Leasehold Improvements: Home Office Edition

Leasehold improvements are changes made to a rental property to meet the specific needs of a tenant. They can be applied to a home office, but it is important to note that these improvements are typically considered a one-time, non-refundable cost. While leasehold improvements can enhance the functionality and appeal of a space, they are generally left behind when a tenant moves out and are owned by the landlord unless otherwise specified in the agreement. In the context of a home office, claiming amortization from leasehold improvements can have tax implications, such as the potential loss of the principal residence exemption. Therefore, it is essential to carefully consider the financial and tax-related aspects before making leasehold improvements to a home office.

Leasehold improvements vs building improvements

Leasehold improvements are alterations made to a rental property to customise it for the particular needs of a specific tenant. They are commonly referred to as tenant improvements or build-outs and are usually undertaken by landlords of commercial properties. They can be initiated by the landlord to attract tenants or agreed upon during lease negotiations.

Leasehold improvements are limited to the interior of the building and must meet specific criteria. Changes made to the exterior of the building, the property grounds, and building improvements that benefit multiple tenants are not considered leasehold improvements. Repairs and common area maintenance also do not qualify as leasehold improvements.

Examples of leasehold improvements include:

• Painting
• Installing partitions
• Changing the flooring
• Putting in customised light fixtures
• Structural modifications
• Adding new drywall and flooring
• Updates to lighting, electrical, and technology systems
• Adding rooms, cubicles, and partitions
• Installing fixed pieces of equipment

Building improvements, on the other hand, are changes made to the building that benefit everyone in the property and generally change the overall structure of the building itself. Examples of building improvements include:

• Putting up a new roof
• Paving a driveway and/or parking lot
• Adding a parking lot
• Renovating the lobby
• Adding or repairing an elevator
• Updating the HVAC system

The distinction between leasehold improvements and building improvements is important, especially when determining who pays for the improvements and how they are treated for tax purposes. Leasehold improvements are typically paid for by the landlord or tenant, while building improvements are generally the responsibility of the building owner. Leasehold improvements are considered qualified improvement property (QIP) for tax purposes and are depreciated over the shorter of either the length of the lease or the life of the improvement. Building improvements, on the other hand, are depreciated over a longer term consistent with real property accounting rules.

What are leasehold improvements?

Leasehold improvements are changes made to a rental property to meet the specific needs of a tenant. They are also known as tenant improvements or build-outs. Leasehold improvements are commonly made in commercial real estate spaces, where building owners want to attract and retain tenants for as long as possible.

Leasehold improvements are made to the interior of a building and can include painting, installing partitions, changing the flooring, or putting in customised light fixtures. They can be as small as changing the lighting or as large as installing specialised equipment. They are distinct from building improvements, which are made outside of the rented space and benefit multiple tenants. For example, if a landlord adds a bathroom to a tenant's suite, it is a leasehold improvement, but if they renovate a bathroom that is shared by multiple tenants, it is a building improvement.

Leasehold improvements are typically paid for by the tenant and revert to the ownership of the landlord upon termination of the lease, unless the tenant can remove them without damaging the property. However, landlords may also pay for leasehold improvements or provide a tenant improvement allowance to cover some of the costs.

Who pays for leasehold improvements?

Whether it's a home office or a commercial space, leasehold improvements are changes made to a rental property to meet the specific needs of a tenant. They can be as small as changing the lighting or as big as installing specialised equipment. Leasehold improvements are usually negotiated between the landlord and the tenant before the lease is signed.

There are four main ways a landlord will pay for leasehold improvements:

• Tenant Improvement Allowance (TIA): The landlord gives the tenant a certain amount of money to cover the improvements, and the tenant oversees the work. The amount varies based on several factors, including square footage.
• Rent Discounts: The landlord offers free or discounted rent for a certain period, and the tenant uses the savings to pay for the improvements.
• Building Standard Allowance: The landlord offers an improvement package with options for flooring, fixtures, and fittings at a certain price. The tenant may select from the package but must pay for any improvements that are not included.
• Turnkey Projects: The tenant submits an improvement plan with cost estimates, and the landlord pays and oversees the work.

If the tenant pays for the leasehold improvements, they own the improvements unless the lease agreement states otherwise. However, they must be able to remove the improvements without damaging the property.

In the case of commercial leaseholds, nearly every net lease makes leasehold improvements the property of the landlord upon completion. The tenant is still responsible for maintaining and insuring the improvements.

When it comes to taxation, leasehold improvements are considered capital and are amortised over the length of the lease.

Are leasehold improvements tax-deductible?

Leasehold improvements are changes made to a rental property to meet the specific needs of a tenant. They are typically undertaken by landlords of commercial properties to make the space more appealing to prospective tenants.

Leasehold improvements are not tax-deductible. However, they are considered to be part of the building and are therefore prone to depreciation. The party that pays for and owns the improvements may take the depreciation deductions. The IRS allows for depreciation deductions, as long as certain conditions are satisfied.

If the landlord pays for the improvements, they own and depreciate the improvements, and there are no tax consequences for the tenant. If the tenant pays for the improvements, they own the improvements and can depreciate them. Upon termination of the lease, the tenant may claim an abandonment loss for the remaining tax basis in these improvements if they are left behind.

In the US, leasehold improvements are depreciated over the economic life of the building. The Protecting Americans from Tax Hikes (PATH) Act of 2015 allowed for a 15-year straight-line cost recovery on qualified leasehold improvements. The Tax Cuts and Jobs Act (TCJA) of 2017 modified some of the requirements, and leasehold improvements are now depreciated over 20 years or more.

Pros and cons of leasehold improvements

Leasehold improvements are changes made to a rental property to meet the specific needs of a tenant. They are commonly undertaken by landlords of commercial properties to attract and retain tenants for longer periods. However, leasehold improvements can also be initiated by the tenant.

Pros

• Customise the space for your needs: Leasehold improvements allow businesses to customise their rented space according to their unique requirements. This can include anything from changing the lighting to installing specialised equipment.
• Improve the quality of your business: A well-designed, comfortable, and practical office space can lead to happier employees and clients, ultimately improving the overall quality of your business.
• Tax advantages: Leasehold improvements are considered an asset and are eligible for depreciation or capital cost allowance (CCA). Depreciation is deductible for tax purposes, potentially lowering your tax burden.

Cons

• Unexpected delays and interruptions: Implementing leasehold improvements can take time and may cause unexpected delays, interrupting planned operations.
• Financing challenges: Depending on the scope and budget of the leasehold improvement plans, financing may be required, which can be difficult to obtain and maintain.
• Improvements are often permanent: Leasehold improvements are typically considered a one-time, non-refundable cost. Once the improvements are made, they cannot be removed when the tenant leaves the leased space.
• Costly: Commercial improvements are a significant expense, and the more alterations a space needs, the higher the cost will be.

Frequently asked questions