Leasehold Improvements: MACRS, Bonus Depreciation, and Section 179

Leasehold improvements depreciation on commercial rental property generally runs over 15 years as Qualified Improvement Property (QIP), but improvements both acquired and placed in service after January 19, 2025 can be written off in full the first year under the restored 100% bonus depreciation rules. Section 179 expensing and the de minimis safe harbor offer alternatives for specific situations, and separate rules govern landlord allowances, lease terminations, and sales.

What Qualifies as Qualified Improvement Property

QIP covers interior improvements to a nonresidential building made after the building was first placed in service by any owner. New interior walls, upgraded lighting, reconfigured office layouts, refreshed retail floors, and similar interior work all fit.¹

Three types of work are excluded and must instead be depreciated over the 39-year period that applies to the building itself:

Building enlargements, such as adding square footage or a new floor.
Elevators and escalators.
Internal structural framework, including load-bearing walls and columns.

The classification matters. A tenant spending $500,000 on interior buildout wants as much of that cost as possible treated as QIP to unlock the faster write-off. For large or mixed projects, a cost segregation study performed by an engineer identifies which components qualify. Simpler jobs (flooring, ceiling tiles, partitions) can usually be classified by a CPA with standard documentation.

The 15-Year MACRS Schedule

Under the Modified Accelerated Cost Recovery System, QIP placed in service after 2017 has a 15-year recovery period using the straight-line method. You deduct an equal share of the cost each year for 15 years. The building shell and any non-qualifying structural work stretch over 39 years, so QIP treatment roughly doubles the annual deduction on the same dollar.²

Businesses that elect out of the business interest deduction limitation under IRC Section 163(j) must use the Alternative Depreciation System instead, which stretches QIP to 20 years on a straight-line basis. That trade-off is worth modeling with a tax advisor before making the interest election.

100% Bonus Depreciation on Post-January 19, 2025 Improvements

The One, Big, Beautiful Bill Act (OBBBA) permanently restored 100% bonus depreciation for QIP both acquired and placed in service after January 19, 2025. The entire cost can be deducted in year one, with no phasedown and no scheduled expiration.³

That reversed a phasedown already underway. Bonus depreciation had stepped from 100% in 2022 down to 60% in 2024 and 40% in 2025, and was set to hit 20% for 2026 before zeroing out in 2027. OBBBA cancelled the glide path and made full expensing permanent.

Watch the acquisition date. Both acquisition and placed-in-service dates must fall after January 19, 2025 for the full 100% deduction. Improvements contracted for before that date but placed in service later still fall under the old phasedown, which can mean as little as 20% bonus depreciation. Long construction timelines that straddle the effective date have caught some businesses off guard.

A taxpayer can also elect a reduced 40% bonus rate instead of 100% for qualified property placed in service during the first tax year ending after January 19, 2025. That option preserves deductions for later, higher-income years rather than concentrating them in a single return.

Section 179 as an Alternative

Section 179 lets a business immediately deduct the full cost of qualifying property, including QIP, up to an annual cap. For tax year 2026, the maximum Section 179 deduction is $2,560,000. The cap phases out dollar-for-dollar once total qualifying property placed in service during the year exceeds $4,090,000, and it disappears completely at $6,650,000.¹

Section 179 carries one limit bonus depreciation does not: the deduction cannot exceed the business’s taxable income for the year. If QIP costs $800,000 but taxable income is $500,000, Section 179 caps out at $500,000 and the remaining $300,000 carries forward. Bonus depreciation has no such income ceiling, which is why most businesses with eligible post-January 2025 improvements will lean on bonus depreciation first. Section 179 still helps when improvements were acquired before OBBBA’s effective date and only qualify for reduced bonus, or when a business wants finer control over the size of the deduction.

Small Costs and the De Minimis Safe Harbor

Not every improvement has to be capitalized. Under the de minimis safe harbor election, a business with an applicable financial statement can immediately expense items costing up to $5,000 per invoice or item. Without an applicable financial statement, the threshold is $2,500 per invoice or item.⁴

The election is made annually on the tax return. It works for a handful of light fixtures or a small partition but will not cover a full buildout. Anything above the threshold has to be capitalized and run through the depreciation rules above.

