What’s in a Name?
The term “tenant improvement,” or “TI” for short, is often used by commercial real estate agents and brokers. But in accounting, it’s usually known as a “leasehold improvement,” while it’s called “build-out” in construction. Regardless of what you call it, this refers to an enhancement of a leased space.
What Are Tenant Improvements?
Leasehold improvements, otherwise known as tenant improvements or build-outs, are structural changes made to a leased space to make it suitable for a new tenant. Examples of these improvements include:
RepaintingNew carpetLighting configurationsHVAC updatesPlumbing upgradesElectrical workFull renovation
These improvements sometimes are done by a contractor that the tenant hires, or the landlord might agree to oversee the work on a turnkey basis. In other cases, both the tenant and landlord might share responsibility for a build-out.
What Is a Tenant Improvement Allowance?
Generally, the landlord covers these improvements as part of what’s called a tenant improvement allowance (TIA). If the budget for improvements surpasses the allowance, the tenant normally makes up the difference. Tenant improvement allowances are worked out during lease negotiations. During the negotiations, a tenant might decide to give up three month’s of free rent in exchange for a higher tenant allowance. The allowance typically comes in the form of a flat amount of money or a per-square-foot amount. If a landlord offers $25 per square foot for tenant improvements at a 5,000-square-foot office space, for instance, then the landlord would cover $150,000 of the build-out costs. In some situations, the tenant must provide the build-out money upfront, and then seek reimbursement from the landlord.
What Qualifies for Tenant Improvement Allowance?
In general, improvements that apply to the space are subject to the allowance. Stuff that goes into the space does not.
Leasehold Improvements vs. Building Improvements
Leasehold improvements, tenant improvements, or build-outs are done within the walls of a structure. They focus on a specific space that’s being leased by a single tenant. Making these improvements is to the tenant’s advantage because they will improve their own business, but not the businesses of other tenants. Improvements made to common areas would be considered building improvements, not leasehold improvements, because they can be enjoyed by more than one tenant. Each tenant typically chips in money for maintenance of common areas in a building.
Accounting for Leasehold Improvements
When it comes to accounting, the tax implications of a build-out depend on who paid for and owns the improvements. Generally, whoever financed and owns the improvements can claim depreciation of these improvements on their tax returns. Typically, the landlord owns tenant improvements. In fact, most leases spell out that these improvements become the property of a landlord, even if the tenant pays for and oversees the work.
The Bottom Line
Tenant improvements enable a business to spruce up a leased space before moving in. During lease negotiations, a business can agree with the landlord on the budget for these improvements. But if the build-out budget goes over the agreed-upon amount, the tenant likely could be on the hook for the extra expenses.
