Leasehold Improvement Concepts Examples and Accounting Essentials

Core Description

• Leasehold improvement refers to tenant- or landlord-funded permanent alterations made to leased premises to suit a tenant’s operations.
• Clear distinction between leasehold improvements, repairs, and other capital expenditures is crucial for accurate accounting and tax reporting.
• Proper planning, documentation, and understanding of both lease terms and regulatory requirements are vital to avoid costly errors and maximize value.

Definition and Background

Leasehold improvements are permanent alterations or renovations to leased space, designed specifically to meet the operational needs of an individual tenant. Unlike general repairs, which simply restore a property to its original condition, leasehold improvements enhance functionality, support branding, and adapt the premises for a tenant’s workflow. Common examples include constructing partitions, upgrading lighting and HVAC systems, installing special flooring, or adding accessibility features.

While the modifications benefit the tenant during their occupancy, ownership of these improvements typically—unless explicitly stated otherwise in the lease—passes to the landlord when the tenancy ends. Key concepts guiding leasehold improvements draw from longstanding property law, where the distinction between fixtures (often remain) and trade fixtures (removable) originally defined what does and does not transfer with a lease.

Historically, as commercial real estate grew, custom build-outs became essential for attracting tenants, leading landlords to offer tenant improvement (TI) allowances or turnkey fit-outs, often negotiated as part of the lease. From an accounting perspective, leasehold improvements are capitalized and depreciated over the shorter of their economic life or the lease term, per US GAAP and IFRS guidance. For tax, special provisions (like Qualified Improvement Property in the US) may accelerate depreciation depending on the current legal landscape.

Global differences exist in defining, funding, and taxing leasehold improvements. For example, UK and EU leases often stipulate detailed end-of-term restoration requirements, while US leases may focus on incentives and accounting treatments.

Calculation Methods and Applications

Understanding how to properly capitalize, depreciate, and track leasehold improvements is fundamental for tenants, landlords, and investors alike.

Cost Basis Determination

To determine the capitalized cost of leasehold improvements, include only those expenses directly leading to the asset being ready for use. These typically cover:

• Materials and labor
• Architectural and engineering design fees
• Necessary construction permits
• Demolition related to the improvement
• Construction management costs

Items such as employee training, temporary relocation, or business disruptions are not capitalizable. Landlord-provided Tenant Improvement Allowances (TIA) must be deducted from the cost basis.

Depreciation and Amortization

Under US GAAP and IFRS, leasehold improvements are depreciated over the shorter of:

• The lease term (including extensions that are reasonably certain), or
• The useful economic life of the improvement

For example, an improvement with a 10-year useful life in a 5-year, non-renewable lease must be depreciated over 5 years.

Straight-line Depreciation Formula

Annual depreciation = (Capitalized cost – Salvage value – Lease incentives) / Depreciation period in years

Typically, most leasehold improvements have no salvage value. Depreciation starts when the asset is placed in service, not upon payment or contract signing.

Tax-Specific Rules

In the US, many improvements qualify as Qualified Improvement Property (QIP), which may be depreciated over 15 years and potentially benefit from bonus depreciation (phasing down through 2026). Other improvements might require 39-year straight-line depreciation.

Special Considerations

• Early lease termination generally requires the unamortized improvement balance to be written off.
• Significant modifications or partial abandonments (for example, removing a partition wall) may require partial derecognition.
• Bonuses, Section 179 expensing, and bonus depreciation rules may affect timing depending on jurisdiction and year.

Comparison, Advantages, and Common Misconceptions

Comparison with Other Terminologies

Advantages of Leasehold Improvements

• Allow tenants to tailor spaces for their workflow, customer service, and branding.
• Enable landlords to offer tailored packages and may increase tenant retention.
• Depreciation and TI allowances can help align expense recognition with revenue benefits.

Disadvantages

• High upfront costs, often recovered slowly due to long depreciation schedules.
• Over-customization can limit future tenant attraction or result in stranded value if the lease ends early.
• Unclear lease terms may expose tenants to unexpected removal or restoration costs.
• Complex accounting and tax rules pose compliance risks.

Common Misconceptions

• All expenses are capitalizable: Routine maintenance, training, and relocation are expensed, not capitalized.
• Tenant always owns improvements: Most improvements revert to the landlord unless clearly identified as removable trade fixtures.
• Tax and book depreciation always match: Tax conventions (such as QIP) may differ from accounting rules, creating timing differences.
• Landlord always pays for improvements: Funding is negotiated—a tenant may bear excess costs over the TI allowance.

Practical Guide

Implementing leasehold improvements requires a structured approach, particularly in commercial leasing.

Defining Scope and Requirements

• Begin by mapping tenant operational needs: size, layout, utility, data, accessibility.
• List performance specifications and standards for each area (for example, acoustic ratings, finishes).
• Avoid limiting product choices to specific brands to maintain flexibility.

