Commercial landlords and tenants spend heavily on tenant improvements each year: interior build-outs, mechanical upgrades, and custom finishes that make leased space usable. Yet many of them never claim the depreciation those improvements generate. The problem usually comes down to one question neither side answers clearly: who actually owns the improvements for tax purposes?
Getting this right matters. Tenant improvement ownership rules can determine tens of thousands of dollars in annual deductions. Get the lease language wrong, and you may hand those deductions to the other party.
This article explains the IRS rules on tenant improvement ownership, how lease terms shift depreciation rights, and what each side can do to protect its position. It includes worked dollar examples for both landlords and tenants, plus lease clause language to review with your advisors.
What Are Tenant Improvements? A Quick Refresher
Tenant improvements (TIs) are alterations or additions made to leased commercial space to suit a tenant's needs. Common examples include interior build-outs, HVAC modifications, partition walls, flooring, lighting, and specialty electrical systems.
Three terms often get used interchangeably, but they carry distinct tax meanings:
- Tenant improvements: A general industry term for any modifications a tenant makes to leased space.
- Leasehold improvements: A general term for improvements made by a lessee to leased property. Before the TCJA, qualified leasehold improvement property (QLIP) was a separate 15-year depreciation category. The TCJA consolidated QLIP and related categories into qualified improvement property (QIP), and the CARES Act later confirmed QIP's 15-year recovery period.
- Qualified improvement property (QIP): Any improvement a taxpayer makes to the interior of nonresidential real property after the building is first placed in service. QIP excludes building enlargements, elevators and escalators, and the internal structural framework (IRC §168(e)(6)). QIP depreciates over 15 years and qualifies for bonus depreciation.
Who pays for the improvements is only one factor. Who owns them for tax purposes is what determines who claims the depreciation.
Lessee vs. Lessor: Who Owns the Improvement?
The IRS does not simply look at who wrote the check. Tax ownership of tenant improvements turns on which party holds the benefits and burdens of ownership.
The IRS Framework for Determining Tax Ownership
The IRS weighs three key elements:
- Economic substance. Who bears the economic risk and reward of the improvement? If the improvement has no value outside the specific lease, the tenant likely owns it for tax purposes.
- Lease terms. Does the lease specify that improvements revert to the landlord at lease end? Reversion clauses can shift tax ownership to the lessor.
- Intent of the parties. Was the improvement intended to be permanent or removable? Permanent fixtures that become part of the building structure point toward landlord ownership.
The general default works like this: If the tenant pays for and installs the improvements, the tenant depreciates them under MACRS over the recovery period assigned to the asset, 15 years for QIP, 39 years otherwise, regardless of the lease term (IRC §168(i)(8)(A)). A five-year lease does not create a five-year write-off. Any basis remaining when the lease ends is generally deductible as an abandonment loss. If the landlord pays, the landlord depreciates them.
A common source of error here is book-vs-tax confusion. Amortizing improvements over the lease term, including "renewal periods the tenant is reasonably certain to exercise," is ASC 842 lease accounting language. It has no application to the tax recovery period.
The gray area sits in the middle. Tenant-funded improvements that become the landlord's property at lease expiration create the most confusion, and the lease language usually resolves the ambiguity.
What if my tenant pays for the improvements, but my lease says I own them at the end?
This is a common dispute in commercial real estate tax planning. When a lease states that all improvements become the landlord's property at termination, the IRS may treat the landlord as the tax owner, even if the tenant paid for the work. Economic substance still matters. If the tenant funded the improvement, used it exclusively during the lease, and received no compensation at expiration, the tenant may still depreciate it. Review the specific lease language with your CPA. The answer depends on the totality of facts and circumstances.
How Tenants Depreciate Their Improvements
Tenants hold a real tax advantage on improvements they own for tax purposes. Under current law, QIP depreciates over 15 years using the straight-line method (Rev. Proc. 2020-25; IRC §168(e)(6)). That is a major acceleration from the 39-year schedule that applies to most other interior work.
