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Leasehold Improvements: Definition and Tax Treatment

By RE Tax Calc Editorial · Published October 29, 2026

What counts as a leasehold improvement, who owns it, and how the tax rules work after the TCJA.

Illustration for Leasehold Improvements Definition
Quick Answer: A leasehold improvement is any permanent structural alteration to the interior of a leased commercial space — partition walls, flooring, lighting, plumbing, and similar build-outs. For tax purposes, most leasehold improvements to nonresidential property placed in service after 2017 qualify as "qualified improvement property" (QIP) with a 15-year MACRS depreciation life and eligibility for bonus depreciation.
IRS Rule: The Tax Cuts and Jobs Act of 2017 consolidated three prior categories — qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property — into a single "qualified improvement property" (QIP) definition under IRC §168(e)(6). The CARES Act (2020) corrected a drafting error to confirm QIP is 15-year MACRS property eligible for bonus depreciation, effective retroactively for property placed in service after December 31, 2017.

What counts as a leasehold improvement?

A leasehold improvement is a physical alteration or addition made to the interior of a leased building to adapt it for a tenant's specific use. These are permanent changes — items that are attached to and become part of the building's structure — as distinguished from furniture, movable equipment, and trade fixtures that the tenant installs and removes when the lease ends.

Common examples of leasehold improvements include:

Notice that all of these examples are interior. The building's exterior — its roof, windows, facade, and structural frame — is not a leasehold improvement regardless of who pays for the work.

What does not count as a leasehold improvement?

Several categories are outside the leasehold-improvement classification and are treated differently for depreciation:

Trade fixtures and personal property. A restaurant tenant's commercial kitchen equipment, a salon's styling chairs, or a retail tenant's shelving units that can be unbolted and removed at lease end are personal property, not leasehold improvements. These are 5- or 7-year MACRS property, generally eligible for both bonus depreciation and Section 179.

Building structural components. Columns, exterior walls, the building shell, elevators, escalators, and load-bearing elements are structural components of the building itself. They are 39-year property even when a tenant funds the work.

Building enlargements. Adding floor area or a new wing changes the building's external dimensions and is not a leasehold improvement. These additions are capitalized as 39-year structural improvements.

Residential rental property improvements. Renovations to apartment interiors do not qualify as QIP because the building must be nonresidential real property. Those improvements are treated as 27.5-year structural additions.

Land improvements. Parking lots, driveways, fencing, and landscaping around the leased building are 15-year MACRS land improvements — a different category from QIP, also eligible for bonus depreciation, but classified under §168(e)(3)(C) rather than §168(e)(6).

From QLIP to QIP: the TCJA change

Before 2018, the tax code maintained three separate favorable categories for commercial interior improvements:

The TCJA, effective for property placed in service after December 31, 2017, eliminated these three categories and created a single, simpler category: QIP. The new definition dropped the "between unrelated parties" requirement of QLIP and the "three years after placed in service" rule, making it easier for some improvements to qualify. However, the TCJA inadvertently omitted QIP from the list of 15-year property in §168(e)(3)(E), causing QIP to default to 39 years — the so-called "retail glitch." The CARES Act retroactively corrected this in March 2020.

Taxpayers who placed qualifying improvements in service in 2018 or 2019 — when QIP was accidentally treated as 39-year property — could fix the error by filing a Form 3115 (change in accounting method) or, for certain taxpayers, an amended return, to claim the shorter 15-year life and any missed bonus depreciation. The IRS provided relief procedures in Rev. Proc. 2020-25.

Who owns leasehold improvements, and who depreciates them?

Ownership of leasehold improvements is a nuanced question that determines who claims the depreciation deduction. The general principle is that the economic owner — the party bearing the cost and economic risk of the improvements — depreciates them.

Tenant-funded improvements: When a tenant pays for improvements out of its own pocket without any landlord reimbursement, the tenant owns the improvements and depreciates them on its own return. This is true even though the improvements physically become part of the landlord's building.

Landlord-funded improvements: When the landlord builds out the space and leases it in improved condition, the landlord owns and depreciates the improvements. The tenant has no depreciable interest.

Tenant improvement allowances (TIA): A TIA is a cash payment or credit from the landlord to fund the tenant's build-out. The tax treatment depends on structure. If the landlord pays contractors directly and retains title, the landlord depreciates. If the landlord pays cash to the tenant and IRC §110's exclusion applies (nonresidential property, reversion to landlord, 15-year-or-less lease term), the tenant excludes the TIA from income but has zero basis in the improvements — no depreciation for the tenant. If the §110 exclusion does not apply, the tenant includes the TIA in gross income and takes a full cost basis in the improvements it built.

What happens at lease end? When a tenant leaves, improvements that revert to the landlord become the landlord's property. The tenant stops depreciating at that point. Any remaining undepreciated basis is a loss or a §1231 gain/loss depending on the circumstances. If the tenant is required to restore the property to its original condition, the restoration costs are a deductible expense in the year incurred.

