Real Estate Tax Calc
What a tenant improvement allowance is
A tenant improvement allowance (TIA) is a sum a commercial landlord agrees to pay — directly or as a rent concession — to help a tenant build out leased space for their specific business use. A new restaurant tenant might need a build-out worth $300,000; the landlord contributes $150,000 as a TIA and the tenant funds the rest.
TIAs are common in commercial and retail leases. They shift some of the construction cost to the landlord in exchange for a longer lease term, higher rent, or both. The tax treatment for each party hinges on a single question: who legally owns the improvements?
When the tenant owns the improvements: IRS Rev. Proc. 2001-28
The most common commercial TIA structure has the tenant owning and depreciating the improvements, with the landlord providing cash (or a rent abatement) to help fund them. Under IRS Revenue Procedure 2001-28, this structure can be tax-neutral for the tenant — the allowance is not taxable income — as long as two conditions are met: (1) the allowance is used exclusively for the tenant's improvements to the leased property; and (2) the improvements are made to the property and become part of the leased space at lease expiration (surrendered to the landlord).
Under this safe harbor, the tenant treats the TIA as an offset to the cost of the improvements rather than as income. The tenant's depreciable basis in the improvements equals the total cost of the improvements minus the TIA received. The tenant then depreciates the net cost over the appropriate recovery period — typically 15 years as Qualified Improvement Property (QIP) if the improvements were to an already-placed-in-service nonresidential building's interior, subject to bonus depreciation eligibility.
When the tenant keeps the improvements: income recognition
If the TIA is not used exclusively for improvements — for example, the tenant uses part of it for furniture, equipment, or general business expenses — the non-improvement portion is ordinary income to the tenant. The IRS can also treat the entire TIA as income if the improvements are not made, if the tenant retains the right to remove the improvements, or if the structure does not meet the Rev. Proc. 2001-28 safe harbor requirements.
Historically, if a landlord pays a TIA and the improvements are owned by the landlord (the tenant does not take them), the entire TIA amount is not income to the tenant because they received nothing — the landlord simply improved their own property. The income question arises only when the tenant actually receives cash or a cash-equivalent benefit.
Landlord's tax treatment: capitalize and depreciate
When the landlord pays a TIA and the landlord owns the improvements, the cost is capitalized and depreciated as part of the building or as a separate leasehold improvement. For nonresidential real property, improvements made to the building's interior are Qualified Improvement Property (QIP) — 15-year property eligible for 100% bonus depreciation through 2022 (phasing out in subsequent years), or straight-line depreciation over 15 years otherwise.
When the landlord pays a TIA and the tenant owns and depreciates the improvements, the landlord's TIA payment is a lease acquisition cost — an intangible asset amortized over the initial lease term (not including renewal options) using straight-line. If a 5-year lease comes with a $100,000 TIA, the landlord amortizes $20,000 per year over 5 years. At lease expiration, any unamortized balance is deducted or treated as a loss, and the improvements revert to the landlord, who may take a new depreciation basis at that point.
Rent abatement as a TIA alternative
Instead of a cash payment, some landlords provide a free-rent period to effectively fund the tenant's build-out. A 2-month free-rent on a $10,000/month lease is economically equivalent to a $20,000 TIA. The tax treatment differs: for the tenant, a rent concession reduces their basis in leasehold improvements if they use the freed cash for improvements; if they do not, it is simply a period of lower occupancy cost with no special tax consequences.
For the landlord, a free-rent period does not create an immediate cash outlay but does require careful accounting: any contingent rental under a lease with free-rent periods must be spread ratably over the lease term under the accrual method of accounting, which can front-load income recognition compared to the cash received.
Tenant's depreciation of improvements
When the tenant owns and depreciates the improvements, the recovery period and method depend on the type of improvement. Qualified Improvement Property (QIP) — any improvement to the interior of a nonresidential building placed in service after the building was first placed in service — has a 15-year recovery period and is eligible for bonus depreciation. Structural components (roofs, HVAC, escalators, elevators, and fire protection systems) are explicitly excluded from QIP and are instead 39-year building improvements.
For a tenant building out leased restaurant space, the interior finishes, flooring, cabinetry, and lighting fixtures are likely QIP eligible for bonus depreciation; the ventilation system may be QIP or may be a structural component depending on its nature. When bonus depreciation was 100% (through 2022), tenants could write off the entire net cost of QIP improvements in year one. The phase-out schedule reduces bonus depreciation to 40% for 2025 property and lower thereafter, so the deduction is spread over more years.
At lease termination, if the tenant abandons improvements that have remaining basis, they can recognize a loss on the abandoned improvements under Reg. Section 1.168(i)-8.
Practical planning: structure the allowance correctly
The difference between a TIA that is tax-neutral and one that creates taxable income for the tenant comes down to documentation and structure. Best practices: (1) document the allowance explicitly in the lease as payable for construction of permanent improvements; (2) require the tenant to provide receipts or contractor invoices for improvement expenditures before disbursing the TIA; (3) specify in the lease that improvements become the landlord's property at lease expiration; and (4) ensure the allowance does not exceed the actual cost of improvements, since any excess over cost is likely income to the tenant.
For large commercial transactions, both parties should consult tax counsel before lease execution. The tax outcome on a $1 million TIA can differ by hundreds of thousands of dollars depending on ownership structure, entity type, and depreciation methodology — a well-structured lease saves far more than the cost of advice.
