Did you know, as a commercial real estate property owner, you can raise your property value and profitability on any type of property? In this blog, you’ll learn how you can raise your property’s value with leasehold improvements and building improvements, and the tax implications for each.
Leasehold Improvements vs. Building Improvements
One of the simplest ways to add value to a property is to make small improvements that make the building more appealing to tenants and future buyers. The good news here is that the changes don’t have to break the bank to be effective.
These improvements can fall into one of two categories: 1) Leasehold or 2) Building Improvements.
- Leasehold improvements benefit the tenant, i.e., lighting, shelving, partitions, flooring.
- Building improvements are made for the building. i.e., new roof, better windows, structural fortification.
The difference between the two is significant with regard to one very important factor: taxes. That’s why it’s critical to understand exactly what a leasehold improvement is before you try and claim it on your next income tax form. Both improvements are managed differently by the Internal Revenue Code.
Leasehold Improvements or Qualified Improvement Property (QIP)
Leasehold improvements, also known as qualified improvement property (QIP), are improvements made exclusively to meet the needs of a particular tenant. The most common are build-outs, such as the installation of drywall, interior doors, lighting, partitions, and plumbing. These are typically completed when a new tenant moves into an office, medical, or retail property.
Right now, the IRS uses the following rules to determine whether an improvement falls under the umbrella of a leasehold improvement.
- The improvement cannot be done by anyone other than the taxpayer (landlord or tenant).
- The improvement must not be done to any common areas, and cannot affect any other tenant’s space.
- It can’t change the structure of the physical building in any way.
- The changes must be made to a building already in service.
In 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act made a few changes to QIP. It allows a 15-year recovery period for QIP and filers can claim first-year depreciation for any QIP.
Aside from the benefit gained by attracting quality tenants and the resultant increase in cash flow, leasehold improvements can be depreciated (though not deducted) using cost segregation depreciation (depreciated over five, seven, or 15 years, versus 39 years) and bonus depreciation (potentially 100% depreciation in the year it was placed into service).
Leasehold Improvement Tax Treatment
The cost of leasehold improvements, or QIP, cannot be deducted but can be depreciated over five, seven, or 15 years. The rules regarding leasehold improvements and depreciation can be quite complicated and dynamic. Be sure to consult with your CPA on your individual tax situation and to keep up with the changing IRS rules.
CRE Building Improvements & Tax Treatment
Anything that changes the function of your building to increase its value (adding square footage or an elevator) or extend its useful life (installing a new roof) is a building improvement. Let’s say you own an older fast-food restaurant. If the tenant asked you to add drive-thru lanes, that would be a building improvement. Some modified triple net (NNN) lease properties, like Starbucks, require the landlord to pay for “structure, roof, and parking lot” in the lease, so these would likely be depreciable if you should ever need to make those improvements.
As for the tax treatment of building improvements, they are depreciated over the same time frame that you depreciate the building, which is 39 years.
10 Ways to Cost-Effectively & Strategically Improve Your CRE Property
1. Upgrade your building’s signage
This is typically the first thing that people will see as they approach or enter your building. A sign that is difficult to read, hidden by bushes and other landscaping elements or that needs a repair can decrease the value of your property.
- Get a new, well-lit sign that is easy to see from the road
- Fix any lightbulbs that are burned out
- Repaint or have a sign company refurbish your aging sign
2. Improve the exterior: curb appeal
- Clean the sidewalks and entryway
- Add new landscaping and potted plants near the doors
- Apply a fresh coat of paint or give the walls a good washing
- Install a newly poured or rebuilt walkway
- Upgrade building, parking lot, and walkway lighting
- Hide garbage dumpsters or pick-up stations from the street
- Get rid of ashtrays and don’t allow smoking by doorways
3. Resurface the parking lot
If it’s in need of an overhaul, this can make a big visual difference.
- If you have a gravel parking lot, consider paving it and installing new lighting to not only improve its functionality but its appeal.
- Eliminate any weeds and rough patches, and have the lines repainted.