When the Landlord Pays or Provides an Allowance

If the landlord pays directly for improvements to a tenant’s space, the landlord capitalizes the cost and depreciates it over the 15-year QIP recovery period.¹

Cash tenant improvement allowances are different. Under IRC Section 110, a tenant can exclude a landlord’s construction allowance from gross income only if all three of these are true:

The lease term, including renewal options, is 15 years or less.
The space is retail — used to sell goods or services to the general public.
The tenant actually spends the allowance on long-lived real property improvements at that location, and the improvements revert to the landlord at lease end.

The exclusion only reaches amounts actually spent on qualifying improvements. Receive a $200,000 allowance and spend $150,000, and the remaining $50,000 is taxable income.⁵

Office tenants, tenants on leases longer than 15 years, and any tenant receiving cash outside these conditions generally must recognize the allowance as income in the year received. They can then capitalize and depreciate the improvements paid for with those funds, which offsets the income over time but creates a year-one tax hit.

On the landlord side, when a tenant pays for improvements that revert at lease termination, IRC Section 109 excludes the value from the landlord’s gross income. The exception: if the improvements substitute for cash rent, the exclusion does not apply and the landlord reports the value as rental income.⁶

Depreciation Recapture When You Sell

If a business selling itself or assigning a lease disposes of leasehold improvements at a gain, some of that gain gets recaptured. QIP is Section 1250 property, and gain attributable to prior depreciation is “unrecaptured Section 1250 gain,” taxed at a maximum 25% rate rather than the lower long-term capital gains rates.⁷

Recapture applies to all depreciation claimed, bonus depreciation included. A business that took a full 100% bonus deduction on $1 million of improvements and later sold for $1.2 million would owe 25% recapture on the $1 million of prior depreciation plus capital gains tax on the $200,000 above original cost. The larger the up-front deduction, the larger the potential recapture, which is worth factoring in when choosing between 100% bonus and spreading the deduction over 15 years.

Ending a Lease Before Improvements Are Fully Depreciated

When a lease terminates and improvements stay with the building, any remaining tax basis in those improvements is deductible in the year the lease ends as an abandonment loss. The loss is ordinary, not capital, so it fully offsets regular business income.⁸

Two conditions have to be met: the tenant cannot sell or exchange the improvements (they stay with the building), and the tenant must permanently give up possession and use. Walking away at lease end typically satisfies both. Different rules apply if abandoned improvements are secured by debt, and abandonment loss treatment is not available for property held for personal use.

Correcting Prior-Year Errors With Form 3115

A common issue: leasehold improvements were placed on a 39-year schedule when they should have been on 15, or depreciation was skipped in prior years. The fix does not require amending old returns. File Form 3115 (Application for Change in Accounting Method) to switch to the correct method and capture the missed deductions in a single year.⁹

The correction falls under Designated Change Number 199, an automatic change with no IRS approval and no user fee. You compute a Section 481(a) adjustment — the cumulative difference between what was deducted and what should have been deducted across all prior years. A negative adjustment (under-deducted) is taken in full in the year of change. For a property mis-depreciated over 39 years for several years, the one-time catch-up can be significant. Attach the original Form 3115 to the timely filed return (including extensions) for the year of change and send a signed copy to the IRS National Office.

Reporting on Form 4562

All depreciation for leasehold improvements flows through Form 4562. Section 179 amounts go on Line 8, with the total on Line 12. Bonus depreciation is reported on Line 14. Any remaining basis depreciated on the standard 15-year MACRS schedule goes on Line 19e, column (g), with the total carried to Line 22. Both landlords and tenants use the same form, and a business using more than one method in the same year reports each on its own line.¹⁰

1
Internal Revenue Service. Publication 946 (2025), How To Depreciate Property
2
Internal Revenue Service. Publication 946 (2025), How To Depreciate Property – Section: Recovery Periods Under GDS
3
Internal Revenue Service. Treasury, IRS Issue Guidance on the Additional First Year Depreciation Deduction Amended as Part of the One, Big, Beautiful Bill
4
Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions
5
Office of the Law Revision Counsel. 26 U.S. Code 110 – Qualified Lessee Construction Allowances for Short-Term Leases
6
Office of the Law Revision Counsel. 26 U.S. Code 109 – Improvements by Lessee on Lessor’s Property
7
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
8
Internal Revenue Service. Publication 544 (2025), Sales and Other Dispositions of Assets – Section: Abandonments
9
Internal Revenue Service. Instructions for Form 3115
10
Internal Revenue Service. Form 4562 – Depreciation and Amortization