Definition: Leasehold improvements are structural modifications made to a rental property to ensure the property meets the requirements of the tenant.
What Does Leasehold Improvements Mean?
What is a leasehold improvement? When a prospective tenant enters a commercial property, it very rarely meets the exact specifications of the tenant’s business. When changes to the property are required, they are called leasehold improvements. These improvements are typically discussed during the negotiation of the lease; although, they may be required by the tenant at any time during the lease term.
Depending on the marketability of a rental property, a lessor may provide improvement incentives to make the property more attractive to prospective tenants. If the lessor does not provide financial support for the improvements, the burden of cost falls on the tenant who will account for the costs appropriately.
How are leasehold improvements accounted for? In accordance with generally accepted accounting principles (GAAP), as well as the IRS tax code, the accounting for improvements is similar to accounting for fixed assets. The purchase cost of the improvement is depreciated over the useful life of the corresponding assets.
While GAAP requires that the depreciable life is spread over the estimated useful life of the improvements, the IRS requires depreciation to occur over the life of the original property (building), or 15 years. While the owner of the property will maintain the improvements as part of the building, the capitalization of the improvements allows the tenant to spread the burden of the expense over the life of the asset.
Let’s look at an example.
Let’s say you’re a distributor of kitchen appliances, and you just signed a lease for additional warehouse space in another city. The property is in need of some upgrades, but it’s a perfect location. After negotiating lease terms and finalizing a deal, the owner of the warehouse has agreed to provide you with $10,000 toward building improvements. Upon entering the building, you and your team determine you need to spend $20,000 for all of the required improvements. After construction and installation of all improvements, the assets will be capitalized at a cost of $20,000, offset by an incentive credit of $10,000 from the property owner.
Define Leasehold Improvements: Leasehold improvement means a physical modification made to leased property to ensure compliance with tenant needs.