Who Has the Right to Depreciate Tenant Improvements?

Under IRC §168(i)(8)(A), tenant improvements are subject to depreciation if they qualify as property under Section 168. However, determining which party has the right to claim depreciation deductions requires careful analysis of who bears the economic burden of the improvements.

General Rules for Tenant Improvement Depreciation

The right to depreciate tenant improvements is governed by who pays for them, not by factors such as:

• Legal title to the improvements
• Maintenance responsibilities
• Disposition rights at lease termination

Tenant-Paid Improvements

When tenants pay for improvements directly, they may claim depreciation deductions even if:

• The lease specifies that legal title belongs to the landlord immediately upon installation
• The improvements will remain with the property after lease termination

The key exception is when tenant payments are structured as rent substitutes. In such cases, the landlord, not the tenant, would have depreciation rights.

Landlord-Provided Improvements

When landlords fund improvements, either through:

• Direct payment for construction, or
• Tenant improvement allowances provided in the lease

The landlord has the right to depreciate these improvements under §168(i)(8). This applies regardless of:

• Who manages the construction process
• Who maintains the improvements
• Whether the tenant selected contractors or materials

Excess Tenant Expenditures

If a tenant spends more than the landlord's improvement allowance:

• The landlord depreciates the portion covered by their allowance
• The tenant cannot depreciate or claim a loss for costs exceeding the allowance

Lease Termination Considerations

Under §168(i)(8)(B), special rules apply when lessor-provided improvements are:

• Made for the benefit of the lessee
• Irrevocably disposed of or abandoned at lease termination

In these cases, the lessor can treat the improvements as disposed of for gain/loss purposes when abandoned at lease end.

Conclusion

The determination of depreciation rights for tenant improvements primarily follows the money - focusing on who actually pays for the improvements rather than other factors like legal title or maintenance obligations. This aligns with the broader tax principle that depreciation should follow economic substance over legal form.

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