Lease Incentives: Accounting Rules for Tenants and Landlords

Lease incentive accounting splits in two directions: under ASC 842, both the tenant and the landlord spread the economic value of the incentive over the lease term, but the IRS generally treats a cash incentive as taxable income to the tenant the moment it lands. That mismatch between the books and the tax return is the heart of the subject, and handling it badly can distort reported earnings or trigger a surprise tax bill in year one.

What Counts as a Lease Incentive

A lease incentive is anything of economic value a landlord gives a tenant to get the lease signed. Three forms dominate commercial leases:

Tenant improvement allowances (TIAs), where the landlord funds the build-out of the leased space. TIAs are often the biggest negotiating point after base rent.
Free-rent periods, usually at the start of the term, that let the tenant set up before cash rent begins.
Direct cash payments covering relocation costs, penalties on a prior lease, or other move-in expenses.

The accounting and tax rules apply differently depending on which form the incentive takes and, for TIAs, which party owns the resulting improvements.

Tenant Accounting Under ASC 842

A lease incentive is not income to the tenant when received. It reduces the total cost of the lease that gets spread over the term. At commencement, the tenant measures the right-of-use (ROU) asset by taking the initial lease liability, adding payments already made, subtracting incentives received, and adding initial direct costs such as legal fees to negotiate the lease.¹

The practical effect: incentives shrink both the ROU asset and the lease liability on day one, which lowers the periodic lease expense. For an operating lease, that expense still hits the income statement on a straight-line basis. A $10,000 incentive on a ten-year lease reduces annual lease cost by $1,000 each year rather than giving the tenant a one-time windfall.¹

Who Owns the Improvements

TIAs require an extra step: identifying the owner of the build-out. If the tenant owns the improvements, the tenant capitalizes the full build-out cost as a fixed asset in property, plant, and equipment and depreciates it separately. The TIA cash still reduces the ROU asset, so lease expense goes down, and depreciation of the improvements appears as its own line. Together, those two effects reflect the true economics.

If the landlord retains ownership of the improvements, the tenant typically does not record a fixed asset. The TIA simply folds into the ROU asset reduction. The distinction changes the depreciation schedule and balance sheet presentation even though total expense over the term lands in roughly the same place.

Free Rent Is Not Zero Expense

A common misconception is that free-rent months produce no lease expense. Under ASC 842, the total rent obligation across the full term, including the free months, gets leveled out on a straight-line basis. Lease expense runs every month at the same rate, including during the rent-free period.¹

Landlord Accounting Under ASC 842

Landlords treat the cost of lease incentives as a reduction of rental revenue rather than a standalone expense. Both cash incentives and the economic value of free-rent periods reduce the rental income the landlord recognizes over the lease term on a straight-line basis. A $100,000 cash incentive on a ten-year lease reduces annual reported rental revenue by $10,000.¹

When the landlord funds a TIA and retains ownership of the resulting improvements, the cost is capitalized as part of the building or leasehold improvement asset and depreciated over its useful life. The landlord has a real asset on its books, so the revenue-reduction treatment does not apply to that portion.

When the tenant owns the TIA-funded improvements, the landlord has effectively handed over cash. The landlord records the TIA as a deferred incentive and amortizes it as a reduction of rental income over the lease term, mirroring the treatment of any other cash incentive.

Tenant Tax Treatment

Here the rules diverge sharply from the books. For tax purposes, a tenant who receives a cash lease incentive, including a TIA paid in cash, generally recognizes the full amount as ordinary income in the year of receipt. The IRS does not let the tenant spread that income across the lease term. A $500,000 TIA on a ten-year lease hits the tax return all at once in year one.

That creates the central book-tax mismatch: financial statements show $50,000 per year in reduced lease expense; the tax return shows $500,000 of income up front, offset over time by depreciation on the improvements if the tenant owns them.

