Tenant Improvements and Lease Incentives: Landlord Tax Basics

By Tom, CPA · Updated October 27, 2026

Part of: Rental Property Taxes

TL;DR: When a landlord pays for tenant build-out it owns, the landlord capitalizes and depreciates it, often as 15-year qualified improvement property for interior commercial work, eligible for bonus depreciation. If the tenant leaves and the improvement is abandoned, the landlord can generally deduct the remaining basis. A cash allowance to a retail tenant may be excluded by the tenant under Section 110. Free rent simply reduces rental income.

Educational only, not tax, legal, or investment advice. Examples are illustrations, not predictions. Rules and limits change; verify current figures and talk to a qualified professional about your situation.

Commercial leases often come with incentives: a tenant improvement (TI) allowance, a few months of free rent, or a landlord-paid build-out. For FIRE investors moving from residential into small commercial or mixed-use properties, the tax treatment is unfamiliar. Residential rentals rarely raise these questions; office and retail space raises them constantly. This guide covers the landlord side under federal rules as of October 2026, with notes on the tenant side.

CPA Warning Label: Ownership of improvements for tax purposes follows the lease terms and the economics, not just who wrote the check. Get the lease language right before you build.

Who owns the improvement?

The first question is who is the tax owner of the improvement. Factors include whom the lease says owns it, who bears the risk of loss, who controls design, whether the landlord or tenant pays, and whether the improvement stays with the building at lease end. Generally:

• Landlord-owned: the landlord builds or pays for improvements that remain the landlord's property. The landlord capitalizes and depreciates them, and the tenant has no income from the improvement.
• Tenant-owned: the landlord pays the tenant cash, and the tenant builds and owns the improvements. The cash is generally income to the tenant unless an exclusion applies, the tenant depreciates the improvements, and the landlord treats the payment as a lease acquisition cost amortized over the lease term.

Write the lease so the tax ownership is clear and consistent with how the money moves.

Depreciating landlord-owned improvements

Improvements to nonresidential real property are generally 39-year property, but an important exception is qualified improvement property (QIP): improvements to the interior of a nonresidential building placed in service after the building was first placed in service, excluding enlargements, elevators and escalators, and the internal structural framework (IRS Publication 946). QIP has a 15-year recovery period and qualifies for bonus depreciation, which is permanently 100% for property acquired after January 19, 2025 (IRS Notice 2026-11).

For a residential rental, improvements are 27.5-year property, and QIP does not apply. Personal property installed as part of a build-out, such as certain fixtures or equipment, may be 5- or 7-year property. A lessor uses the regular MACRS recovery period for improvements even if the lease term is shorter.

When the tenant leaves

If a lessor's improvement made for a lessee is irrevocably disposed of or abandoned at the end of the lease, the lessor can generally treat it as a disposition and deduct the remaining adjusted basis (Section 168(i)(8)(B)). In practice, when the next tenant demolishes the old build-out, the landlord writes off what is left of the old improvements. This requires records that track each tenant's build-out as a separate asset; lumping all improvements together makes a later write-off hard to support. If 100% bonus was taken, there may be nothing left to write off.

Section 110 for retail tenants

Section 110 gives a safe harbor for cash or rent reductions a landlord provides to a retail tenant to construct or improve qualified long-term real property for use in the tenant's business at the retail space, under a lease of 15 years or less. The tenant excludes the allowance from income to the extent it is spent on the improvements, and the improvements are treated as nonresidential real property owned by the landlord, who depreciates them. Both parties must follow the lease and statement requirements in the regulations. The safe harbor does not apply to office or industrial space, though general tax ownership principles may reach a similar result if the landlord owns the improvements.

Free rent and other incentives

• Free or reduced rent: a cash-basis landlord simply has less rent income in the free months. Leases with stepped or deferred rent above certain thresholds can fall under Section 467, which may require accruing rent on a straight-line or stated schedule; this matters mainly for larger leases.
• Lease acquisition costs: commissions, legal fees and cash inducements paid to a tenant to sign are amortized over the term of the lease, not deducted at once (IRS Publication 527 treats similar costs of obtaining a residential lease the same way).
• Payments to cancel a lease: a landlord who pays a tenant to leave early generally amortizes the payment over the remaining term of the canceled lease. A tenant who pays a landlord to cancel, by contrast, generates rental income to the landlord when received (Publication 527).
• Tenant-paid improvements in lieu of rent: the fair value is rental income to the landlord (Publication 527).

Illustration

Illustration: A FIRE investor owns a small retail strip center and signs a 10-year lease in February 2026 with a coffee shop. The landlord funds and owns a $90,000 interior build-out, pays a $12,000 leasing commission, and gives three months of free rent.

• Build-out: qualifies as QIP. With 100% bonus depreciation, the landlord deducts $90,000 in 2026. Without bonus, 15-year straight-line under the half-year convention would give $3,000 in year 1.
• Commission: amortized over 120 months. 2026 deduction for 11 months: $12,000 x 11 / 120 = $1,100.
• Free rent: no income for February through April; income starts in May.
• Exit: if the tenant leaves after five years and the next tenant demolishes the build-out, any remaining basis is deductible then. With bonus taken, there is none.

On a later sale, the $90,000 of bonus depreciation on QIP, which is Section 1250 property, is subject to the rules for nonresidential real property; accelerated depreciation in excess of straight line can be recaptured as ordinary income (Publication 544). Simplified figures.

Mixed-use and residential properties

Many FIRE investors first meet these rules in a mixed-use building: a storefront with apartments above. Improvements to the commercial space can be QIP only if the building is nonresidential real property for tax purposes; a building is residential rental property if 80% or more of its gross rental income comes from dwelling units (IRS Publication 946). In a building that is mostly apartments, the whole structure and its improvements are 27.5-year property, and retail build-outs there do not qualify for the 15-year QIP period. Run the 80% test each year, since a change in rent mix can change the building's classification for new improvements. Keep separate cost records for each space so you can apply the correct life and later write off abandoned build-outs.

Passive losses and planning

Large bonus deductions on commercial build-outs often create a passive loss for an investor who is not a real estate professional (IRS Publication 925). The $25,000 allowance for active participants still applies to commercial rentals, but it phases out between $100,000 and $150,000 of MAGI. If the loss will be suspended anyway, electing out of bonus depreciation for that class and using straight-line may better match deductions to future income and reduce recapture exposure.

Lease drafting checklist

• Who owns improvements during and after the lease?
• Is the allowance cash to the tenant, or landlord-paid construction?
• For retail, does the lease include the Section 110 language and is the term 15 years or less?
• What happens to improvements at lease end: surrender, removal, or restoration?
• Are free rent and rent steps large enough to raise Section 467 questions?
• Does the tenant reimburse any build-out costs, and if so, is that rent income or a reduction of the landlord's basis?
• Who keeps the invoices and cost breakdown needed to classify each asset?

Have the lease reviewed by a real estate attorney and the tax treatment reviewed before signing, since changing the structure after construction is difficult.