State tax considerations
State income tax treatment of TIAs generally follows federal, but some states have different depreciation rules. States that have not conformed to the TCJA's QIP changes may still use 39-year lives for improvements. Bonus depreciation conformity varies significantly — California, for example, does not conform to federal bonus depreciation and requires straight-line depreciation regardless of what was claimed federally. In states with their own depreciation rules, tenants and landlords may need to maintain separate federal and state depreciation schedules, and the state tax treatment of the TIA may differ materially from the federal treatment.
A worked example: a $150,000 allowance
A landlord signs a 10-year lease with a retail tenant and agrees to a $150,000 tenant improvement allowance toward a $250,000 build-out; the tenant funds the remaining $100,000. If the lease is structured so the tenant owns and depreciates the improvements and the allowance is used exclusively for them, the tenant's depreciable basis is the $250,000 cost minus the $150,000 allowance = $100,000, recovered over the applicable period (15 years as Qualified Improvement Property for qualifying interior work, subject to bonus rules). The tenant recognizes no income on the allowance.
On the landlord's side, because the tenant owns the improvements, the $150,000 allowance is a lease acquisition cost amortized straight-line over the 10-year lease term — $15,000 per year. If instead the lease made the landlord the owner of the improvements, the landlord would capitalize and depreciate the $150,000 (typically as 15-year QIP for qualifying interior work), and the tenant's income analysis would turn on whether it received cash or only the benefit of improvements to the landlord's property.
IRC Section 110: the retail construction allowance exclusion
For retail tenants, the statute that most directly governs a TIA is IRC Section 110. It lets a lessee exclude from gross income a cash construction allowance (or rent reduction) received from a landlord under a short-term lease of retail space — a lease of 15 years or less — to the extent the allowance is used within the applicable period to construct or improve qualified long-term real property for use in the tenant's business at that retail space.
Two consequences follow. First, the improvements must be real property that reverts to the landlord at lease end — not the tenant's movable personal property. Second, under Section 110(b), that property is treated as owned by the landlord, so the landlord (not the tenant) depreciates it, generally as 39-year nonresidential real property or 15-year QIP for qualifying interior work. Both parties are expected to attach an information statement to their returns under the Section 110 regulations. If the allowance exceeds the cost of qualifying improvements, the excess is taxable income to the tenant.
Book-tax difference: TIAs under lease accounting
The tax treatment described here can diverge sharply from how a TIA is reported on financial statements. Under the ASC 842 lease-accounting standard, a tenant generally treats a TIA as a lease incentive that reduces the right-of-use asset and is recognized as a reduction of lease expense over the lease term. That book treatment does not change the tax analysis, which depends on ownership of the improvements and, for retail tenants, on Section 110.
The result is a book-tax difference that must be tracked: the timing and amount of income or expense recognized for financial reporting will not match the tax return. Businesses that prepare GAAP financial statements should coordinate their lease accounting with their tax reporting so the deferred tax accounting is correct.
Common mistakes and how to structure the allowance
The recurring errors: treating the entire allowance as automatically tax-free without meeting the exclusive-use and reversion conditions; letting the allowance exceed the cost of qualifying improvements (the excess is income to the tenant); and failing to specify in the lease who owns the improvements and that they revert to the landlord. Any of these can convert a tax-neutral allowance into taxable income.
Structure defensively: state in the lease that the allowance is payable only for construction of permanent improvements, require contractor invoices before disbursing funds, cap the allowance at actual improvement cost, and confirm the lease qualifies as a short-term retail lease if you intend to rely on Section 110. On a large allowance, the difference between a well-drafted and a sloppy lease can be six figures of tax — well worth counsel before signing.
Frequently asked questions
Is a tenant improvement allowance taxable income to the tenant?
Not if it is used exclusively for improvements to the leased space and the improvements are surrendered to the landlord at lease end, per IRS Rev. Proc. 2001-28. If the allowance is used for non-improvement purposes, the non-improvement portion is ordinary income.
How does a landlord deduct a tenant improvement allowance?
If the landlord owns the improvements, they capitalize and depreciate them (typically 15-year QIP). If the tenant owns the improvements, the landlord treats the allowance as a lease acquisition cost amortized over the lease term.
What depreciation period applies to leasehold improvements?
Interior improvements to a nonresidential building (after the building's initial placed-in-service date) are generally Qualified Improvement Property with a 15-year MACRS life, eligible for bonus depreciation. Structural components remain 39-year property.
What happens to leasehold improvements at lease termination?
If the tenant owns them and abandons them, the remaining basis can be deducted as an abandonment loss. If the improvements revert to the landlord, the landlord may take a new depreciation basis at the property's fair market value at that point.
Does bonus depreciation apply to tenant improvements?
Yes — Qualified Improvement Property qualifies for bonus depreciation. For property placed in service in 2024, the bonus rate is 60%; it phases down to 40% in 2025 and 20% in 2026 under the TCJA schedule. Bonus depreciation rules have changed with subsequent legislation, so confirm the rate for your placed-in-service year before relying on it.
What is the IRC Section 110 construction allowance exclusion?
Section 110 lets a retail tenant under a lease of 15 years or less exclude a landlord's construction allowance from income, to the extent it is used to build qualified long-term real property that reverts to the landlord at lease end. Any allowance exceeding the improvement cost is taxable to the tenant.
Who depreciates the improvements under a Section 110 allowance?
The landlord. Section 110(b) treats the qualifying improvements as nonresidential real property owned by the lessor, so the landlord depreciates them (generally 39-year property, or 15-year QIP for qualifying interior work), not the tenant.
Is a tenant improvement allowance a lease incentive for accounting?
For financial reporting under ASC 842, a TIA is generally treated as a lease incentive that reduces the right-of-use asset and lease expense over the term. That book treatment is separate from the tax rules and typically creates a book-tax difference to track.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.