MACRS recovery period and method

Leasehold improvements that qualify as QIP are 15-year MACRS property under the GDS. The depreciation method is straight-line, and the applicable convention is the half-year convention (or mid-quarter if applicable). Using straight-line over 15 years with the half-year convention, the first-year deduction without any bonus is 3.33% of basis (half of the 6.67% annual rate). With bonus depreciation on top, the first-year deduction is substantially higher.

Under the Alternative Depreciation System (ADS), QIP has a 20-year straight-line recovery period. ADS is mandatory for certain taxpayers: those whose property is used predominantly outside the U.S., tax-exempt-use property, and businesses that elect out of the interest-expense limitation under IRC §163(j). Real property trades or businesses that make the §163(j)(7) election must use ADS for their nonresidential real property, residential rental property, and QIP — which means giving up bonus depreciation for QIP and spreading the deduction over 20 years instead of 15.

Common Mistake: Businesses that elect out of the interest-expense limitation under §163(j) must use ADS for their real property and QIP — and ADS property is ineligible for bonus depreciation. Electing out of §163(j) in a year of large QIP investment can cost significantly more in deferred depreciation than it saves in interest deduction. Model both scenarios before making the election.

Bonus depreciation for leasehold improvements

Because QIP has a 15-year MACRS life (20 years or fewer under the bonus-depreciation eligibility threshold), it qualifies for bonus depreciation under IRC §168(k). The applicable bonus percentage depends on the year the improvement is placed in service:

Bonus depreciation is the default — it applies automatically unless the taxpayer affirmatively elects out on a per-class basis. If you want to depreciate QIP over 15 years rather than take a large first-year deduction, you must make an election out of bonus depreciation on your timely filed return (including extensions).

Tax treatment of a tenant improvement allowance

The landlord–tenant relationship around TIAs creates a common source of confusion. When a landlord provides cash to a tenant specifically for building improvements, the tenant's tax treatment follows a two-step analysis.

First, is the TIA excludable from income under IRC §110? The exclusion applies when: (1) the allowance is for improvements to nonresidential real property, (2) the improvements revert to the landlord at the end of the lease, and (3) the lease term is 15 years or less including renewal options. When all three conditions are met, the tenant excludes the TIA from income but takes a zero cost basis in the improvements — no depreciation deduction for the tenant.

Second, if any condition fails, the entire TIA is ordinary income to the tenant, but the tenant also takes a cost basis equal to its actual expenditure on the improvements. The tenant then depreciates those improvements as QIP with a full basis. In practice, many commercial leases now exceed 15 years (with renewal options), which pushes TIAs outside the §110 exclusion and into ordinary income with a depreciable basis.

Worked numeric example

A medical practice signs a 12-year lease (including a five-year renewal option) on 3,000 square feet of nonresidential office space. The landlord pays a $180,000 TIA. The lease term including the renewal option exceeds 15 years, so IRC §110 does not apply. The medical practice includes $180,000 in gross income. It spends the full $180,000 on interior build-out (exam rooms, reception desk, flooring, lighting) completed in 2025.

Cost basis of QIP: $180,000

Bonus depreciation (2025 rate: 40%): $180,000 × 40% = $72,000

Remaining basis: $180,000 − $72,000 = $108,000

Year-1 regular MACRS (half-year): $108,000 ÷ 15 × 0.5 = $3,600

Total year-1 depreciation: $72,000 + $3,600 = $75,600

The $180,000 TIA is income, but $75,600 of it is offset in year one by the depreciation deduction, and the remaining basis continues to depreciate over 15 years. The net taxable income in year one from the TIA is $180,000 − $75,600 = $104,400 — significantly less than the full TIA.

Frequently asked questions

What is the difference between a leasehold improvement and a trade fixture?

A leasehold improvement becomes a permanent part of the building (partition walls, ceiling tiles, flooring). A trade fixture is installed by the tenant for business purposes and is removable without material damage to the property — the tenant can take it when the lease ends. Trade fixtures are personal property; leasehold improvements are real property.

Who depreciates leasehold improvements?

The party that economically owns them. If the tenant pays and improvements revert to the landlord at lease end, the ownership question depends on the arrangement. If the tenant paid with its own funds and has an economic interest, the tenant depreciates. If the landlord funded and retains ownership, the landlord depreciates.

What recovery period applies to leasehold improvements after the TCJA?

15 years under MACRS GDS as qualified improvement property (QIP), corrected retroactively by the CARES Act. Under ADS the life is 20 years. Improvements to residential rentals or the building's structural shell remain 27.5 or 39 years.

Are leasehold improvements eligible for bonus depreciation?

Yes, if they qualify as QIP. Bonus depreciation was 100% for property placed in service through 2022, then phases down: 80% (2023), 60% (2024), 40% (2025), 20% (2026), and 0% afterward under current law.

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.

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