With contributions from Marcus Atherly.
The federal tax code provides significant tax benefits for lessees who improve their leased business property — bonus depreciation, expensing under Section 179, and a shorter depreciable life, for example.
Assuming your improvements satisfy the various rules to qualify, the tax benefits can help you to recover your costs more quickly. However, these rules changed significantly as a result of the Tax Cuts and Jobs Act of 2017.
To understand the potential benefits for leasehold improvements and their relevance to your situation, it’s important to first understand a few key tax-related concepts.
Section 1250 and Section 1245 Property
As a general rule, if an improvement is attached to the structure of the building in some way, it is considered real property under Section 1250 of the Internal Revenue Code (IRC).
Movable property, such as furniture and equipment, is personal property under Section 1245 of the Code.
Leasehold improvements are enhancements to a leased space that are paid for by a tenant or landlord. For example, an interior improvement such as the addition of built-in cabinetry, electrical additions or carpeting.
Federal Tax Rules Before the Tax Cuts and Jobs Act of 2017
Before the Act, the federal tax code established separate definitions and rules for qualified leasehold improvements, qualified restaurant property, qualified retail property and qualified improvement property.
These pre-Act rules were as follows:
|Type of Property||Straight Line Recovery Period||Eligible for Section 179||Eligible for Bonus Depreciation|
|Qualified Leasehold Improvement Property||15||Yes||Yes|
|Qualified Improvement Property||39||No¹||Yes|
|Qualified Restaurant Property||15||Yes||Yes|
|Qualified Retail Property||15||Yes||No²|
|Qualified Restaurant or Retail + QIP||15||Yes||Yes|
Federal Tax Rules After the Tax Cuts and Jobs Act
Effective for property placed in service after 2017, the Act consolidates the various leasehold improvement categories into one category — qualified improvement property. It includes the former qualified leasehold improvement property, qualified restaurant property and qualified retail property.
Qualified improvement property consists of improvements to the interior of nonresidential real property. These improvements must have been placed in service after the building was first placed in service. Qualified improvement property excludes enlargements to the building and the building’s elevators/escalators.
The primary federal tax benefits for lessees and building owners who improve qualifying business property include bonus depreciation, expensing under Section 179, and a shorter depreciable life.
|Type of Property||Straight Line Recovery Period³||Eligible for Section 179||Eligible for Bonus Depreciation³|
|Qualified Improvement Property||15||Yes||Yes|
Under the Act, qualified improvement property has a depreciable life of 15 years.³ This 15-year life can provide a significant tax benefit as nonresidential Section 1250 property is typically depreciable over a 39-year period.
Section 179 Expensing
You can generally expense qualified improvements under Section 179, as opposed to depreciating them.
The Act increased the expensing limit to $1 million, up from $510,000. Section 179 expensing phases out based on asset additions over $2.5 million, up from the pre-Act $2.03 million.
Bonus depreciation provides a deduction equal to a percentage of the adjusted basis of qualifying property the first year it is placed in service. Qualified improvement property is eligible for bonus depreciation.³
The Act extends the deduction for bonus depreciation through 2026. Effective for property placed in service after September 27, 2017, the percentage for bonus depreciation increased to 100% (from 50%) through 2022. After 2022, the percentage decreases by 20 percent each year.
Under the Act, both new and used property are eligible for bonus depreciation. Property must generally have a recovery period of 20 years or less, which excludes residential real property and nonresidential real property that does not qualify as qualified improvement property.
¹ Unless the property also qualifies as qualified leasehold improvement, qualified retail improvement or qualified restaurant improvement property.
² Unless the improvement also qualifies as qualified leasehold improvement property.
³ In an apparent oversight, Congress did not establish the intended 15-year recovery period for qualified improvement property in the Act, although it had signaled its intent to do so. Until a technical correction to the Act is enacted, the recovery period is 39 years and such property is not eligible for bonus depreciation.
Wondering how the Tax Cuts and Jobs Act affects the rules