Revenue Service. "[Publication 946 (2023), How To Depreciate Property](https://www.irs.gov/publications/p946)."
>     
> 9.  Accounting Tools. "[How To Account for Leasehold Improvements](https://www.accountingtools.com/articles/how-do-i-account-for-leasehold-improvements.html)."