Real Estate Tax Calc
What is a tenant improvement allowance?
A tenant improvement allowance (TIA), sometimes called a build-out allowance or construction allowance, is money the landlord provides to fund changes to the leased space so the tenant can occupy and use it for its intended purpose. TIAs are extremely common in commercial real estate — office, retail, medical, industrial, and mixed-use leases all routinely include them. They are negotiated as part of the lease and typically expressed as a dollar amount per square foot of rentable space.
Common TIA-funded improvements include demising walls, dropped ceilings, flooring finishes, built-in millwork, interior lighting, plumbing and restrooms, HVAC distribution, electrical panels and outlets, IT infrastructure raceways, and fire suppression modifications. These are all interior improvements to the leased space — exactly the type of work that qualifies as QIP for the party that owns and depreciates it.
A TIA is distinct from a free-rent or rent-abatement period (where the landlord foregoes rent during construction) and from a landlord build-out (where the landlord directly contracts the work with its own contractors and delivers improved space). The TIA model gives the tenant control over the construction and design process while the landlord provides the financial subsidy.
Landlord tax treatment: capitalizing TIA payments
From the landlord's perspective, a TIA is a cost of acquiring or retaining a tenant. The tax treatment depends on which party owns the improvements. Under general tax principles, if the landlord funds improvements to its own building — whether directly or through a TIA — those costs are capital expenditures that the landlord depreciates.
When the landlord retains ownership of the improvements. If the TIA is paid as part of an arrangement where the improvements revert to the landlord at the end of the lease, the IRS treats the TIA as the landlord's cost of making improvements to its building. The landlord capitalizes the TIA amount as the basis of QIP (assuming the improvements are to the interior of a nonresidential building placed in service after the building was first placed in service). The landlord then depreciates the QIP as 15-year MACRS property and can claim bonus depreciation in the year the improvements are placed in service.
When the tenant owns the improvements. In less common arrangements where the tenant retains ownership of the improvements (perhaps custom equipment installations), the TIA may be treated as a loan (if repayable), as rent, or as a payment for services, depending on the economic substance of the arrangement. These situations require careful structuring and documentation.
Landlord timing. The landlord's depreciation clock starts when the improvements are placed in service — typically when the tenant's build-out is complete and the improvements are ready for their intended use, not when the TIA check is written. If the landlord funds the TIA in 2025 but construction finishes in January 2026, depreciation begins in 2026.
Tenant tax treatment: the IRC §110 exclusion
For the tenant, a TIA that is a cash payment from the landlord is potentially gross income under IRC §61's broad definition of income. Congress provided a specific exclusion in IRC §110 for construction allowances used in commercial leases, but it comes with conditions.
Under §110, a tenant may exclude a "qualified lessee construction allowance" from gross income if all of the following are true:
- The allowance is received under a short-term lease of retail or other commercial space (nonresidential real property).
- The allowance is for the purpose of constructing or improving qualified long-term real property — improvements to the interior of the building.
- The qualified long-term real property reverts to the landlord (lessor) at the end of the lease.
- The lease term is 15 years or fewer, counting all renewal options.
When §110 applies, the tenant excludes the TIA from income — but there is a price: the tenant's basis in the improvements is zero. With a zero cost basis, the tenant has no depreciation deduction. The tax benefit to the tenant of the §110 exclusion is simply avoiding income recognition, not getting a depreciation deduction.
When the §110 exclusion does not apply
The §110 exclusion fails — and the TIA becomes ordinary income — in several common situations:
Lease term exceeds 15 years. A 10-year base with two 5-year renewal options is a 20-year potential term. §110 fails and the full TIA is income. This is increasingly common as tenants push for longer lease terms with multiple renewal options.
Improvements do not revert to the landlord. If the tenant is permitted or required to remove the improvements at lease end, the reversion condition fails.
Residential property. §110 requires "retail space" — meaning nonresidential. Residential rental property does not qualify.
TIA used for non-qualifying purposes. If the tenant uses the TIA for furniture, trade fixtures, or other personal property rather than interior real property improvements, the allocable portion may not qualify even if the other conditions are met.
When §110 fails, the tenant includes the full TIA amount in gross income in the year received. But the tenant also takes a cost basis equal to what it actually spends on qualifying improvements. That basis can then be depreciated as QIP — 15-year MACRS with bonus depreciation. In many cases, the first-year bonus deduction substantially offsets the income inclusion.
Who owns and depreciates the improvements?
Ownership drives everything in TIA tax analysis. The general rule is that the economic owner — the party that bears the cost and receives the benefit — depreciates the improvements. But the analysis is fact-specific:
Landlord retains ownership, funds improvements directly: Landlord depreciates. Tenant has no depreciable interest.
Landlord pays TIA, §110 exclusion applies: Depends on who built and who retains ownership. Typically the landlord capitalizes the TIA as improvement cost and depreciates. The tenant excludes income and has zero basis.