The Section 110 Exclusion

Section 110 of the Internal Revenue Code provides a narrow safe harbor letting certain tenants exclude a TIA from gross income entirely. All of the following must be true:

The leased property is used in the tenant’s business of selling goods or services to the general public.
The lease term is 15 years or less.
The improvements qualify as nonresidential real property that reverts to the landlord at lease end.
The excluded amount does not exceed what the tenant actually spent on the build-out.

The retail-space requirement is the biggest limitation. Office tenants, warehouse operators, and industrial users do not qualify, regardless of lease length or improvement ownership.²

There is a trade-off. A tenant using the Section 110 exclusion cannot claim depreciation on the portion of improvements funded by the TIA. The income is gone, and so are the corresponding deductions. When the exclusion applies, the landlord is required to treat the improvements as the landlord’s own nonresidential real property for depreciation purposes.²

Depreciating Tenant-Owned Improvements

When the tenant treats a TIA as taxable income and owns the resulting improvements, those improvements become depreciable assets. Recovery period depends on what was built. Interior improvements to nonresidential buildings placed in service after 2017 generally qualify as qualified improvement property (QIP) with a 15-year recovery period under MACRS.³ Structural components of the building, such as exterior walls or the roof, follow the 39-year recovery period for nonresidential real property.⁴

The split between 15-year QIP and 39-year building components matters. Recovering $500,000 of qualifying interior work over 15 years rather than 39 accelerates the deduction and partially offsets the upfront income hit from the TIA.

Landlord Tax Treatment

A landlord making a cash incentive payment deducts the cost by amortizing it over the lease term. The amortization effectively reduces taxable rental income each year, generally consistent with the financial accounting treatment.

When the landlord pays for and retains ownership of TIA-funded improvements, the costs are capitalized into the building’s depreciable basis. Interior improvements qualifying as QIP follow the 15-year recovery period; structural work falls under the 39-year schedule for nonresidential real property.⁴ Depreciation runs on its own schedule regardless of lease term, so a landlord depreciating improvements over 15 or 39 years on a seven-year lease will still have remaining basis after the tenant leaves.

If the Section 110 exclusion applies, the landlord must by statute treat the improvements as the landlord’s own nonresidential real property, even though the tenant performed the construction, and depreciates them accordingly.²

Early Termination

Ending a lease early forces both sides to clean up. For the tenant under ASC 842, the remaining ROU asset and lease liability come off the books, and any difference, including the unamortized portion of lease incentives baked into the ROU asset, flows through the income statement as a gain or loss. If the landlord paid a large TIA that was only partially amortized against the ROU asset, termination can produce a noticeable financial-statement gain for the tenant.

Landlords face the mirror image. Any unamortized deferred incentive balance being spread against rental revenue is written off. For tax, the landlord can generally deduct the remaining unamortized incentive cost in the year of termination as a loss on the abandoned lease arrangement. Separately depreciated building improvements continue on their original MACRS schedule, since those assets are tied to the building rather than the tenant.

Tracking the Book-Tax Gap

The timing difference is simple to describe and real work to maintain. Financial statements spread the incentive evenly across the lease term; the tax return front-loads the income and gives back deductions through depreciation over 15 or 39 years. For the tenant, that creates a deferred tax asset in year one that reverses gradually as depreciation accumulates.

Taking the $500,000 TIA example on a ten-year lease: books show $50,000 per year of reduced lease expense; the tax return shows $500,000 of income in year one and roughly $33,333 per year of depreciation if the improvements qualify as 15-year QIP. The cumulative effect swings from a large unfavorable difference in year one to a smaller favorable difference in later years. Whoever owns the tax provision needs to model this out at lease inception and update it if the lease is modified or terminated.

Landlords carry a smaller but parallel burden. Financial accounting spreads the incentive cost against rental income evenly, while MACRS front-loads deductions on owned improvements. The resulting temporary difference runs in the opposite direction from the tenant’s and demands the same diligent tracking through modifications and terminations.

1
FASB. ASU 2016-02 Leases Topic 842
2
Office of the Law Revision Counsel. 26 USC 110 – Qualified Lessee Construction Allowances for Short-Term Leases
3
Internal Revenue Service. Publication 946 – How To Depreciate Property
4
Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System