QIP also qualifies for bonus depreciation. Under the Big Beautiful Bill, qualified property acquired and placed in service after January 19, 2025 receives permanent 100% bonus depreciation (IRC §168(k); IRS guidance). A tenant can expense the full cost of qualifying improvements in Year 1, provided the tenant has enough business income to use the deduction.
One timing caveat applies. Property acquired between January 1 and January 19, 2025, or under a written binding contract signed before January 20, 2025, is limited to 40% bonus rather than 100%.
For improvements that do not qualify as QIP, tenants recover the cost over the MACRS period assigned to the asset, generally 39 years for nonresidential real property, even when that period runs past the end of the lease. The lease term does not shorten the tax recovery period; the remaining basis is addressed through an abandonment loss at lease end.
Common tenant improvements eligible for acceleration:
- Interior build-outs and partition walls
- Specialty electrical and data cabling
- Custom lighting and ceiling systems
- Flooring and decorative finishes
- Interior HVAC serving the tenant's space, where it meets the QIP definition
Financial Example: Tenant Build-Out
A dental practice spends $180,000 on a build-out of leased commercial space in 2025, and the improvements qualify as QIP. The figures below assume a 37% marginal tax rate and enough business income to absorb the deduction.
- Depreciable basis: $180,000
- Recovery period: 15 years (QIP)
- 100% bonus depreciation: $180,000 first-year deduction
- First-year tax savings at 37%: $66,600
Compare that with straight-line depreciation over 39 years: roughly $4,615 per year, or about $1,708 in annual tax savings. Bonus depreciation does not create extra deductions over the life of the asset; it accelerates them into Year 1. The benefit is the time value of that first-year cash, roughly $64,892 more than a 39-year schedule would deliver in the first year.
How Landlords Depreciate Tenant Improvements
When landlords own tenant improvements, they generally depreciate them over the recovery period for the building type: 39 years for nonresidential property and 27.5 years for residential rental property (IRC §168(c); IRS Publication 946).
Those are long timelines. A cost segregation study can reclassify components of tenant improvements into shorter-life categories. Specialty electrical, decorative finishes, and custom cabinetry often qualify as 5- or 7-year Section 1245 property, and site work such as parking, sidewalks, and landscaping is generally 15-year land-improvement property. With 100% bonus depreciation, those reclassified components become immediately deductible. R.E. Cost Seg's engineering analysis, including site visits, identifies which components qualify.
HVAC is a common point of confusion. HVAC serving a nonresidential building is generally a 39-year structural component and is not bonus-eligible, though it may qualify for Section 179 expensing. Only interior HVAC that meets the QIP definition falls into the 15-year, bonus-eligible category.
TI Allowances and Depreciation
Many commercial leases include a tenant improvement allowance: cash or a rent concession the landlord provides to fund the tenant's build-out. When the landlord funds and owns the improvements, the landlord depreciates them.
The structure matters for tenants. If the landlord pays a cash allowance to the tenant to build tenant-owned improvements, that allowance is generally taxable income to the tenant, unless it meets the Section 110 safe harbor for qualified lessee construction allowances on short-term retail leases (IRC §110). Set the allowance structure with your CPA before signing.
Landlords should be careful about improvements that revert to them at lease termination. Under IRC §109, a lessor excludes from income the value of lessee-built improvements received at the end of a lease, unless the improvements are in lieu of rent. IRC §1019 correspondingly denies the lessor any basis in them. No basis means no depreciation. A landlord does have basis in improvements it funded itself, including through a TI allowance, and in amounts treated as received in lieu of rent, which are income to the landlord.
Financial Example: Landlord TI Allowance with Cost Segregation
A landlord provides a $250,000 TI allowance for a retail fit-out and owns the improvements. Without cost segregation, the full $250,000 depreciates over 39 years, about $6,410 per year. The figures below assume a 37% marginal rate and that the landlord can currently use the deduction (see the passive activity note below).
