Many tenants, especially in commercial buildings, want custom buildouts and structural modifications to make leasehold spaces suitable for their specific business needs.
To attract such tenants, you should make allowances for or pay for leasehold improvements. Luckily, the modifications often include the addition of shorter-lived assets whose depreciation you can accelerate.
Therefore, it makes sense to take advantage of the leasehold improvements bonus depreciation opportunity to reduce or eliminate your tax liability. You will need a cost segregation study to identify the property components that qualify for bonus depreciation.
At Seneca Cost Segregation, we specialize in conducting engineering-based studies that identify and reclassify shorter-lived building components, such as personal property, site improvements, and qualified improvement property.
Moreover, we provide post-study support to ensure you and your CPA can implement our findings effectively. Request a free proposal.
What Are Leasehold Improvements?
Leasehold improvements are modifications made to a rental property to meet the specific needs of a tenant.
The modifications are generally permanent or semi-permanent and typically include installing interior walls, partitions, customized lighting, and new flooring. Some tenants may also want upgrades to plumbing or electrical systems.
At the end of the lease, the landlord retains ownership of the new assets, unless the lease agreement states otherwise.
Qualified Improvement Property (QIP) vs. Qualified Leasehold Improvements (QLI)
The tax code historically referred to modifications made to the interior of a building that were eligible for favorable tax treatment as Qualified Leasehold Improvements (QLI).
However, the Tax Cuts and Jobs Act (TCJA) of 2017 replaced the term QLI with the broader Qualified Improvement Property (QIP).
In establishing QIP, TCJA 2017 consolidated various categories of leasehold improvements, including the former QLI. For accurate classification of QIP for the purpose of claiming leasehold improvements bonus depreciation, it is best to commission a cost segregation study.
Can You Take Bonus Depreciation on Leasehold Improvements?
Yes, you can take bonus depreciation on leasehold improvements if they meet Qualified Improvement Property criteria.
Bonus depreciation, also called Additional First Year Depreciation Deduction, is a tax incentive allowing you to deduct up to 100% of the value of a qualifying property in the year you put it in service.
Properties with recovery periods of 20 years or less generally qualify for bonus depreciation. Because the prescribed recovery period for QIP is 15 years, leasehold improvements that meet the QIP criteria qualify for bonus depreciation.
Eligibility of Leasehold Improvements for Bonus Depreciation
The eligibility criteria for QIP are as follows:
- The improvements must be to the interior of a building
- The property must be a non-residential real property (e.g., office, retail, commercial)
- The improvements must be placed in service after the building was originally placed in service by any taxpayer
Additionally, QIP explicitly excludes improvements to enlarge the building (e.g., expanding floor space or building volume), elevators/escalators, and changes to the building’s core structure (e.g., structural columns and load-bearing walls).
Common improvements that do qualify include:
- Ceiling
- Drywall
- Framing
- Floorings
- Interior doors
- Fire protection equipment
- Electrical and lighting systems
- HVAC and plumbing, if they are within the tenant’s space
Either the landlord or the lessee can claim bonus depreciation on the QIP, depending on who paid for the leasehold improvements.
How Bonus Depreciation Works for Leasehold Improvements
Traditionally, you depreciate the entire cost basis of a commercial property linearly over 39 years. However, many building components don’t last that long.
The IRS allows you to segregate the building components so you can subject them to depreciation schedules consistent with their actual useful lives. The IRS prescribes the following recovery periods for various property components:
- Real property (the core building structure): 39 years
- Site improvements (landscaping, fences, parking lots, etc): 15 years
- Qualified Improvement Property: 15 years
- Personal property (office furnishings, fixtures, etc): 7 years
Because bonus depreciation applies to properties with recovery periods of 20 years or less, it is QIP’s 15-year recovery period that unlocks bonus depreciation for leasehold improvements.
Instead of allocating the entire cost of the improvements over 15 years, you can expense up to 100% of the cost immediately with bonus depreciation.
The original Tax Cuts and Jobs Act of 2017 initially allowed for 100% bonus depreciation through 2022, phasing it out as follows:
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
- 2027: 0%
However, the One Big Beautiful Bill Act, signed into law on July 4, 2025, reversed the phase-out schedule, permanently reinstating bonus depreciation to 100% for properties placed in service after January 19, 2025.
Assuming you make qualifying leasehold improvements worth $100,000, how would bonus depreciation work under these circumstances? Here’s how:
- If the improvements were in 2022, 100% bonus depreciation applies, and you can deduct the entire $100,000 (you can do so retroactively by filing for a change in accounting method using IRS Form 3115).
- If the improvements were in 2024, 60% bonus depreciation applies, and you can deduct $60,000 immediately. You’ll depreciate the remaining $40,000 normally over 15 years.
- If you completed the improvements after January 19, 2025, 100% bonus depreciation applies, and you can immediately expense the entire $100,000.
Key Changes Under the Tax Cuts and Jobs Act (TCJA)
Before the Tax Cuts and Jobs Act of 2017, there were separate categories of properties that were eligible for favorable tax treatment, which included:
- Qualified Leasehold Improvement Property (QLIP)
- Qualified Restaurant Property (QRP)
- Qualified Retail Improvement Property (QRIP)
TCJA replaced these separate categories with a single, broader classification: Qualified Improvement Property (QIP).