- If you don’t have a parking lot, consider renting space from a neighboring building or property to offer to potential renters or buyers as a valuable selling point.
4. Replace doors
Replacing doors from standard hollow core doors with sturdier, more visually appealing doors can add a unique, upscale appearance to your property. This tactic is especially effective in multi-family apartment buildings, office buildings, and in some retail environments.
5. Improve lighting
Installing better lighting in more areas is one of the most cost-effective yet dramatic ways to improve the appearance of a space. In addition to light fixtures, consider adding energy-efficient light bulbs. LEDs, for example, use 25 to 30 percent less energy than incandescent light, last 25 times longer, and don’t put out any heat. Using LEDs can create significant savings, in turn, increasing your cash flow and your property’s overall long-term value.
Some specific lighting ideas:
- Add recessed LED bulbs to maximize the light level without affecting the visual flow of a space.
- Remember to choose the LED color temperature wisely. Light temperature depends on the Kelvin value of a bulb. A lower Kelvin value means the light will be warmer and more yellow, which comes out as a cozier light. A higher Kelvin value means the light will be bluer, considered an energizing light.
- In general, office common areas look best with LED bulb values between 3500 and 4100K, while bulbs with a value of 5,000 to 6,500K are best for office workspaces, medical facilities, garages, and warehouses.
6. New floors
Carpets, while relatively inexpensive in the short term, can be costly when you consider the expense of replacing a carpet every two or three years. Wooden floors, or luxury vinyl tile that looks like wood but is more durable and cost-effective, have the greatest appeal. A building with a clean, hard-floor surface sends a totally different vibe than a damp, matted, carpeted floor.
7. Beautify molding (trim)
- Contemporary spaces benefit from thin molding to create seamless home designs.
- Sand and stained wood molding add rustic appeal to interiors.
- Faux, lightweight pieces can inexpensively and easily add detail along ceilings, floors, and window frames.
8. Clean up or change the ceiling
- A dirty, water-stained, or yellow drop ceiling is an eyesore, clean it or change it out.
- New plastic or metal drop ceiling tiles are modern, cleanable, and add an upscale look.
- If you have a plaster or drywall ceiling, patch any dents and give it a fresh coat of paint.
9. Ramp up security
- Add security so people feel safe on your property.
- Lower your liability costs with an alarm system.
- Light up dark areas and put cameras where they can be seen.
10. Add More Outdoor Space
- If you own a restaurant, add outdoor seating.
- If you own a store, add a bench for those who want to wait or need a break.
- If you own a residential rental or multi-tenant complex, add a courtyard or play area.
All ten of these basic CRE property improvement ideas can also improve your resale value, result in higher rental income, encourage tenants to stay longer, and provide potential tax benefits.
Don’t Want to do Any Improvements? Own a NNN Lease Property
If you own an absolute NNN lease property, the tenant takes care of everything. You simply own the property and live a life of freedom! An absolute NNN lease tenant is typically an investment-grade, multibillion-dollar company that pays all taxes, insurance, common area maintenance, and all other expenses related to the property. You simply collect rent and utilize the tax benefits that fit your situation. It’s as simple as that.
To Wrap It Up – Leasehold Improvements & Building Improvements & Their Tax Implications
Before deciding on any property improvements, look carefully at the tax implications. Leasehold improvements are not always straightforward. They are typically in the tenant’s favor, subject to constant rule changes by the IRS, and may or may not fit your individual financial or property ownership goals. Leasehold improvements can, however, help you get a reliable, long-term tenant. These improvements are typically depreciable over five, seven, or 15 years.
Building improvements are major improvements that change the structure and/or use of the space. Sometimes these changes can be requested by the tenant, but once the building’s use or structure is altered, improvements are subject to 39- year depreciation.
If you would like to learn how you can be a property owner who does not have to pay for any improvements, expenses, management fees, taxes, insurance, or CAM, contact Westwood Net Lease Advisors for a no-obligation conversation about triple net lease investing. We offer education, advisory services, and all buyer representation from before the property search through closing, at no cost to you. 314-997-5227