Bonus Depreciation for Lessee Improvements

The One Big Beautiful Bill Act (OBBBA), enacted in July 2025, has brought significant changes to the tax treatment of capital investments, especially for retail store lessees making improvements to their leased spaces. One of the most impactful provisions is the permanent restoration of 100% bonus depreciation for Qualified Improvement Property (QIP) placed in service after January 19, 2025. This blog post explains how lessee-owners of retail stores can leverage this powerful incentive, the requirements they must meet, and how to properly claim the deduction.

1. What Is Qualified Improvement Property (QIP)?

Qualified Improvement Property (QIP) is defined in IRC §168(e)(6) as any improvement made by the taxpayer to an interior portion of a building which is nonresidential real property, provided the improvement is placed in service after the date the building was first placed in service.

Key Points:

• Interior Improvements Only: QIP includes only improvements to the interior of nonresidential buildings (such as retail stores, offices, or restaurants).
• Exclusions: QIP does not include improvements attributable to:
  • The enlargement of the building,
  • Any elevator or escalator, or
  • The internal structural framework of the building.

Lessee Improvements: If a lessee (such as a retail store operator) makes and owns the improvements to the leased space, those improvements can qualify as QIP, provided all statutory requirements are met. The lessee must be the tax owner of the improvements (i.e., they bear the economic risk of loss and are entitled to depreciation deductions).

2. OBBBA’s Permanent 100% Bonus Depreciation for QIP

Permanent Restoration of 100% Bonus Depreciation

The OBBBA permanently reinstates 100% bonus depreciation for most qualified property, including QIP, acquired and placed in service after January 19, 2025. This means that eligible taxpayers can deduct the entire cost of qualifying improvements in the year they are placed in service, rather than depreciating them over 15 years.

Acquisition and Placed-in-Service Requirements

• Acquisition Date: The property must be acquired after January 19, 2025. If acquired under a written binding contract, the acquisition date is the contract date.
• Placed-in-Service Date: The property must be placed in service after January 19, 2025.
• Self-Constructed Property: For self-constructed improvements, the construction must begin after January 19, 2025. The “10% cost test” safe harbor allows construction to be considered as begun when more than 10% of the total cost (excluding land and preliminary activities) is incurred or paid.
• Original Use: For QIP, the “original use” requirement is satisfied if the improvement is made by the taxpayer and placed in service after the building was first placed in service, even if the building itself is not new.

3. Special Requirements and Limitations for Lessee Improvements

Ownership and Business Use

• Tax Ownership: The lessee must be the tax owner of the improvements (i.e., they paid for and own the improvements for tax purposes).
• Active Business Use: The improvements must be used in the active conduct of a trade or business.

Recovery Period and Exclusions

• Recovery Period: QIP is assigned a 15-year recovery period under MACRS, making it eligible for bonus depreciation.
• Exclusions: As noted, improvements related to building enlargement, elevators/escalators, or the internal structural framework are not QIP and do not qualify for bonus depreciation.

Placed-in-Service Date

• The improvements must be placed in service after January 19, 2025, to qualify for 100% bonus depreciation under the OBBBA.

Related-Party Restrictions

• The property must not be acquired from a related party as defined in IRC §179(d)(2) and §267, or in a transaction where the basis is determined by reference to the transferor’s basis (e.g., certain exchanges or gifts).

Section 179 Expensing Option

• Section 179 allows taxpayers to expense the cost of qualifying property (including QIP) up to a limit ($2.5 million, increased to $4 million under the OBBBA, with a phase-out threshold of $4 million).
• Business Income Limitation: The Section 179 deduction cannot exceed the taxpayer’s aggregate business income for the year.
• Section 179 vs. Bonus Depreciation: Section 179 expensing is elective and subject to annual limits, while bonus depreciation is automatic unless the taxpayer elects out. Section 179 can be used for both new and used property, while bonus depreciation for QIP is available for improvements made by the taxpayer.

4. How to Claim the Deduction

Filing Requirements

• IRS Form 4562: Use this form to report depreciation and amortization, including bonus depreciation and Section 179 expensing.
  • Part I: Section 179 deduction.
  • Part II: Special depreciation allowance (bonus depreciation).
  • Part III: MACRS depreciation for property not fully expensed.

Correcting Prior Depreciation

• Amended Return: If an error is discovered in the year the property was placed in service and the statute of limitations is open, an amended return can be filed to correct depreciation.
• Form 3115 (Change in Accounting Method): If the error relates to a prior year and the statute is closed, or if a change in method is required (e.g., switching from straight-line to bonus depreciation), file Form 3115 to request a change in accounting method and claim a Section 481(a) adjustment.

5. Summary Table: Key Requirements for Lessee QIP Bonus Depreciation Under OBBBA

Key Takeaways:

• Ensure the improvements meet the QIP definition and are not excluded by statutory limitations.
• The lessee must be the tax owner of the improvements and use them in an active trade or business.
• Comply with all acquisition, placed-in-service, and related-party rules.
• Maintain thorough documentation to support the deduction.
• Use IRS Form 4562 to claim the deduction, and correct prior depreciation using an amended return or Form 3115 as appropriate.

With careful planning and compliance, retail store lessees can maximize the tax benefits of their capital investments under the OBBBA’s expanded bonus depreciation regime .

Documentation and substantiation practices (e.g., invoices, lease provisions, landlord consents) that best support a lessee’s claim that they are the tax owner of interior improvements for federal bonus depreciation purposes?

