When a commercial tenant vacates leased space and leaves built-out improvements behind, the tax treatment of the abandonment of leasehold improvements is generally an ordinary loss equal to the tenant’s remaining adjusted basis in those improvements, deductible in the year the abandonment actually occurs.1Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets The size of that deduction turns on how much depreciation you already claimed, and getting it depends on proving abandonment to the IRS and reporting it correctly on Form 4797.
What “Remaining Basis” Actually Means
Your abandonment loss is not the amount you originally spent on the build-out. It is the original capitalized cost reduced by every dollar of depreciation you claimed, or should have claimed, along the way.2Office of the Law Revision Counsel. 26 U.S. Code 165 – Losses
Straight-line MACRS on non-QIP nonresidential real property runs 39 years, so a decade of occupancy recovers roughly a quarter of the cost and leaves the rest available as an abandonment loss. Qualified Improvement Property uses a 15-year recovery period, which recovers a larger share over the same period.3Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System
Bonus depreciation changes the picture dramatically. If you claimed 100% bonus depreciation when you placed QIP in service — as many tenants did for property placed in service between 2018 and 2022, and as tenants can again for qualified property acquired after January 19, 2025 under the One Big Beautiful Bill Act — your remaining basis is zero.4Internal Revenue Service. Treasury, IRS Issue Guidance on the Additional First Year Depreciation Deduction Amended as Part of the One Big Beautiful Bill There is nothing left to abandon for tax purposes. Section 179 expensing works the same way: anything expensed under Section 179 reduces the basis available for later abandonment.
Before doing anything else, pull your depreciation schedules and confirm what actually remains. If prior bonus depreciation or a Section 179 election zeroed the asset, the abandonment is a non-event on your return.
Proving the Abandonment
The IRS does not treat a lease running out as an automatic abandonment. Two elements have to line up: an intent to permanently give up the property with no expectation of recovering value, and an overt act that makes the abandonment real.5eCFR. 26 CFR 1.165-2 – Obsolescence of Nondepreciable Property
Intent
You must show you relinquished all rights to the improvements permanently. If the lease permitted removal and you chose to leave them, document the reason. Usually the answer is that the improvements are permanently affixed and cannot be separated without destroying them. Active negotiation with the landlord about the improvements works against intent, because the negotiation itself implies you still see value in them.
The Overt Act
Intent alone will not carry the deduction. The strongest evidence is a signed lease surrender or termination agreement stating that you are relinquishing all interest in the improvements. Supporting acts include returning keys, disconnecting utilities in your name, and removing all personal property from the premises.
Timing
The loss belongs to the year the abandonment actually occurs, which may not be the year the lease ends on paper.2Office of the Law Revision Counsel. 26 U.S. Code 165 – Losses If you move out in November but the surrender agreement is signed the following February, the deduction likely belongs to the later year. Nail down the sequence.
Records to Assemble
- Original cost records: invoices, contractor agreements, and the capitalization entries showing what was spent.
- Depreciation schedules covering the full history, including any bonus depreciation and Section 179 amounts, so you can prove the remaining adjusted basis.
- The signed lease surrender agreement confirming permanent relinquishment of the improvements and the premises.
- Photographs or inspection reports showing the improvements were permanently affixed and could not be economically removed.
Audits of these deductions look for gaps in the paper trail. A six-figure ordinary loss supported by nothing more than a depreciation schedule and a handshake will not survive scrutiny.
Calculating the Loss
The deductible loss equals adjusted basis at the moment of abandonment: original capitalized cost minus all depreciation previously claimed, including bonus depreciation and any Section 179 amounts.
Suppose you spent $150,000 building out a retail space in 2020 and claimed $55,000 in total MACRS depreciation over the five years before vacating. Your adjusted basis is $95,000, and that is the deductible loss. If you also claimed $40,000 in bonus depreciation when the asset was placed in service, total prior depreciation would be $95,000, leaving a $55,000 loss instead.
Getting the depreciation number wrong is the most common error, and it works in one direction: understating prior depreciation inflates the loss, and the IRS can assess tax on the difference plus penalties. The “allowed or allowable” rule closes off the other direction. If you claimed less depreciation than you were entitled to, your basis is still reduced by the amount you should have claimed. Skipping depreciation in earlier years does not give you a larger abandonment loss later.
