Real Estate Tax CalcThe evolution from qualified leasehold improvement property to QIP
Before the Tax Cuts and Jobs Act (TCJA) of 2017, the Code contained three separate 15-year categories for commercial interior improvements: qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. TCJA collapsed all three into a single category — qualified improvement property (QIP).
Due to a drafting error, TCJA accidentally assigned QIP to the 39-year nonresidential class, eliminating bonus depreciation eligibility. The CARES Act of 2020 retroactively corrected this, effective for QIP placed in service after December 31, 2017. All interior improvements to nonresidential buildings made after the building's initial placed-in-service date are now QIP with a 15-year GDS life and bonus depreciation eligibility.
What qualifies as QIP: the four-part definition
Under Section 168(e)(6), QIP is any improvement to an interior portion of a nonresidential real property building, placed in service after the date the building was first placed in service, that is not: (1) an enlargement of the building, (2) an elevator or escalator, (3) attributable to the internal structural framework, or (4) made by the owner of the building before it was placed in service.
Interior only: improvements to the building envelope (roof, exterior walls, windows, building-wide HVAC) do not qualify.
Nonresidential only: residential rental property does not have QIP. Improvements must be to an office building, retail space, warehouse, or other nonresidential real property.
After initial placed-in-service date: a new build-out of a newly constructed building is part of the original cost, not QIP.
No structural framework: improvements to core structural support do not qualify.
Lessee vs. lessor: who depreciates the improvement?
The owner of the leasehold improvement depreciates it. Ownership depends on who paid and the lease terms:
Tenant-paid improvements (lessee-owned): The tenant capitalizes and depreciates over 15 years as QIP. When the lease expires, the undepreciated basis is abandoned or written off.
Landlord-paid improvements with no tenant allowance: The landlord depreciates as QIP.
Tenant improvement allowances (TIA): If the landlord provides a cash TIA, the analysis depends on who controls construction. Landlord controls construction = landlord owns and depreciates. Tenant controls construction = tenant owns and depreciates; landlord treats the TIA as a lease incentive amortized over the lease term.
This distinction is frequently disputed in audits. The key factor is actual control of construction, not the label given to the payment.
Section 110: tenant exclusion of landlord TIA from income
Under Section 110, a tenant does not include a landlord-provided TIA in gross income if: (1) paid under a short-term lease (15 years or less including options), (2) for improvements to be used in the tenant's trade or business on the leased premises, and (3) at lease end the improvements become the landlord's property.
If Section 110 applies, the tenant excludes the TIA from income but has zero basis in the improvements — meaning no depreciation. Only if the tenant funds improvements beyond the TIA can the tenant take depreciation on the excess.
Section 110 is often overlooked: tenants receive TIAs without considering whether the allowance is income and, if excluded, whether they have a basis to depreciate. Misapplication results in improper depreciation claims or over-reported income.
Bonus depreciation on QIP: the current schedule
Because QIP is 15-year GDS property, it qualifies for bonus depreciation under Section 168(k). Current bonus depreciation rates:
100% bonus for property placed in service after September 27, 2017 and before January 1, 2023.
80% bonus for property placed in service in 2023.
60% bonus for property placed in service in 2024.
40% bonus for property placed in service in 2025.
20% bonus for property placed in service in 2026.
0% for 2027 and after (unless Congress acts to extend).
ADS property (required for Section 163(j)(7) electors) uses a 20-year life for QIP and is not eligible for bonus depreciation.
Abandoned leasehold improvements at lease termination
When a lease terminates, lessee-owned improvements left behind may qualify for an abandonment loss equal to the undepreciated basis, deductible in the year of termination. This is a tax-deductible loss, not subject to capital loss rules.
If the tenant must restore the space under the lease, they cannot take an abandonment loss — the removal is a contractual obligation. The cost of removal is deductible, and proceeds from salvaged materials offset the deduction.
If the lessor made improvements that revert at lease end, the lessor continues depreciating them. When the property is later sold or re-let, the improvement's remaining basis is part of the depreciable basis.
Current bonus depreciation law: the OBBBA restoration
The bonus depreciation schedule embedded in the older TCJA rules — 80% for 2023, 60% for 2024, 40% for 2025, 20% for 2026 — was overtaken by legislation. The One Big Beautiful Bill Act (OBBBA), enacted in July 2025, permanently restored 100% bonus depreciation for qualifying property placed in service after January 19, 2025.
For leasehold improvements this is significant: QIP placed in service after that date is again eligible for 100% first-year bonus depreciation rather than the reduced phase-down rate. Improvements placed in service earlier still use the rate in effect for their placed-in-service year. Because these percentages are set by statute and have changed more than once, always confirm the rate for the specific year an improvement is placed in service before relying on it.
The interaction with the QIP definition is unchanged: only property that actually meets the four-part QIP test gets the 15-year life and bonus eligibility. A non-qualifying improvement remains 39-year property regardless of the bonus percentage in effect.
A worked example: a tenant build-out
A retail tenant signs a 10-year lease and spends $300,000 building out interior space — new flooring, partitions, lighting, and fixtures — all interior work to a nonresidential building placed in service after the building's original in-service date. The improvements qualify as QIP.
Because the tenant paid for and controls the construction, the tenant owns the improvements and depreciates them. As 15-year QIP eligible for 100% bonus depreciation (for a post-January 19, 2025 placement), the tenant can deduct the full $300,000 in year one, subject to the passive activity and business-income limits.