A cost segregation study identifies:
- $95,000 in 5-year property (specialty electrical, decorative finishes, custom cabinetry)
- $40,000 in 15-year property (land improvements and qualifying site work)
- $115,000 remaining as 39-year property
With 100% bonus depreciation on the accelerated components:
- First-year deduction: $135,000 (bonus) + $2,949 (39-year portion) = $137,949
- First-year tax savings at 37%: $51,041
Without cost segregation, first-year tax savings would be about $2,372. The study accelerates roughly $48,669 of tax savings into Year 1.
Passive activity note: Rental real estate losses are generally passive under IRC §469. A landlord may not be able to deduct TI depreciation against active or W-2 income unless they qualify as a real estate professional or materially participate in a qualifying short-term rental. Suspended losses carry forward until the taxpayer has passive income or sells the property.
Common Mistakes That Cost Deductions
Four mistakes account for most lost TI depreciation deductions:
- Mistake 1: The tenant claims depreciation on improvements the lease assigns to the landlord. If the lease and the economic substance point to landlord ownership, the tenant's claim will not hold up under IRS scrutiny.
- Mistake 2: The landlord depreciates improvements it never paid for. If the tenant paid for improvements that revert to you at lease end, IRC §§109 and 1019 generally mean you recognize no income and take no basis, so there is nothing new for you to depreciate. You do have basis in improvements you funded yourself, including via a TI allowance, and in amounts received in lieu of rent, which are income to you.
- Mistake 3: Neither party claims the deduction. The tenant assumes the landlord is depreciating the improvements, and the landlord assumes the tenant is. No one takes the deduction.
- Mistake 4: Using 39-year straight-line on improvements that qualify for 15-year QIP or shorter lives. Defaulting to 39 years when components qualify for 5- or 15-year recovery defers tens of thousands in deductions.
Comparison: Tenant vs. Landlord Depreciation Scenarios
Lease Clause Templates to Protect Your Depreciation Rights
Lease language is a primary factor in TI depreciation outcomes. The IRS looks to the lease agreement to help establish ownership, reversion, and removal rights. Clause language is evidence of the parties' intent, but it does not override the economic substance of the arrangement. Draft these terms with your CPA and real estate attorney before signing.
Landlord-Protective Clause
"All improvements, alterations, and additions made to the Premises by Tenant shall become the property of Landlord upon installation and shall remain upon and be surrendered with the Premises at the expiration or termination of this Lease. Landlord shall be entitled to all tax benefits associated with such improvements, including depreciation deductions."
Investor impact: This supports the landlord's claim to depreciate tenant-installed improvements. The claim still depends on the facts. If the tenant funds and exclusively uses an improvement, the IRS may respect tenant ownership despite the clause.
Tenant-Protective Clause
"All improvements made by Tenant at Tenant's sole expense shall remain the property of Tenant for the duration of the Lease Term. Tenant shall be entitled to depreciate such improvements for federal and state tax purposes. At Lease expiration, Tenant may remove improvements or abandon them at Tenant's election."
Investor impact: This supports the tenant's right to depreciate improvements throughout the lease. The removal option reinforces the tenant's ownership position and can preserve a loss deduction on any remaining basis when the lease ends.
Hybrid Clause
"Improvements funded solely by Landlord or through Landlord's TI Allowance shall be Landlord's property for all purposes, including tax depreciation. Improvements funded solely by Tenant shall be Tenant's property for tax purposes during the Lease Term. At Lease expiration, Tenant-funded improvements shall revert to Landlord."
Investor impact: This allocates ownership based on who funds the improvement and gives both parties a clearer basis for their respective deductions.
Every TI depreciation clause should address these elements:
- Ownership of improvements during and after the lease
- Reversion rights at lease expiration
- Removal rights for the tenant
- Cost allocation between landlord-funded and tenant-funded improvements
- Tax reporting responsibility for each party
Can I renegotiate my lease to change who gets the depreciation deduction?
