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The CARES Act fixed the qualified improvement property (QIP) "retail glitch" in 2020, restoring QIP's 15-year recovery period and its eligibility for bonus depreciation (see IRS Rev. Proc. 2020-25). Yet one question still trips up landlords and tenants on nearly every build-out: who actually gets to depreciate the improvement? The Big Beautiful Bill has now made 100% bonus depreciation permanent, which raises the stakes on getting that answer right.
Misclassifying who owns an improvement is one of the most common errors we see in lease reviews. The difference between correct and incorrect classification can mean tens of thousands of dollars in accelerated deductions, or deductions claimed by the wrong party and disallowed on audit.
This article breaks down the IRS rules governing leasehold improvement depreciation. You'll learn how lease agreements determine depreciation rights and which clauses to review before your next deal.
What Are Leasehold Improvements and Why Does Ownership Matter?
Leasehold improvements are permanent modifications made to rental property to meet a tenant's specific needs. You may also hear them called tenant improvements or TIs. Common examples include:
- Interior partition walls
- Lighting systems
- Specialized flooring
- Interior electrical and plumbing modifications
- Interior HVAC and mechanical upgrades
Here's the part that catches people off guard. The party that pays for improvements doesn't automatically get the depreciation deduction.
Tax ownership differs from physical ownership. The IRS doesn't simply look at who wrote the check. It weighs the benefits and burdens of ownership across several factors, including who controls the improvement, who bears the risk of loss and maintenance, and what the lease says about ownership and removal. Ownership is a facts-and-circumstances test, not a single yes-or-no clause.
Get this wrong, and you could miss deductions you're entitled to, or claim deductions that get disallowed on audit.
The IRS Rules: Who Actually Gets to Depreciate?
The general rule is straightforward. The party with tax ownership of the asset claims depreciation. That party must also have a cost basis in the improvement to depreciate it.
1. Tenant-owned improvements
If the tenant owns the improvement for tax purposes, the tenant depreciates it under MACRS over the asset's assigned recovery period, 15 years for QIP, regardless of the lease term. This is a common misconception worth correcting: current law does not let you write the improvement off over a shorter lease. Under IRC §168(i)(8), lessee improvements are recovered under MACRS even when that period is longer than the lease.
Tenant-owned QIP is generally eligible for bonus depreciation under the same rules that apply to any taxpayer. If the tenant abandons the improvement when the lease ends, the tenant can generally claim a loss for the remaining undepreciated basis at that time.
2. Landlord-owned improvements
If the landlord owns the improvement and has basis in it, the landlord depreciates QIP over 15 years. Under the Big Beautiful Bill, the landlord may claim bonus depreciation on QIP that is both acquired and placed in service after January 19, 2025, per IRS guidance on the additional first-year depreciation deduction. Property under a written binding contract signed before January 20, 2025 falls under the prior phase-down rules instead.
Factor
Tenant-Owned
Landlord-Owned (QIP)
Recovery period
MACRS period (15 yrs for QIP), ignoring lease term
15 years
Bonus depreciation
Yes, if QIP and taxpayer-owned
Yes, if acquired and placed in service after Jan 19, 2025
At lease end
May claim loss on remaining basis if abandoned
Continues depreciating
Can tenants still get bonus depreciation on improvements they pay for?
Yes. If you hold tax ownership of qualified improvement property and have a cost basis in it, you can generally claim bonus depreciation just as a landlord could. The 15-year recovery period and QIP definition apply the same way. What differs is whether the lease actually gives you tax ownership. Confirm your specific facts with your tax advisor.
What counts as QIP?
Only improvements to the interior of a nonresidential building, placed in service after the building was first placed in service, and made by the taxpayer. Enlargements, elevators and escalators, and any work on the internal structural framework do not qualify; those revert to 39-year treatment and are not bonus-eligible.
Lease Agreement Clauses That Determine Depreciation Rights
The lease is the primary document the IRS examines to weigh tax ownership. Four clauses matter most, and each is a factor in the benefits-and-burdens analysis.
1. Ownership of improvements clause
This states whether improvements become landlord property upon installation or remain tenant property. Look for language like "all improvements shall become the property of Landlord" or "Tenant shall retain ownership of all improvements."
2. Removal/restoration clause
If the tenant must remove improvements at lease end, they are more likely to retain tax ownership. If improvements stay with the property, the landlord typically owns them for tax purposes.
