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How to account for tenant improvements

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Why Your Accounting for Tenant Improvement Allowances is Dead Wrong.

How to account for tenant improvements

In this post I will explain the correct way to account for tenant improvement allowances and other lease incentives under current GAAP lease accounting rules. Note that incentives refer to any payments made by the landlord to (or on behalf of) the tenant. This includes reimbursements for moving expenses, payments for tenants to break existing leases, and payments for tenant improvement allowances (even if the tenant never receives cash and simply submits invoices to the lessor for a prescribed amount of leasehold improvements that the lessor has agreed to fund).

Let me begin by telling you the entry NOT to make. When you receive a tenant improvement allowance, the WRONG entry to make is a debit to cash and a credit to leasehold improvements. The FASB has expressly stated that incentives received should NOT be netted against leasehold improvements, yet this is what we often see companies doing. And it is wrong.

The correct entry is to record the payment as a liability which is amortized (as a reduction to rent expense) over the life of the lease. Here is a quick example:

Assume a tenant enters into a 10 year operating lease requiring the tenant to make payments of $1,000 in years 1-5 and $2,000 in years 6-10. In order to induce the tenant to enter into the lease, the landlord agrees to provide funding of up to $1,000 for leasehold improvements. The total cost of the leasehold improvements is $20,000. The entries to make are as follows:

CR Lease Incentive Liability 1,000

To record receipt of the tenant improvement allowance

2) DR Leasehold Improvements 20,000

To record payment for total leasehold improvements by tenant

3) DR Rent Expense 1,500

CR Deferred Rent 500

To record rent payment in Yr 1 (Straight-line expense: 15,000 total pmts divided by 10 yr term)

4) DR Lease Incentive Liability 100

CR Rent Expense 100

To amortize the tenant improvement allowance (Straight-line: 1,000 TIA divided by 10 yr term)

You can combine entries 3) and 4) above as follows:

DR Rent Expense 1,400

DR Lease Incentive Liability 100

CR Deferred Rent 500

To record rent payment in year 1 AND amortize tenant improvement allowance

Note that as a result of the tenant improvement allowance, rent expense each year is $1,400 instead of $1,500. A common question I get asked is how the entries would be different if the tenant never receives the cash, that is, if the tenant submits invoices to the lessor and the lessor pays the contractor directly. In that case, rather than debiting cash in the first entry, you would debit leasehold improvements, as follows:

DR Leasehold Improvements 1,000

CR Lease Incentive Liability 1,000

To record allowance paid directly to contractor for leasehold improvements

DR Leasehold Improvements 19,000

To record leasehold improvements paid by Tenant

These entries can be combined as follows:

DR Leasehold Improvements 20,000

CR Lease Incentive Liability 1,000

To record total leasehold improvements and allowance paid directly to contractor by landlord

Note that the $1,000 paid directly to the contractor by the landlord would be reported as a non-cash transaction on the cash-flow statement.

There you have it: how to account for tenant improvement allowances under current accounting rules. Please note that under the proposed new lease accounting rules, accounting for tenant improvement allowances will be very different. I will address that in a different post. Please leave questions or comments below.

About LeaseQuery: LeaseQuery is lease accounting software that helps companies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A. Visit us at www.LeaseQuery.com

How to account for tenant improvements

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I negotiated a $25,000 tenant improvement from my landlord. I have to pay for this and then will be reimbursed when the work is completed and I move in. How do I record these expenses and then the reimbursement?

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How do I enter tenant improvement expenses that will be reimbursed by the landlord?

You can expense it almost the same way the landlord will, as a capital asset improvement. But i would book it as repairs since you wnill need to track it to issue 1099s to your contra ctors and vendors anfd you will be receiving one from the landlord.

Plan ahead any contractors you can pay by credit card or paypal do not get a 1099 from you

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How do I enter tenant improvement expenses that will be reimbursed by the landlord?

If its an improvement to the landlords building that the landlord is paying for it, then Im not sure that is your asset at all – I think its the landlords asset. If the landlord is paying for the work, then you probably pay the landlord rent during that period.

If so then I think all the expenses would simply be backcharged to the owner ultimately resulting in zero net to the business.

It would be a different situation if the landlord waived some rent and you paid for the work – then it would be a TI asset to the tenant.

How to account for tenant improvements

As you navigate the complexities of ASC 842 compliance, you may be wondering how and when to account for leasehold improvements.

What are leasehold improvements?

From an accounting standpoint, leasehold improvements are any modifications, enhancements or additions made by a tenant to their leased space (or the “leasehold interest”) that add business value.