Yes. Lease amendments can modify TI ownership and depreciation rights, but changing ownership mid-lease creates complexity. The party giving up the deduction may need to file Form 3115 to change accounting methods and report a Section 481(a) adjustment. The party gaining the deduction will need documentation supporting the new ownership position. Both parties should coordinate with their CPAs before executing an amendment.
What Happens When the Lease Ends or the Property Sells?
TI depreciation does not simply stop when a lease ends or a property changes hands. Several tax events can occur.
Lease Expiration
When tenant improvements revert to the landlord at lease end, the tenant may claim an abandonment loss for any remaining undepreciated basis (IRC §165; disposition rules under IRC §168(i)(8) and Reg. §1.168(i)-8). Many tenants miss this because they stop tracking the adjusted basis of their TIs after move-out.
Early Lease Termination
If a tenant vacates before the lease expires, the remaining undepreciated basis of tenant-owned improvements can generally be deducted in the year of termination as an abandonment loss.
Property Sale
When a landlord sells, depreciation on the TIs is recovered at sale through recapture. Depreciation on the building and structural components (Section 1250 property) is treated as unrecaptured Section 1250 gain and taxed at a maximum 25% rate (IRC §1(h)). Components reclassified as Section 1245 personal property through cost segregation are recaptured as ordinary income, up to the 37% top rate (IRC §1245).
For landlords planning a 1031 exchange, a like-kind exchange can defer gain on the real property. Since the TCJA, Section 1031 applies to real property only (IRS like-kind exchange guidance). Cost-seg components classified as Section 1245 personal property can trigger recapture at the exchange if the replacement property holds less Section 1245 property, so coordinate any study with the exchange.
Financial Example: Early Lease Termination
A tenant vacates a warehouse 4 years into a 10-year lease after spending $120,000 on improvements that do not qualify as QIP and are therefore recovered over 39 years under MACRS, not over the lease term. The figures below assume a 37% marginal rate and ignore first-year convention adjustments.
- Annual straight-line depreciation (39 years): roughly $3,077
- Total depreciation claimed (4 years): roughly $12,308
- Remaining undepreciated basis: roughly $107,692
- Abandonment loss in year of termination: roughly $107,692
- Tax savings at 37%: roughly $39,846
Many tenants miss this deduction. If you terminate a lease early, work with your CPA to claim it.
What happens to my depreciation deductions if I sell the property before the tenant's lease is up?
When you sell a property with active tenant improvements, depreciation taken on those TIs is recovered at sale. Depreciation on 39-year structural components (Section 1250 property) is treated as unrecaptured Section 1250 gain, taxed at a maximum 25% rate. Components accelerated through cost segregation into 5- or 15-year categories (Section 1245 property) are recaptured as ordinary income, up to 37%. A 1031 exchange can defer gain on the real property, but since the TCJA it applies to real property only, and Section 1245 components can create current recapture if the replacement property holds less such property.
Take Control of Your TI Depreciation
Key takeaways:
- Tax ownership decides who depreciates. Lease terms, economic substance, and the parties' intent, not who paid, control the deduction.
- QIP plus 100% bonus lets tenants expense qualifying improvements in Year 1, provided they have income to use the deduction.
- A cost segregation study can move a meaningful share of TI cost into 5-, 7-, and 15-year property, producing large first-year deductions for landlords.
- Passive loss rules can defer the benefit. Confirm you can use the deduction this year before you count on the cash (IRC §469).
- Set lease language before signing. Use the clauses above as a starting point with your CPA and attorney.
Whether you fund a $250,000 TI allowance as a landlord or build out a $180,000 space as a tenant, these rules directly affect your cash flow and returns. Schedule a free cost segregation consultation to see which improvements qualify for accelerated depreciation.
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