3. TI allowance structure
How the landlord funds improvements affects ownership and basis. If the landlord pays contractors directly, the landlord typically has basis and retains tax ownership. If the landlord reimburses the tenant, the analysis depends on the lease terms and how the allowance is characterized.
For retail build-outs specifically, IRC §110 provides a codified safe harbor that governs many TI allowances, it is the single most-used provision in retail deals. When a short-term lease of retail space (15 years or less) provides a qualified lessee construction allowance, that allowance is excluded from the tenant's income, and the resulting "qualified long-term real property" is treated as owned by the lessor for depreciation purposes (§110(b); Reg. §1.110-1). Two practical points are worth flagging:
- Revert-and-use conditions. Section 110 requires the property to revert to the lessor at lease termination and the allowance to be used to construct that property. Documentation matters here, and there is an information-reporting requirement to satisfy.
- Recovery period is unsettled. Whether §110 property can also be 15-year QIP rather than 39-year nonresidential real property is not free from doubt. Rather than assume a recovery period, confirm the right treatment with your tax advisor.
4. Lease term and renewal options
These affect lease-acquisition cost amortization and book treatment — not the MACRS recovery period of the improvement itself, which ignores the lease term.
Example: A landlord funds a $120,000 retail build-out, and the lease makes the improvements the landlord's property. Because the landlord owns the QIP and has basis in it, the landlord, not the tenant, depreciates it. With 100% bonus depreciation on QIP placed in service after January 19, 2025, that's a $120,000 first-year deduction, worth $44,400 at a 37% marginal rate ($120,000 × 37% = $44,400). If the tenant pays but the lease assigns ownership to the landlord, sec. 109 generally keeps that value out of the landlord's income and sec. 1019 denies the landlord basis, so the tenant, who has the cost basis, typically claims the depreciation. Amounts that are in substance rent are a separate analysis.
Financial Impact: Running the Numbers
With 100% bonus depreciation, whether the landlord or the tenant owns the QIP, the first-year result is the same. What actually drives the outcome is (1) whether the improvement is QIP and (2) whether the owner can use the deduction this year. Consider the same $200,000 improvement placed in service after January 19, 2025.
One caveat that trips up build-outs: most leasehold improvements are self-constructed property, and for self-constructed property the "acquired after January 19, 2025" test is met when physical work of a significant nature begins, not when the work is finished or the space is occupied (Reg. §1.168(k)-2(b)(5)(iv); a 10%-of-cost safe harbor is also available).
So a build-out that broke ground in, say, November 2024 but was placed in service in mid-2025 falls under the old phase-down (40% for a 2025 placed-in-service year), not 100%. Because leasehold improvements almost always straddle a construction period, confirm your begin-construction date before assuming the full 100%.
Scenario A: The improvement qualifies as QIP
A $200,000 interior improvement to a nonresidential building qualifies as QIP.
- 100% bonus depreciation: $200,000 deduction in Year 1
- At a 37% marginal rate: $74,000 tax savings in Year 1 ($200,000 × 37%)
Scenario B: The improvement does not qualify as QIP
The same $200,000 is spent on an enlargement or internal structural framework, which is excluded from QIP. It recovers over 39 years, straight-line, and is not bonus-eligible.
- Annual depreciation: about $5,128 per year ($200,000 ÷ 39)*
- Year 1 tax savings at 37%: about $1,897
The Year 1 difference is roughly $72,100 — driven almost entirely by classification, not by who signed the check. This is why identifying what qualifies as QIP (and what a cost seg study can reclassify to even shorter lives) matters so much.
*Simplified full-year illustration; actual first-year amounts depend on the placed-in-service month and applicable conventions.
What if my lease has renewal options? Do they change my depreciation?
For the improvement itself, no. You depreciate a tenant-owned improvement over its MACRS recovery period (15 years for QIP) regardless of the lease term or renewal options. Renewal options can affect how you amortize lease-acquisition costs and your book (GAAP) useful life, but they don't shorten or lengthen the tax recovery period of the improvement.
Negotiating Depreciation Rights in New Leases
Depreciation rights are negotiable. Both parties can benefit from structuring deals intentionally.
