Leasehold Improvements
Leasehold improvements are alterations and modifications made to a commercial rental property with the purpose of enhancing its marketability or to fulfill the specific business requirements of the tenant. These alterations and changes can include installing partitions, painting walls or other interior space, fitting customized light fixtures, changing ceiling/ flooring etc.
The Internal Revenue Service defines a leasehold improvement as an improvement that is incurred solely by the lessee (or sublessee) for a building or part of a building that the lessee or sublessee occupies and that is completed at least three years after the building or building component was first used by anyone. The following improvements do not qualify as leasehold improvements: enlargement of the building, addition of an elevator or escalator, relating to structural components that benefit a common area or affect the internal framework of the building.
The IRS permits depreciation for leasehold improvements over the economic life of the improvement, which typically is anywhere between five and ten years. The IRS allows you to claim depreciation on qualified leasehold improvements in the same manner as on nonresidential real estate, if the improvement meets certain criteria.
Can Leasehold Improvements Be Expensed?
In addition, if you are a landlord or property owner and incur leasehold improvements for the benefit of a tenant, you can deduct those costs under Section 179 expensing. The IRS permits the deduction of up to $25,000 in taxable income for qualifying leasehold improvements.
Whether or not these expenses can be expensed depends on the nature of the lease and any internal capitalization or materiality policies for the company. It is important to consult with your tax professional before taking any depreciation on these expenses.
The IRS requires leasehold improvements to be amortized over the length of the lease or over their useful life, whichever is shorter. For example, let’s say a hair salon signs a five-year lease with the landlord. The lease term is shorter than the estimated useful life of the improvements, so they will record their annual amortization expense over a five-year period on their own accounting documentation.
Another consideration for the accounting treatment of leasehold improvements is whether or not there is an asset retirement obligation associated with them. If there is, you must account for these assets on the balance sheet.
If the leasehold improvement is not subject to an asset retirement obligation, you must account for the cost of the leasehold improvement in the same way you would a fixed asset such as office furniture or equipment. In addition to amortizing the cost of the leasehold improvement, you must also record it on the accumulated depreciation section of your assets account on your tax return.
You must report the cost of the leasehold improvement as a decrease to your business checking account. You can use this account for a variety of reasons, including paying off any debt that you owe to the lessor, or for recording an adjustment to your rent for a given year. You can also use this account to record an additional amount of depreciation that you accumulated during the year, but only if you meet specific rules set by the IRS.