When your business decides to lease space for the first time, you may be introduced to the somewhat confusing topic of leasehold improvements. We'll sort out the confusion in this article and explain some of the options you'll face as you negotiate a new lease.
What Are Leasehold Improvements?
Accountants call them "leasehold improvements," while commercial realtors use the term "tenant improvements" and builders refer to "build-outs." All these terms reference physical alterations made to rented space to customize it for the benefit of the tenant. Only the alterations performed within the physical confines of the rented space qualify as leasehold improvements and may include carpet and flooring, painting, or adding partitions, wiring or light fixtures. Improvements made outside of the rented space, such as to common area bathrooms or elevators, are called "building improvements" and are paid for by the landlord. The payments for leasehold improvements are a little more complicated.
How Are Leasehold Improvements Paid For?
Leasehold improvements can be paid for by the landlord, the tenant or both. There are several ways this can happen.
Tenant Improvement Allowance (TIA)
The TIA is an amount of money your landlord will spend on your leasehold improvements, usually stated in the lease as a fixed lump sum or as a per-foot amount. If your improvements cost more than the TIA, you will have to pay the overage. Make sure the TIA is paid directly to the suppliers and contractors performing the improvements. If the landlord hands the TIA directly to you, the IRS might deem it taxable income. Since you are responsible for the overage, consider supervising the improvements rather than letting the landlord control them. That's because the landlord has little incentive to keep costs down, since you will pay the excess above the TIA. If the landlord insists on controlling the work, then you should negotiate a lease clause that specifies all sealed bids will be opened in your presence. You should also negotiate lease language that limits the fees the landlord or contractor can charge and gives you discretion on how the TIA is spent. You might be able to get a rent rebate if the leasehold improvements cost less than the TIA.
Building Standard Allowance (BSA)
The BSA is a package of specified improvements for which your landlord is willing to pay. If you want anything more, you'll pay the extra cost. However, the landlord is responsible for any cost overruns on the standard improvements. This arrangement is often used in new construction when the contractors are still on site and can easily perform the improvements. You also might be able to negotiate a rent rebate if you ask for less than the BSA.
This method can be used alone or in conjunction with others. The landlord agrees to free or reduced rent for a specified number of months to help you cover your share of the leasehold improvement expenses. Typically, the landlord will kick in an allowance and the tenant pays for any excess costs. The tenant will usually control the project. Keep in mind that rent discounts, while useful in the short run, do nothing to prevent the landlord from hiking the rent when the lease expires.
In this arrangement, the landlord pays all the costs and controls all the work. Typically, the improvements are completed before the tenant moves in. You will be responsible for the costs of any changes or additions to the improvement plan once the lease is signed. This method sounds appealing because the landlord is on the hook for any cost overruns from the original plans. But be careful about landlords who skimp on the quality of the improvements in order to save money. To that end, you might want to add a lease clause that gives you final approval of the turnkey job. This will protect you from cheap materials or shoddy work. Another concern is the rent amount—has it been jacked up too high in relation to the cost of the turnkey improvements?
How Much Should You Spend on Leasehold Improvements?
It's important not to overspend on leasehold improvements because you usually can't take them with you. If you have a long-term lease or renewal concession on your lease, you might be willing to spend more. On the other hand, if you have a lease that you don't expect to renew, you don't want to spend money on improvements that will have a service life longer than the lease. In that case, the landlord will reap the benefits for those years between the expiration date and the end of the service life. You can negotiate that point before you sign the lease if you have some idea that you won't be renewing.
Although the tenant doesn't own the building, the leasehold improvements it pays for are a noncurrent asset of the company. The tenant's improvement costs are usually capitalized and recovered over a multiyear amortization period. The amortization period is the shorter of the lease period or the useful life of the improvements, or 15 years. This depends on whether you are operating under tax basis or generally accepted accounting principles (GAAP) financial reporting. However, if the lease contains a concession that allows the tenant to re-lease at a bargain rate, then the lease term isn't used to establish the amortization period.
For example, suppose you lease office space and spend $150,000 on leasehold improvements. The expected useful life of the improvements is 20 years. You can't deduct that cost all at once as a current expense (unless it's a trivial amount). Instead, you amortize the cost over a fixed period—that is, you break the deduction into annual installments. If the lease is for five years and has no renewal concessions, you can deduct $30,000 a year ($150,000 / 5 years) to recover your leasehold improvement costs. On the other hand, if your lease contains a bonus for re-signing after the five-year lease term expires, you must amortize over 15 years at the rate of $10,000 a year ($150,000 / 15 years).