Landlord pays TIA, §110 does not apply: Tenant includes TIA in income. Tenant owns improvements (it spent the money). Tenant depreciates as QIP and can claim bonus depreciation on the full basis.
Tenant funds improvements independently: Tenant owns and depreciates QIP. No TIA involved.
How to calculate a TIA budget
TIAs are typically negotiated as a per-square-foot amount. The market rate varies significantly by market, property type, and condition of the space. A "warm shell" space (basic mechanicals in place, no finishes) typically commands a higher TIA than a "cold dark shell" (just the building envelope). "Second-generation" space (previously built out) may need less allowance.
A simple TIA budget calculator works as follows:
Step 1 — Estimate total build-out cost per square foot: General commercial office finishes typically run $75–$150+ per square foot in most US markets. Medical office, lab, or restaurant space can be $150–$300+ due to specialized systems. Check with a local contractor for a market estimate.
Step 2 — Determine tenant's contribution: The tenant's contribution per square foot = Total build-out cost per SF − TIA per SF. For example: $120 build-out − $50 TIA = $70 tenant contribution per SF.
Step 3 — Total tenant spend: Multiply tenant contribution per SF × total rentable SF. Example: $70 × 5,000 SF = $350,000 tenant out-of-pocket cost.
Step 4 — Total depreciable basis (if §110 does not apply): If the tenant includes the TIA in income (§110 inapplicable), the tenant's depreciable basis = total build-out cost, including the TIA portion. For a $600,000 build-out funded by $250,000 TIA and $350,000 tenant cash, the tenant's QIP basis = $600,000.
Worked example: the numbers
A law firm signs a 12-year lease (base) with two 3-year renewal options on a 6,000-square-foot office suite. The total lease term including renewals is 18 years. The landlord provides a $300,000 TIA. The firm spends $420,000 on total interior improvements in 2025 (completing the build-out in November 2025).
§110 analysis: 18-year total term. Exceeds 15 years. §110 does not apply.
Tenant income: $300,000 (full TIA is ordinary income in 2025)
Tenant's depreciable QIP basis: $420,000 (total spend — the firm paid $420,000 in construction costs; the TIA reimbursed $300,000 of that)
Bonus depreciation (2025 rate: 40%): $420,000 × 40% = $168,000
Remaining basis for regular MACRS: $420,000 − $168,000 = $252,000
Year-1 regular MACRS (half-year): $252,000 ÷ 15 × 0.5 = $8,400
Total year-1 depreciation deduction: $168,000 + $8,400 = $176,400
Net taxable income effect: $300,000 income − $176,400 depreciation = $123,600 net income in year one. The remaining $243,600 of basis ($252,000 − $8,400 = $243,600) continues to depreciate at $16,800/year ($252,000 ÷ 15) for the remaining 14 full years.
TIA vs. rent abatement
Two common landlord concessions — the TIA and rent abatement (free rent during the build-out period) — have different tax profiles. A TIA is a cash payment; the tax questions center on income recognition and depreciation. Rent abatement is simply foregone rent — the landlord doesn't include it in income, and the tenant doesn't deduct it as a rent expense during the abatement period. But rent abatement may be taxable if it is structured as advance rent or if the economic arrangement requires income to be recognized over the full lease term. The GAAP and tax accounting for rent abatements differ, adding another layer of complexity for lessees under ASC 842.
Form reporting
For the landlord: capitalize the TIA on your asset schedule, list it on Form 4562 as QIP, and carry the deduction to Schedule E or the relevant business schedule. Report bonus depreciation in Part III of Form 4562.
For the tenant (when §110 does not apply): report the TIA as gross income on your business return. Capitalize the improvement costs and report QIP depreciation on Form 4562. The bonus depreciation appears in Part III. If the §110 exclusion does apply, no income is reported and no depreciation is taken — the asset does not appear on Form 4562.
Frequently asked questions
Is a tenant improvement allowance taxable income to the tenant?
It depends. If IRC §110 applies — the TIA is for improvements to nonresidential property, the improvements revert to the landlord, and the lease term including renewals is 15 years or fewer — the tenant excludes the TIA from income. If any condition fails, the TIA is ordinary income. The tenant then takes a cost basis in the improvements and can depreciate them.
Can a tenant depreciate improvements paid for with a TIA?
Only if the §110 exclusion does not apply. When §110 applies, the tenant excludes the TIA from income but has zero basis — no depreciation. When §110 does not apply, the tenant includes the TIA in income and takes a full cost basis in the improvements, which it then depreciates as QIP.
How do landlords account for TIA payments?
Landlords capitalize TIA payments (or the cost of improvements they fund directly) as real property improvements. They classify qualifying interior improvements as QIP — 15-year MACRS property — and can claim bonus depreciation in the year placed in service.
What happens to leasehold improvements at lease expiration?
Improvements typically revert to the landlord. The tenant stops depreciating them and may recognize a §1231 loss or gain. If the tenant is required to restore the property to original condition, demolition costs are deductible when incurred.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.