Costs
How the IRS treats tenant improvements under Section 179 and cost segregation
Workspace property leasing tax rules let tenants and owners deduct build-outs through Section 179, qualified improvement property and cost segregation studies.
What to take away
- The deduction follows ownership, so a tenant needs a qualifying leasehold interest to claim it.
- Qualified improvement property sits at IRC §168(e)(6) and takes a 15-year recovery period.
- Section 179 expensing for tax years beginning in 2025 is capped at $1,250,000, phasing out above $3,130,000.
- Bonus depreciation steps down under the Tax Cuts and Jobs Act, with a later reset for property acquired after January 19, 2025.
- A cost segregation study earns its fee on a large build-out owned by a profitable tenant.
Who can claim the deduction on a tenant build-out
The deduction follows the depreciable interest, not the invoice.
A tenant reaches Section 179 through two tests. The work must be tangible personal property or qualified real property. The tenant must also hold a qualifying interest in the space.
A short lease with no purchase option often fails the second test, so the landlord claims the deduction on work the tenant paid for. The clauses that decide which side you land on are set out in 4 lease clauses that decide CAM charges and TI allowances in Denver.
[figure 1]
Section 179 eligibility for tenant improvements
Does the taxpayer have a qualifying interest in the property?
improvement may qualify for Section 179 expensing
improvement must be depreciated over a longer period
Section 179 limits, the phase-out and the income ceiling
Section 179 lets a business deduct qualifying property in the year it is placed in service. The dollar limit, phase-out threshold and income limitation sit in Publication 946.
For tax years beginning in 2025 the limit is $1,250,000, phasing out above $3,130,000 placed in service. Those amounts are indexed, so confirm them for your year.
The income ceiling usually bites first, because Section 179 cannot create or increase a loss for most taxpayers. A break-even tenant carries the unused amount forward.
Qualified improvement property: IRC §168(e)(6) and the 15-year life
QIP is an interior improvement to a nonresidential building, placed in service after the building itself. The definition sits at IRC §168(e)(6) inside the U.S. Code.
Enlargements, elevators, escalators and changes to the internal structural framework are excluded. A mezzanine or a moved core wall returns to a 39-year schedule.
QIP takes 15 years and is bonus-eligible. A tenant on a short lease may never hold the improvement long enough to run that schedule.
[figure 2]
Qualified improvement property vs building shell
Qualified improvement property
- Recovery period
- 15 years
- Bonus depreciation
- Eligible
- Annual deduction
- Larger
- Lease analysis impact
- Visible
Building shell
- Recovery period
- 39 years
- Bonus depreciation
- Not eligible
- Annual deduction
- Smaller
- Lease analysis impact
- Almost invisible
The build-out is a construction project inside a lease, covered in tenant improvements.
Bonus depreciation percentages by placed-in-service year
Bonus depreciation percentages
- 2023 80 %
- 2024 60 %
- 2025 40 %
- 2026 20 %
- 2027 and later 0 %
Legislation passed after the Tax Cuts and Jobs Act reset this schedule for property acquired after January 19, 2025. The rate depends on the placed-in-service year and the acquisition date.
QIP keeps its 15-year life in a year when the bonus rate is zero.
Take the percentage from the instructions for Form 4562 for the year you file.
Cost segregation: what the study splits and when to skip it
A study assigns each element of a build-out to a tax class based on its actual life.
Skip the study when:
When to skip it
- One suite is small enough that the fee eats the first-year benefit.
- The tenant is unprofitable and cannot use the deductions now.
- The lease is short and restoration falls due before the schedule runs.
Five-year property commonly covers carpet, millwork and specialty electrical. Partitions, ceilings and lighting usually land in the 15-year class. The breakdown in the commercial leasing checklist gives the preparer a structure for separating contractor costs by trade.
Form 4562 reporting and records to retain
Form 4562 is where Section 179 and depreciation are claimed. Part I covers Section 179, Part II bonus depreciation, Part III MACRS.
Only the party with the qualifying interest files for a given asset. Attach a schedule to the lease listing who depreciates what, and over which period.
Records to keep:
Records to retain
- Fixed asset register by tax class
- Contractor schedule of values by trade
- Cost segregation report and its authority citations
- Placed-in-service dates for each phase
Example: turning the deduction into an occupancy cost per square foot
Occupancy cost per square foot
- Add base rent and operating expenses per square foot.
- Add the tenant's net build-out cost across the term.
- Subtract the value of the deductions the tenant can claim, discounted at the tenant's cost of capital.
Take 20,000 square feet on a ten-year lease at $30 per square foot for rent and operating expenses. The build-out costs $60 per square foot ($1.2 million) and the allowance is $20 per square foot ($400,000), leaving a net cost of $800,000, or $4 per square foot a year.
Assume a 24% marginal rate and an 8% discount rate, with Section 179 and bonus depreciation writing off the eligible basis in year one. On a 39-year shell schedule the same $800,000 gives about $33,000 of present-value benefit. Accelerated, about $178,000.
The $145,000 difference is worth about $21,500 a year, or $1.10 per square foot. Net lease versus gross lease covers where the rest of the operating cost gap sits.