QIP now has a 15-year recovery period. While the 15-year recovery period was the intention from the outset, a drafting error when the TCJA was initially passed in 2017 assigned a 39-year life.
As a result, leasehold improvements placed in service in 2018 and 2019 were not eligible for bonus depreciation.
To address this issue, the CARES Act of 2020 retroactively applied the intended 15-year life. If you made qualifying leasehold improvements in 2018 and 2019, you can “catch up” on the bonus depreciation you may have missed using IRS Form 3115.
Depreciation Methods and Tax Treatment Options
Leasehold improvements bonus depreciation allows you to deduct a significant portion of the cost of your improvements in the first year. It is a valuable tool, but the IRS allows the use of other depreciation methods.
The standard depreciation method is the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, you have two options:
- General Depreciation System (GDS): Under GDS, QIP has a 15-year recovery period. It’s the standard method that allows for bonus depreciation.
- Alternative Depreciation System (ADS): ADS is a less common method that assigns a 20-year recovery period to QIP. Your improvements won’t be eligible for bonus depreciation. You can elect to use ADS when you want to avoid interest expense limitations.
When you need an alternative to bonus depreciation that allows you to expense the cost of improvements immediately, you can also use Section 179.
Section 179 allows you to deduct the cost of qualifying property when you first place it in service. However, it differs from bonus depreciation because it has the following limitations:
- There’s an annual dollar limit that a business can expense using Section 179. For example, for tax years beginning in 2024, the maximum deduction is $1,220,000.
- The deduction begins to phase out dollar-for-dollar once you place more than the allowed maximum Section 179 property into service during the tax year. For example, for tax years beginning in 2024, the threshold is $3,050,000.
- You cannot create a loss using Section 179.
In contrast, bonus depreciation has no dollar limit, and you can create or increase a net loss by taking a massive first-year deduction that outpaces your income.
Indeed, many savvy property investors are now making their real estate losses non-passive so that they can use the paper losses to offset all income, including business and W-2 income. Their tax planning strategy typically has two moving parts:
- Qualifying for Real Estate Professional (REP) status or being a material participant in a Short Term Rental (STR) to ensure their real estate losses are non-passive
- Doing cost segregation studies year-round on old or new properties to consistently lock in tax savings using bonus depreciation on site/land improvements, personal property, and QIP
You too can make cost segregation a central component of your real estate tax planning strategy. With Seneca Cost Segregation by your side, you’ll get the IRS-compliant engineering-based property classification report you need to confidently claim up to 100% bonus depreciation.
Contact us today to lower your tax bill with a cost segregation study.
Common Challenges and How to Avoid Them
Let’s explore the pitfalls investors commonly encounter when claiming bonus depreciation for leasehold improvements.
- Misclassification of property: The tax code has strict guidelines on what constitutes a QIP. A common pitfall is including 39-year real property in QIP. It is best to rely on cost segregation companies to get accurate classifications.
- Using incorrect placed-in-service dates: The placed-in-service date isn’t necessarily the date you complete the project. You must maintain accurate records to demonstrate when the property was ready for its designated use.
- Incorrect treatment of 100% bonus depreciation: Many investors do not understand which properties qualify for 100% bonus depreciation. Under the TCJA, properties placed in service between September 28, 2017, and December 31, 2022, qualify for 100% bonus depreciation. Additionally, the One Big Beautiful Bill Act makes properties placed in service after January 20, 2025, eligible for 100% bonus depreciation.
Frequently Asked Questions (FAQs)
Here are answers to some of the commonly asked questions about leasehold improvements and bonus depreciation.
What Is the Difference Between Leasehold Improvements and Tenant Improvements?
There’s no material difference. In the context of commercial real estate, the two terms are used interchangeably to refer to modifications/improvements made to the
interior of a leased property to meet the specific needs of the tenant.
Is Bonus Depreciation Available for Residential Rental Properties?
Yes, bonus depreciation is available for residential rental properties. You’ll need a cost segregation study on the residential property to identify and classify the qualifying components.
Can Nonprofit Organizations Claim Bonus Depreciation on Leasehold Improvements?
Bonus depreciation is a tax deduction. Since the typical non-profit is tax-exempt, it doesn’t have a tax liability against which to claim a deduction. Bonus depreciation won’t be helpful to such an organization.
Conclusion
Leasehold improvements make properties fit for their intended use. You shouldn’t look at them as just necessary business investments, though. Uncle Sam allows you to turn them into a powerful tax-saving tool, permitting deductions of up to 100% of the costs in the first year.
However, claiming the deductions isn’t automatic. You must correctly identify leasehold improvements that meet QIP criteria.
Don’t rely on guesswork or an accountant’s estimations. At Seneca Cost Segregation, we conduct engineering-based studies to identify every qualifying leasehold improvement, as well as other short-lived assets in your property that are eligible for accelerated depreciation, such as site improvements.
Request a free proposal to see how much you can save in taxes with an IRS-compliant cost segregation study.