Reviewing the Lease

• Inspect all clauses relating to consent, TI allowances, build-out timing, removal, restoration, and amortization.
• Negotiate clear approval timelines, responsibilities, and restoration caps where possible.

Budgeting and Funding

• Build a detailed project budget, separating hard costs (construction, materials) and soft costs (design, permits).
• Align with TI allowance, cash flow projections, and risk reserves.
• Decide upfront who will fund overages and how changes are controlled.

Obtaining Permits and Insurance

• Confirm occupancy type and all code requirements: life safety, fire, accessibility.
• Ensure all work receives proper permits, landlord approval, and insurance coverage.
• Plan around permitting milestones to prevent delays.

Execution and Project Management

• Prequalify contractors, obtain competitive bids, and schedule construction to minimize business disruption.
• Use contract forms like GMP (guaranteed maximum price) to manage cost risk.
• Hold regular meetings, track project milestones, and document all finishes and systems installed.

Quality Control and Handover

• Insist on detailed inspections, especially for above-ceiling and life safety work.
• Require closeout documentation: as-built drawings, warranties, and fixed asset inventories.

Accounting and Documentation Best Practices

• Track each component separately for accounting (leasehold improvement, building improvement, repairs).
• Archive all invoices and agreements for audit readiness.

Case Study (Fictitious Example)

A midsized design firm based in New York leases 8,000 square feet in a downtown office building. The landlord offers a USD 50/sf TI allowance, covering most of the planned build-out: glass conference rooms, new carpet, custom lighting, and advanced cabling. The improvements cost USD 500,000 in total. The tenant’s accounting team capitalizes the eligible costs and depreciates them over the five-year lease term, as the lease has no reasonably certain renewal option. When the lease ends, all built-in assets revert to the landlord, per the lease agreement, and the tenant removes only IT servers and movable furniture. Additional costs for removing redundant cabling are accounted for as a restoration expense, planned and accrued during the final year.

Resources for Learning and Improvement

• US GAAP and IFRS Standards: ASC 842, ASC 360, IFRS 16, IAS 16, IAS 36.
• IRS Publications: IRS Pub. 946, Form 4562, and IRC 168 for Qualified Improvement Property.
• Construction and Lease Guides: AIA A201/A102, BOMA standards, CSI MasterFormat.
• Legal and Lease Structuring Resources: NAIOP guides, RICS Red Book, Appraisal Institute texts.
• Risk and Safety Manuals: NFPA (National Fire Protection Association), OSHA, ASHRAE, WELL and LEED standards.
• Industry Associations: AICPA, NAIOP, IFMA, RICS.
• Educational Content: Webinars, CPE courses, and case study collections focused on lease accounting, tenant fit-outs, and tax planning.

FAQs

What counts as a leasehold improvement?

Leasehold improvements are permanent changes to leased space for specific tenant use, such as built-in partitions, HVAC and electrical upgrades, and specialized lighting. Movable furniture and temporary fixtures are generally excluded.

Who pays for leasehold improvements?

Either party can pay, or costs may be shared. Landlords often provide a tenant improvement allowance (TIA); any cost above this allowance is typically paid by the tenant.

How are leasehold improvements recorded in accounting?

The party controlling the improvement capitalizes it, depreciating over the shorter of the useful life or lease term under US GAAP/IFRS. Only directly attributable costs are included; routine repairs are expensed.

How are leasehold improvements depreciated for tax?

In the US, many improvements qualify as Qualified Improvement Property (QIP), eligible for accelerated depreciation and sometimes bonus depreciation. For other improvements, a 39-year schedule may apply. Tax treatment varies by jurisdiction.

What happens to leasehold improvements at lease end?

Most often, leasehold improvements become the landlord’s property. The tenant may need to remove certain items or restore the space, depending on the lease. Early termination may result in accelerated expense recognition.

What is a tenant improvement allowance (TIA)?

A TIA is a landlord contribution (in cash or construction) to help pay for improvements. For accounting, it is treated as a lease incentive, amortized against rent over the lease term.

Can leasehold improvements be removed or transferred?

Generally, only trade fixtures (equipment or installations used in tenant’s business) may be removed before lease end, as long as damage is repaired. Most improvements remain unless the lease states otherwise.

Repairs vs. improvements: how to distinguish?

Repairs maintain current functionality and are expensed. Improvements enhance utility or extend asset life and are capitalized. Use the “betterment, adaptation, or restoration” test to distinguish.

Conclusion

Leasehold improvements are an important aspect of shaping functional and attractive leased spaces for tenants, while also adding long-term value for landlords. A disciplined approach—covering scoping, funding, approvals, tax and accounting, and end-of-lease issues—can help all parties optimize outcomes and minimize pitfalls. Distinguishing leasehold improvements from repairs, understanding ownership and funding rules, and maintaining robust documentation are crucial. As real estate and workplace needs evolve, careful planning and clear, fair lease terms will ensure leasehold improvements remain an effective tool for transforming spaces and supporting business requirements.