Tenant Improvements and Bonus Depreciation

What are tenant improvements?

Tenant improvements (also called leasehold improvements or build-outs) are permanent alterations to the interior of a commercially leased space made to fit it for a tenant's use. They include partition walls, dropped ceilings, lighting systems, flooring, HVAC distribution, plumbing, and specialized finishes or millwork. The defining feature is permanence — these are structural additions that become part of the building, as opposed to furniture, trade fixtures, or removable equipment.

Tenant improvements can be paid for by the landlord (often through a tenant improvement allowance), by the tenant directly, or through a combination of both. Who pays matters for tax purposes because, in general, the party that owns the improvements is the party that depreciates them. When a landlord pays and retains ownership, the landlord claims the deduction. When the tenant pays out of pocket (or the landlord provides a cash allowance that the tenant treats as income), the tenant owns the improvements and depreciates them.

What is qualified improvement property (QIP)?

QIP is the tax-law category that governs the depreciation treatment of most tenant improvements. Under IRC §168(e)(6), QIP means any improvement to an interior portion of a building that is nonresidential real property, so long as:

• The improvement is placed in service after the date the building itself was first placed in service (i.e., you cannot make QIP improvements to a brand-new building in the same year it opens), and
• The improvement is not attributable to the enlargement of the building, an elevator or escalator, or the internal structural framework of the building.

The "interior" and "nonresidential" limitations are critical. Exterior improvements — a new roof, a facade upgrade, a parking lot — do not qualify. Improvements to residential rental property do not qualify. If the improvement widens, heightens, or otherwise enlarges the building's footprint or structural shell, it also fails the test.

Before the Tax Cuts and Jobs Act (TCJA, effective 2018), the code contained three separate favorable categories: qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property. The TCJA collapsed all three into a single QIP category with the intention of giving it a 15-year MACRS life. Due to a drafting error, QIP was omitted from the statutory list of 15-year property and defaulted to 39 years. The CARES Act fixed that retroactively, restoring the 15-year classification and eligibility for bonus depreciation for all QIP placed in service after December 31, 2017.

What does NOT qualify as QIP?

Understanding the exclusions prevents costly classification errors. These improvements do not qualify as QIP:

• Building enlargements. Adding square footage, new floors, or a new wing is structural work, not an interior improvement to an existing portion.
• Elevators and escalators. Explicitly excluded by statute. A new elevator shaft or cab is 39-year structural work.
• Internal structural framework. Load-bearing columns, beams, exterior walls, and the building's core structure are excluded. Note this differs from interior partitions, which are nonstructural and do qualify.
• Residential property improvements. Apartment building interior renovations are not QIP because the building must be nonresidential real property.
• Exterior improvements. Roofs, windows, doors, parking lots, driveways, and landscaping are structural components or land improvements — outside the QIP definition regardless of the property type.
• Same-year improvements to a new building. If you purchase a commercial building and make improvements in the same tax year it is first placed in service, those improvements are added to basis at 39 years, not treated as QIP.

The 15-year MACRS classification and method

Once improvements satisfy the QIP definition, they land in the 15-year MACRS property class under the General Depreciation System (GDS). The method is straight-line, and the applicable convention is the half-year convention (or mid-quarter if more than 40% of personal property placed in service falls in Q4). Under the Alternative Depreciation System (ADS) — which is required for certain taxpayers such as those electing out of the business-interest limitation under IRC §163(j) — QIP uses a 20-year straight-line life.

Using straight-line over 15 years, the annual deduction on $300,000 of QIP is $300,000 ÷ 15 = $20,000 per full year. With the half-year convention in year one, the first-year deduction before bonus is $10,000, and the final year picks up the remaining half-year.

Bonus depreciation rates and the phase-down schedule

Because QIP has a recovery period of 15 years — which is 20 years or less — it qualifies for bonus depreciation under IRC §168(k). Bonus depreciation allows a taxpayer to deduct a percentage of the asset's unadjusted depreciable basis in the year it is placed in service, with any remaining basis depreciated under the regular MACRS schedule.

The bonus percentages under current law (as of this writing) are:

• 100% — property placed in service after September 27, 2017, and before January 1, 2023
• 80% — placed in service in calendar year 2023
• 60% — placed in service in calendar year 2024
• 40% — placed in service in calendar year 2025
• 20% — placed in service in calendar year 2026
• 0% — placed in service after December 31, 2026, under current statute

Congress has periodically modified bonus depreciation rules; always confirm the applicable rate for the year the property is placed in service with current IRS guidance or a tax professional. Taxpayers can elect out of bonus depreciation on a class-by-class basis — meaning you can opt out for all 15-year property placed in service during the year. This election is irrevocable for that tax year and class.

Worked numeric example

Suppose a retail chain signs a 10-year lease on a 4,000 square foot space and spends $450,000 on interior build-out (flooring, partitions, dropped ceiling, lighting, HVAC distribution) in 2026. All improvements are to the interior of a nonresidential building placed in service years earlier, and none involve the building's structural frame or an elevator. These improvements qualify as QIP.