If instead the improvements did not qualify as QIP — say they included an addition that enlarged the building — that portion would be 39-year property, deductible at roughly 2.56% per year (about $7,700 annually on $300,000). The classification difference is the whole ballgame: $300,000 now versus $7,700 a year for 39 years.
Section 179 as an alternative for leasehold improvements
Since the TCJA, QIP and certain nonresidential building systems — roofs, HVAC, fire protection, alarm, and security systems — are eligible for Section 179 expensing. The OBBBA raised the Section 179 dollar limit substantially, giving landlords and tenants a second immediate-expensing route for improvements.
Section 179 differs from bonus depreciation in two respects that matter for leasehold improvements: it cannot create or increase a loss (it is capped at the active trade-or-business taxable income of the entity placing the property in service, with any excess carried forward), and it phases out once total qualifying purchases exceed a threshold. A tenant with strong operating income might use Section 179; a passive landlord with little active income usually gets more value from bonus depreciation, which can create a deductible loss.
The two can be layered: elect Section 179 up to the income limit, then apply bonus depreciation to the remaining basis. The optimal mix depends on the taxpayer's income picture and state conformity.
Common mistakes with leasehold improvement depreciation
The most common errors are: defaulting QIP to a 39-year life because the preparer is unaware of the CARES Act correction; misidentifying who owns the improvement, and therefore who depreciates it, when a tenant improvement allowance is involved; overlooking Section 110 so a tenant either reports the allowance as income unnecessarily or depreciates improvements in which it has zero basis; and treating improvements to the building envelope (roof, exterior walls, windows) as QIP when they do not qualify.
Another frequent issue is failing to claim an abandonment loss on undepreciated tenant improvements when a lease ends and the tenant walks away — leaving a deduction on the table. Conversely, tenants who are contractually required to restore the premises sometimes wrongly claim an abandonment loss they are not entitled to.
Planning tips: settle ownership and control of construction in the lease itself, document the TIA and Section 110 analysis at signing, and reconcile the depreciation method with state conformity so the state return is not overstated.
Frequently asked questions
What is the depreciation life for leasehold improvements under current law?
Most interior leasehold improvements to nonresidential buildings qualify as QIP with a 15-year MACRS GDS life. QIP is eligible for bonus depreciation (100% pre-2023, phasing down 20% per year through 2026). The old 'qualified leasehold improvement property' category was replaced by QIP effective 2018.
Does the landlord or tenant depreciate a leasehold improvement?
The party who owns the improvement depreciates it — ownership depends on who paid and controls construction. Tenant-funded improvements are depreciated by the tenant; landlord-funded by the landlord. When a TIA is provided, ownership is determined by who controls construction.
What happens to undepreciated leasehold improvements when a lease ends?
If the tenant owns improvements and abandons them at lease termination, the tenant may deduct the remaining undepreciated basis as an abandonment loss. If the tenant must restore the space, removal cost is deductible but no abandonment loss is available.
Can I take bonus depreciation on leasehold improvements?
Yes, if the improvements qualify as QIP. QIP is 15-year property eligible for bonus depreciation — 20% for 2026 placements, 40% for 2025, 60% for 2024. Improvements that do not qualify as QIP use a 39-year life and are not bonus-eligible.
What is Section 110 and when does it apply to a tenant allowance?
Section 110 is an exclusion from income for tenants receiving landlord TIAs under a short-term lease (15 years or less). If it applies, the tenant excludes the allowance from gross income but has zero basis — no depreciation. Only the amount the tenant pays beyond the TIA can be depreciated.
What is the ADS life for leasehold improvements (QIP)?
20 years under ADS, compared to 15 years under GDS. The longer life applies to taxpayers required to use ADS for QIP — primarily those who elected real property trade-or-business status under Section 163(j)(7). ADS QIP is not eligible for bonus depreciation.
Did OBBBA change bonus depreciation for leasehold improvements?
Yes. The One Big Beautiful Bill Act, enacted July 2025, restored 100% bonus depreciation permanently for qualifying property placed in service after January 19, 2025, superseding the TCJA phase-down. QIP placed in service after that date is again eligible for 100% first-year bonus depreciation. Improvements placed in service earlier use the rate in effect for their year.
Can I use Section 179 instead of bonus depreciation on a build-out?
Yes, if the improvements qualify as QIP or as eligible building systems (roof, HVAC, fire protection, alarm, security). Section 179 cannot create a loss and phases out above a purchase threshold, so it suits taxpayers with active business income. Bonus depreciation, which can create a loss, is often better for passive landlords. The two can be combined.
What happens if my improvement is not QIP?
It falls into the 39-year nonresidential real property class, straight-line, with no bonus eligibility. Common examples are enlargements of the building, elevators and escalators, work on the internal structural framework, and improvements to the building envelope such as the roof or exterior walls.
Does the tenant or landlord get the abandonment loss when a lease ends?
The party that owns the improvement and does not recover its basis takes the loss. A tenant that owns and abandons improvements at lease end may deduct the remaining undepreciated basis. A landlord whose improvements revert simply continues depreciating them. A tenant contractually required to restore the space cannot claim an abandonment loss.
Sources
- IRS Publication 946 — How to Depreciate Property
- IRS — Cost Segregation Audit Techniques Guide
- IRS Publication 527 — Residential Rental Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.