Cost Segregation for Leasehold Improvements: Special Considerations
- USA Cost Segregation
- Mar 20
- 3 min read
Updated: May 6
In the world of commercial real estate, maximizing tax benefits is a priority for property owners and tenants alike. One powerful strategy to reduce tax liability is cost segregation, which involves breaking down the cost of a property into various asset categories, each of which is depreciated over different periods. While cost segregation is widely known for its application to the purchase of real estate, it also holds valuable opportunities for leasehold improvements.
What Are Leasehold Improvements?
Leasehold improvements refer to modifications or upgrades made to a leased property by the tenant to better suit their business needs. These improvements can range from simple renovations like new flooring and lighting to more significant changes, such as the addition of walls, HVAC systems, or plumbing. However, while these improvements are often necessary for a tenant's operations, they come with significant costs.
The good news is that cost segregation can help tenants accelerate depreciation on these leasehold improvements, providing substantial tax relief.
Why Cost Segregation for Leasehold Improvements is Important
Leasehold improvements are often considered personal property rather than part of the building itself, which means they may qualify for shorter depreciation schedules. Instead of the typical 39-year depreciation for commercial real estate, leasehold improvements can often be depreciated over a 15-year or even 5-year period depending on their nature. This accelerated depreciation can significantly reduce taxable income in the early years of the lease, providing a valuable cash flow benefit for tenants.
However, there are several special considerations when it comes to applying cost segregation to leasehold improvements.
Key Considerations
Qualifying Property
Not all leasehold improvements are eligible for accelerated depreciation. The IRS has specific guidelines for what qualifies as personal property versus structural property. For instance, items like carpeting, specialized lighting, and certain types of flooring may qualify for 5- or 15-year depreciation, while structural improvements, such as new walls or plumbing, might be subject to a longer depreciation schedule. It's essential to have a professional cost segregation study conducted to determine which improvements qualify and how to classify them accurately.
Lease Term
The lease term is another critical factor. To claim accelerated depreciation on leasehold improvements, the tenant must have a lease with at least 15 years remaining at the time the improvement is made. This requirement helps ensure that the tenant will benefit from the depreciation before the lease ends. Shorter-term leases may not offer the same advantages for cost segregation purposes.
Tenants vs. Landlords
While tenants typically benefit from cost segregation on leasehold improvements, landlords can also use cost segregation to accelerate depreciation on improvements made by tenants. If a landlord owns the improvements after they are completed, they may be able to depreciate these assets over a shorter period, which provides them with tax savings as well.
Compliance and Documentation
Since leasehold improvements often involve both tenant and landlord responsibilities, ensuring proper documentation is essential. Both parties should maintain accurate records of all costs incurred for the improvements and seek professional advice when conducting a cost segregation study to ensure compliance with IRS guidelines.
Cost segregation offers significant benefits for both tenants and landlords when applied to leasehold improvements. By accelerating depreciation, businesses can unlock cash flow benefits and reduce tax liabilities. However, due to the complexities of the tax laws surrounding these improvements, it’s essential to consult with a cost segregation specialist to navigate the process and ensure full compliance. Proper planning and documentation can make all the difference in maximizing these opportunities.