Cost basis: $450,000

MACRS classification: 15-year GDS, straight-line, half-year convention

2026 bonus depreciation rate: 20% (under current law)

Year-1 bonus deduction: $450,000 × 20% = $90,000

Remaining basis: $450,000 − $90,000 = $360,000

Regular MACRS on remaining basis, year 1 (half-year): $360,000 ÷ 15 × 0.5 = $12,000

Total year-1 deduction: $90,000 + $12,000 = $102,000

If the bonus rate had been 100%, the entire $450,000 would have been deducted in year one, leaving nothing to depreciate over the remaining 15-year life. At 20%, the tenant still gets a meaningful acceleration — $102,000 in year one versus $15,000 ($450,000 ÷ 15 × 0.5) without any bonus.

Section 179 as an alternative

Section 179 of the IRC allows a taxpayer to immediately expense the cost of qualifying property in the year it is placed in service, up to an annual dollar cap (indexed for inflation; check IRS Rev. Proc. for the current year's limit). QIP is qualifying property under Section 179. Unlike bonus depreciation, Section 179 cannot create or increase a net operating loss — the deduction is limited to taxable income from active trades or businesses. This limits its utility for real estate investors whose QIP expenses exceed their business income.

Key distinctions between bonus depreciation and Section 179 for QIP:

• Bonus depreciation can generate a loss and has no dollar cap on the amount deducted per year (beyond the applicable percentage of basis). It applies uniformly to all QIP placed in service during the year unless you elect out.
• Section 179 is elected asset-by-asset, cannot exceed the annual dollar limit, and cannot create a loss. It is more flexible when you want to pick specific assets to expense.

In practice, taxpayers with QIP that exceeds the Section 179 dollar limit or who want to create a loss for tax-planning purposes generally prefer bonus depreciation over Section 179.

Who claims the deduction — landlord or tenant?

The party that owns the improvements depreciates them. Ownership is determined by who bears the economic risk and retains the asset at the end of the lease. The following scenarios outline common arrangements:

Tenant-paid improvements (no allowance): The tenant owns the improvements and depreciates them as QIP on its own return. If the tenant is a pass-through entity (LLC, partnership, S-corp), the depreciation flows to the owners' individual returns.

Landlord-paid improvements: The landlord owns the improvements, classifies them as QIP, and takes the depreciation deduction. The landlord is the one who reports the improvements on Form 4562.

Tenant improvement allowance (TIA) — landlord retains ownership: When the landlord pays a TIA directly to contractors and retains ownership, the landlord depreciates the improvements. The tenant does not have a depreciable asset.

TIA paid to tenant — IRC §110 exclusion: If the landlord pays cash to the tenant and the IRC §110 exclusion applies (nonresidential property, improvements revert to landlord, lease term ≤15 years), the tenant excludes the TIA from income but takes a zero cost basis in the improvements. The tenant has no depreciation deduction because its cost basis is zero.

TIA paid to tenant — §110 exclusion does not apply: The tenant includes the TIA in income and also takes a cost basis equal to what it spent on the improvements. The tenant depreciates QIP and can claim bonus depreciation on that full basis.

Form 4562 reporting requirements

Both bonus depreciation and regular MACRS are reported on Form 4562, Depreciation and Amortization. For QIP:

• Part II handles the Section 179 election, if applicable.
• Part III, Special Depreciation Allowance is where you report the bonus deduction. Line 14 (or the applicable line for the current form year) collects the bonus percentage and qualified property cost.
• Part III, MACRS Depreciation then captures the regular depreciation on the remaining basis. List the asset in the appropriate line for 15-year property, noting GDS, straight-line, and the half-year convention.

The total depreciation from Form 4562 flows to the relevant schedule — Schedule E for rental real estate, or the business schedule (Schedule C or Form 1065/1120S for entities) for a business property. Keep supporting records: the date placed in service, the contract or invoice amount, a description of the work, and a record of whether the improvement meets QIP criteria. These records support the classification if the IRS audits.

State conformity to bonus depreciation

Bonus depreciation is a federal provision. Many states start with federal taxable income but do not fully conform to bonus depreciation — some require an addback of the federal bonus and then allow their own slower depreciation schedule. Common non-conforming states include California, New York, and Illinois, among others. Investors with QIP in multiple states should track a separate state depreciation schedule where the state decouples from federal bonus depreciation, adding back the acceleration and recouping it over the asset's remaining MACRS life. Verify each state's conformity for the applicable tax year.

The passive-activity interaction

A large bonus depreciation deduction on QIP can create a significant loss, but whether that loss is usable in the current year depends on the passive-activity loss rules. If the property is a rental held passively and the owner is not a real estate professional, the rental loss from bonus depreciation may be suspended until there is passive income or the property is sold. Run the numbers with and without bonus to determine whether the acceleration delivers current-year tax savings or merely creates a suspended loss carryforward. For active business use of commercial space, the loss may be fully usable against other income.

Frequently asked questions

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

Related

• Cost Segregation Calculator
• What Is MACRS Depreciation for Real Estate?
• Leasehold Improvements Depreciation Life