Why Ordinary Loss Treatment Is Valuable
An abandonment loss that is not part of a sale or exchange produces an ordinary loss, fully deductible against ordinary business income.1Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets Ordinary losses offset income dollar-for-dollar, without the annual caps that apply to capital losses for individuals. For a business generating $400,000 in taxable income, a $95,000 ordinary loss reduces the current-year tax bill immediately.
Reporting the Loss on Your Return
Report the abandonment on Form 4797, Sales of Business Property. The form’s name is misleading; it covers dispositions that are not sales, including abandonments.6Internal Revenue Service. About Form 4797, Sales of Business Property The 2025 instructions direct taxpayers to enter a qualifying abandonment loss on line 10 of Part II, which handles ordinary gains and losses.7Internal Revenue Service. Instructions for Form 4797 – Sales of Business Property
You will enter the date the improvement was acquired, the date of abandonment, a gross sales price of zero (no proceeds were received), and depreciation allowed or allowable through the disposition date. The net loss flows from Form 4797 to your main return: Form 1040 for individuals, Form 1120 for C corporations, or Form 1065 or 1120-S for partnerships and S corporations, with the loss passing through on each owner’s Schedule K-1.
The depreciation figure on Form 4797 must match your depreciation records exactly. If you claimed bonus depreciation or Section 179 in the placed-in-service year, those amounts belong in the total depreciation figure. Omit them and you create an artificially large loss that draws audit attention.
A Payment From the Landlord Changes Everything
If you receive anything from the landlord for the improvements — a cash payment, a rent credit, or a lease buyout — the transaction is no longer an abandonment. It becomes a sale or exchange, and the tax treatment shifts.
Under Section 1241 of the Internal Revenue Code, amounts received by a tenant for cancellation of a lease are treated as received in exchange for the lease. When that payment compensates you for improvements left behind, your remaining basis offsets the payment: a payment above basis produces a gain, and a payment below basis produces a loss.
Because the improvements are business property held longer than a year, the result runs through Section 1231 netting.8Office of the Law Revision Counsel. 26 U.S. Code 1231 – Property Used in the Trade or Business and Involuntary Conversions Net Section 1231 gains are taxed at long-term capital gain rates; net Section 1231 losses are ordinary. On a gain, depreciation recapture under Sections 1245 and 1250 can recharacterize part of the gain as ordinary income to the extent of prior depreciation.
A true abandonment with no payment produces a clean ordinary loss under Section 165, with no netting and no recapture. Accepting even a nominal payment moves you into sale-or-exchange territory. If the improvements have little value to the landlord and negotiations are dragging, walking away with nothing sometimes yields cleaner tax treatment than a small buyout.
Partial Dispositions During the Lease
You do not have to wait for the lease to end. If you renovate mid-lease and tear out components — flooring, built-in shelving, interior walls — you can elect to treat the removed pieces as a partial disposition under Treasury Regulation 1.168(i)-8.9eCFR. 26 CFR 1.168(i)-8 – Dispositions of MACRS Property
The election lets you deduct the remaining basis of the discarded component in the year it comes out, instead of continuing to depreciate an asset that no longer physically exists. Skip the election and the old component’s basis stays embedded in the asset, so you end up depreciating both the old and new components at once, overstating the asset and missing a deduction.
Make the election on a timely filed return for the year the component was removed. You will need to identify the cost of the disposed component (sometimes requiring an allocation from a lump-sum contract) and calculate accumulated depreciation on that component through the disposition date. The loss lands on Form 4797, the same as a full abandonment. Restaurant and retail tenants who remodel every few years often find this election reduces the net cost of each renovation cycle.
When the Build-Out Was Funded by the Landlord
A construction allowance from the landlord can eliminate the abandonment deduction before you ever get to it. Section 110 provides a safe harbor: a qualifying construction allowance is excluded from the tenant’s gross income if the lease is for retail space with a term of 15 years or less, the money is spent on qualified long-term real property that reverts to the landlord at lease end, and the lease agreement expressly says so.10Office of the Law Revision Counsel. 26 U.S. Code 110 – Qualified Lessee Construction Allowances for Short-Term Leases Under that safe harbor the landlord is treated as owner of the improvements, the landlord claims depreciation, and the tenant has no basis to deduct at abandonment.
If the allowance does not meet Section 110 — the lease exceeds 15 years, the space is not retail, or the required language is missing — the allowance is generally taxable income to the tenant, and the tenant capitalizes the improvement and depreciates it. In that case the tenant retains basis that can generate an abandonment loss when the space is vacated, subject to the same intent, overt act, and documentation requirements.