For landlords:
- Retain ownership of, and basis in, improvements to claim QIP bonus depreciation
- Fund TI allowances in a way that keeps the improvements landlord-owned
- Include clear language stating improvements become your property
For tenants:
- Negotiate language that gives you tax ownership if you want the deduction (tenant-owned QIP is bonus-eligible too)
- Include removal rights for improvements at lease end
- Weigh the trade-off between rent concessions and depreciation benefits
A cost segregation study can identify additional accelerated depreciation within leasehold improvements. Components like specialized electrical, decorative fixtures, and certain flooring may qualify for 5-year or 7-year recovery periods instead of 15.
Does it ever make sense for a landlord to let the tenant take the depreciation?
Yes. A deduction only has value to a party that can use it. A landlord in a low or zero bracket, a REIT, a tax-exempt entity, or an owner already carrying suspended losses may get little benefit, while a high-income tenant might. Trading depreciation rights for better rent terms can benefit both sides.
Who Can Actually Use the Deduction?
Owning the depreciation is only half the picture. Whether it produces savings this year depends on several limits investors often overlook:
- Passive activity loss rules. Rental losses, including those created by bonus depreciation, are generally passive. They can only offset passive income unless you qualify for real estate professional status or meet the short-term rental material-participation rules. Suspended losses carry forward.
- At-risk and basis limits. You can only deduct losses to the extent you're at risk and have basis in the activity.
- State conformity. Not every state conforms to federal bonus depreciation. Some require an add-back and regular-schedule depreciation for state tax.
- Section 179 alternative. Certain nonresidential building systems: roofs, HVAC, fire protection, and security systems can be expensed under Section 179 instead, subject to its own dollar and income limits.
Common Mistakes to Avoid
Investors frequently make these errors with leasehold improvement depreciation:
- Assuming the payer gets the deduction. Tax ownership and basis, not payment, determine depreciation rights.
- Not reviewing lease language before claiming depreciation. The IRS weighs your lease and the benefits and burdens of ownership, not your assumptions.
- Using the wrong recovery period. QIP uses a 15-year life, not the old 39-year schedule. Tenant-owned improvements use the MACRS recovery period, not the lease term.
- Overlooking cost segregation. An engineering-based study can accelerate deductions further within leasehold improvements.
- Ignoring recapture at sale. You'll owe tax on depreciation you've claimed when you sell.
What happens to my depreciation if I sell the property or terminate the lease early?
You'll face recapture on depreciation you've claimed. Personal property (Section 1245 assets, such as the 5- and 7-year items a cost seg study identifies) is recaptured as ordinary income, up to the 37% top rate. Real property (Section 1250) is more nuanced: depreciation taken above straight-line is recaptured as ordinary income, while the straight-line portion is "unrecaptured Section 1250 gain," taxed at a maximum 25% rate. Because bonus depreciation on QIP exceeds straight-line, part of that gain can come back as ordinary income, worth modeling before you sell.
If a tenant abandons improvements mid-lease, they may claim a loss for the undepreciated basis. A 1031 exchange can defer recapture but doesn't eliminate it. If you've already filed and need to correct your method, Form 3115 lets you catch up missed deductions through a §481(a) adjustment. Consult your CPA before any disposition.
Key Takeaways
- Tax ownership, not who pays, controls the deduction, and the owner must have cost basis. The IRS weighs the benefits and burdens of ownership.
- Tenant-owned improvements are depreciated under MACRS (15 years for QIP), ignoring the lease term. A 5-year lease does not create a 5-year write-off.
- Both landlords and tenants can claim 100% bonus depreciation on QIP acquired and placed in service after January 19, 2025, so classification (is it QIP?) usually matters more than which party owns it.
- A deduction only helps a party that can use it. Passive activity rules, tax bracket, and entity type (REIT or tax-exempt) decide whether depreciation delivers real savings this year.
- Recapture is not uniform. Section 1245 property recaptures at ordinary rates up to 37%; unrecaptured Section 1250 gain is capped at 25%, but bonus-driven excess depreciation can be ordinary.
- Cost segregation finds more savings. Components within leasehold improvements may qualify for 5- or 7-year lives instead of 15.
Classifying leasehold improvements correctly is one of the highest-leverage decisions in any lease. On a single property, getting it right can mean tens of thousands of dollars in additional first-year deductions.
Not sure who owns the depreciation on your improvements? A complimentary lease review from R.E. Cost Seg shows exactly where your depreciation rights stand and where deductions may be sitting unclaimed.