To substantiate a lessee’s claim that they are the tax owner of interior improvements to leased nonresidential real property—such as Qualified Improvement Property (QIP)—for purposes of claiming federal bonus depreciation (including under the OBBBA and IRC §168(k)), the lessee must be able to demonstrate, through documentation and facts, that they bear the economic burdens and benefits of ownership. This is critical because only the tax owner may claim depreciation deductions, including bonus depreciation, under IRC §§167 and 168 .

Below is a detailed analysis of the documentation, substantiation practices, and contractual language that best support a lessee’s claim to tax ownership, as recognized by the IRS and courts.

1. Key Legal Principles: Tax Ownership of Leasehold Improvements

• Tax ownership is determined by who bears the economic benefits and burdens of the property, not merely by legal title .
• The party that capitalizes the cost and is not fully reimbursed by the lessor is generally considered the tax owner and may depreciate the improvements.
• If the lessor reimburses the lessee for the full cost of improvements, the lessor is the tax owner and claims depreciation.

2. Types of Documentation and Evidence

A. Invoices and Payment Records

• Invoices, receipts, and canceled checks showing the lessee paid for the improvements directly and was not fully reimbursed by the landlord.
• Construction contracts between the lessee and contractors, with the lessee as the named party responsible for payment.
• Proof of unreimbursed costs: If the lessee receives a tenant improvement allowance (TIA) from the landlord, records must show the lessee’s costs exceeded the TIA, and the lessee was not reimbursed for the excess.

B. Lease Provisions and Contractual Language

• Lease language should clarify:
  • The lessee’s obligation to construct and pay for improvements.
  • Whether the lessee or lessor retains rights to the improvements during and after the lease term.
  • Whether the lessee is entitled to remove the improvements at lease end (indicative of lessee ownership), or if improvements must remain with the landlord (indicative of lessor ownership).
  • Any requirement for the lessee to restore the premises to original condition (may support lessee ownership if removal is required).
• Assignment of risk: Provisions stating the lessee bears the risk of loss or damage to the improvements.
• Depreciation rights: If the lease is silent, the party who capitalizes the cost and is not reimbursed is generally the tax owner.

C. Landlord Consents and Approvals

• Landlord consents to the lessee’s construction of improvements, especially if the landlord disclaims ownership or reimbursement.
• No requirement for landlord reimbursement: Documentation that the landlord does not reimburse or only partially reimburses the lessee for the improvements.

D. Other Supporting Evidence

• Insurance policies: If the lessee insures the improvements, this supports their claim of ownership.
• Property tax records: If the lessee pays property taxes on the improvements, this is evidence of ownership.
• Accounting records: Lessee’s books should capitalize the cost of improvements as assets, not as expenses or pass-throughs.

3. IRS and Court Guidance on Substantiation

A. IRS Guidance

• The IRS recognizes that the party who incurs the cost and is not fully reimbursed is the tax owner and may depreciate the improvements.
• If the lessee receives a TIA, only the unreimbursed portion is depreciable by the lessee; the landlord depreciates the portion covered by the TIA .
• The IRS will look to the substance of the transaction over its form, considering all facts and circumstances, including lease terms, payment records, and the parties’ intent.

B. Case Law

• Gladding Dry Goods Co. v. Commissioner: The right to depreciate leasehold improvements is based on the capital investment, not legal title.
• Hopkins Partners v. Commissioner: Legal title and right of possession are not determinative; the party with the capital investment and economic risk is the tax owner.
• Elder-Beerman Stores Corp.: If the lessee is not fully reimbursed for improvements, the lessee is deemed the owner for tax purposes and may depreciate the unreimbursed portion.

4. Best Practices for Substantiation

A. Maintain Comprehensive Records

• Invoices, contracts, and payment records for all improvement costs.
• Lease agreements with clear language on improvement ownership, reimbursement, and removal rights.
• Landlord consents and any correspondence regarding improvements.
• Accounting records showing capitalization of improvement costs.

B. Draft Lease Provisions Carefully

• State explicitly that the lessee is responsible for the cost and construction of improvements.
• Clarify whether improvements are to be removed or left in place at lease end.
• Address risk of loss, insurance, and property tax obligations.

C. Document Economic Burdens and Benefits

• Show that the lessee bears the risk of loss, pays for insurance, and is responsible for maintenance and repairs.
• Demonstrate that the lessee is not fully reimbursed for the cost of improvements.

D. Address Tenant Improvement Allowances

• If a TIA is received, document the total cost, the amount reimbursed, and the unreimbursed portion.
• Only the unreimbursed portion is depreciable by the lessee; the landlord depreciates the reimbursed portion.

5. Special Considerations for Bonus Depreciation (Including OBBBA and QIP)

• Bonus depreciation under IRC §168(k) and as amended by the OBBBA is only available to the tax owner of the property.
• The lessee must show that the QIP is “owned” for tax purposes, not just used.
• Improvements must be capitalized and not expensed or reimbursed in full by the landlord.
• Improvements must meet the definition of QIP: made to the interior of nonresidential real property, placed in service after the building was first placed in service, and not attributable to building enlargement, elevators/escalators, or internal structural framework.

6. Summary Table: Key Documentation and Evidence

7. Conclusion

To maximize the likelihood that the IRS and courts will respect a lessee’s claim to bonus depreciation on leasehold improvements, the lessee should:

• Maintain clear, contemporaneous documentation of all costs, payments, and contractual obligations.
• Ensure lease language and related agreements support the lessee’s economic ownership and risk.
• Document any tenant improvement allowances and unreimbursed costs.
• Retain evidence of economic burdens and benefits (insurance, taxes, maintenance).

By following these practices, a lessee can persuasively establish tax ownership of improvements and substantiate their eligibility for bonus depreciation, including under the OBBBA for Qualified Improvement Property.