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July 2, 2021

Chances are you have heard of leasehold improvements in passing.  However, you might not know what encompasses them or what this term really means.  Furthermore, most people question who pays for these modifications.  Let’s demystify this term, explaining exactly what is and what is not a leasehold improvement.

A Plain English Explanation of Leasehold Improvements

Leasehold improvements (aka. build-outs and tenant enhancements) are alterations that a leaseholder or property owner makes. They do this to create a space that is much more enjoyable or useful for a tenant.  Leasehold improvements are quite common in the context of commercial real estate.  The logic in making these advancements is they improve property to the point that attracting tenants proves significantly easier.  An added bonus is they make it that much easier to boost tenant retention rates.

What Qualifies as a Leasehold Improvement?

When it comes to leasehold improvements, plenty of people are quick to ask the question of: “Who pays for leasehold improvements?”  These are property enhancements that the property owner typically pays for.  There is also the potential for property owners to provide tenants with monthly rent discounts if they choose to pay for the alterations with their own money.  Furthermore, property owners and tenants can reach an agreement in which the cost of the enhancements is shared between the parties.

Certain modifications qualify as leasehold improvements while others do not.  As an example, modifications made to a property to improve its utility or attractiveness in the terms of tenant use and those that draw in new tenants do qualify.  This means alterations made to a property’s floors, walls and ceiling all qualify.

Contrary to popular opinion, alterations made to a building’s exterior or modifications that benefit tenants in other parts of the building do not qualify as leasehold improvements.  This means the construction of a roof, an elevator upgrade and the paving of a walkway do not qualify.

Some property owners and tenants commonly wonder, “Is signage a leasehold improvement?”  In certain cases, signage does not qualify as it does not improve the property’s in the context of utility.  However, in the context of commercial real estate, adding signs to a property where a store or other business is located definitely qualifies as it suits the tenant’s preference.  In short, an enhancement with a specific design that meets a tenant’s preferences or operational needs is a leasehold improvement.

Notable Examples

To provide additional clarity as to what does and does not qualify as a leasehold improvement, let’s take a look at a few examples.  Consider a commercial property that a tenant uses as a call center.  The addition of cubicles for employees and even the installation of phone lines qualify.  The addition of facility new rooms, special lighting, counter space for receptionists, new flooring and retail shelves all qualify, too.

Some tenants and property owners ask the question of: “Is leasehold improvement an intangible asset?”  In short, leasehold improvements are not intangible.  Rather, these improvements are tangible additions or enhancements made to a property.  To repeat the examples above, the construction of new rooms, the addition of new cubicles, the addition of new technology and other improvements to a property are tangible assets that are viewable and touchable.

The Difference Between Building Improvements and Leasehold Improvements

Building improvements are not exactly the same as leasehold improvements.  The primary difference is that the latter is completed within the rented space’s walls and performed in a manner that benefits tenants.  They are also buildings that derive from a piece of land that is on lease.  Alternatively, building improvements have the potential to reach completion outside of the space that a tenant has.

As an example, if a landlord adds a bathroom to a tenant’s suite, it is a leasehold improvement as opposed to a building improvement.  However, let’s assume that the bathrooms on an entire floor shared by multiple tenants within the building receive improvements. Alternatively, what if they undergo additional construction? This qualifies as a building improvement as more than one tenant benefits from it.

In the Context of Taxation and Depreciation

Leasehold improvements often go into the “capital” category in the context of taxation.  This means that they are amortized across the entire length of the lease.  This is an important point of note as these modifications receive different treatment in the context of taxation upon its creation.  The 2018 Tax Cuts and Jobs Act or TCJA for short, rolls them all into one convenient group referred to as qualified improvement property, commonly referred to with the acronym of QIP.  The depreciation bonus of 15 years is not present in this new taxation law, meaning depreciation occurs across 20+ years.

If the landlord fully owns the leasehold improvement, it will be amortized rather than depreciated.  Amortization refers to the writing off of an asset’s initial cost in a specific period of time.  As an example, imagine new flooring is installed on a commercial property after a tenant inks a 15-year lease and there is an expectation that the flooring will require replacement in 7 to 8 years. Consequently, the cost of the leasehold improvement will undergo amortization in that period of time.  Such amortization occurs across the leasehold improvement’s useful life.  If the enhancement will last longer than the term during which the tenant will occupy the building, it is subject to amortization across the term’s time.

The Issue of Landlord Approval

Leasehold improvements requested by tenants or those which a tenant is willing to pay for almost always require landlord approval.  A tenant receives persuasion to submit plans for these alterations, presenting a proposal to the landlord.  However, suppose the landlord does not agree with the specific leasehold improvement in question. In this case, they have the right to request a different plan or completely reject the proposal.