Tenants often make these improvements to their leased spaces to:

  • Customize the layout and design of their leased space
  • Improve ergonomics and make the space more employee- or customer-friendly
  • Brand the leased space with a company’s look and feel

Examples of leasehold improvements

Leasehold improvements can be any update or change to a leased property’s interior finishes beyond what the landlord provides as standard.

They may include upgrades to drywall, electrical, flooring, carpentry and similar features, as well as permanently affixed displays, shelving, partitions, lighting, signage and other enhancements that help customize the space.

Leasehold improvements may be made at any time during the term of a lease — or before moving into a space.

For instance, in a new shopping mall, a landlord typically provides a “vanilla box” that a retailer will want to customize with improvements — adding dressing rooms, sales counters and other features that will make the leasehold interest more valuable as a business location.

Furthermore, enhancements that are not considered a leasehold improvement include modifications to exterior or shared spaces, as well as interior features such as data cabling, furniture, non-permanent fixtures or equipment that can be removed when the tenant moves out.

How leasehold improvements impact ASC 842

Leasehold improvements are reported as property, plant and equipment (PP&E) assets on the balance sheet. ASC 842 does not change the way they are handled, unless a tenant uses a tenant improvement allowance to make their improvements.

When a tenant makes leasehold improvements using a tenant improvement allowance, ASC 842 requires a different treatment than the previous accounting under ASC 840. Under ASC 842, a tenant improvement allowance is treated as a lease incentive that reduces the ROU asset. If the tenant improvement allowance is not yet received, the lease liability is also reduced in future minimum lease payments.

Here are the basics you need to know about leasehold improvements relating to ASC 842 compliance:

What is a tenant improvement allowance?

A tenant improvement allowance (also called a TI allowance or TIA) may be offered to a tenant by a landlord, which the tenant may choose to use to pay for leasehold improvements. It is one of several types of lease incentives that a landlord may offer to attract tenants and is often part of lease negotiations.

The TI allowance amount will be included in the lease, along with how it will be paid. For example, it may be offered as a rent discount, paid directly to contractors or provided as a reimbursement to the tenant after the work is complete. The lease may also stipulate what leasehold improvements the allowance may cover.

Reporting a TI allowance for leasehold improvements

Under ASC 840, a TI allowance (or other lease incentive) was generally reported as a separate liability. The liability would have been reduced on a straight-line basis and reduced rent expense.

Now, under ASC 842, if a TI allowance is paid to a tenant up front, it reduces the tenant’s ROU asset, but adds a leasehold improvement asset in the amount that was paid. In other words, the tenant now has a lower lease cost and a separate monthly expense related to the leasehold improvement.

For example, suppose an ROU asset is calculated at $1 million and the landlord offers a lease incentive of $100,000 in a TI allowance. The result would be a $100,000 reduction in the ROU asset and $100,000 in leasehold improvement (PP&E) assets:

ROU asset $1,000,000 – TI allowance $100,000 = Total assets $900,000 lease + $100,000 PP&E

Tracking and managing lease details

Although leasehold improvements themselves are not affected by ASC 842, there are implications in the context of lease incentives and TI allowances as part of new lease negotiations.

Understanding leasehold improvements, lease incentives and the latest accounting treatments is critical to compliance with ASC 842. At the very least, tenants should keep track of all leasehold improvement costs, since they are assets that can be amortized or depreciated.

Leasehold improvements and lease incentives are just some of the critical details that need to be tracked for effective lease accounting and management. A technology solution like Visual Lease makes it easy for you to track these and other crucial aspects of your lease portfolio.

To learn more, contact us at (888) 876-6500 — or to see Visual Lease in action, register for our daily product tour .

Leasehold Improvement can be described as the changes that are made to the leased or rental property in order to ensure that it is best suited for the purposes of the tenant.

During the course of the lease agreement, there might be a number of changes that the tenant requires in order to bring the property to its proper usage.

When making changes in the structure, or the building, it is important to consider the fact that leasehold improvements are mostly undertaken by the property owner, and therefore, they need to be properly accounted for in order to get the best possible results.

However, there is no hard and fast rule that leasehold improvements need to be solely undertaken by the property owner only. In certain cases, the tenant can also provide for these expenses, after bringing them to the notice of the property owner.

As a matter of fact, it is also highly important to ensure the fact that these leasehold improvements are often significant in terms of the financial value, and therefore, they need to be properly accounted for in order to make it best suited to both parties.

Some examples of leasehold improvements include paintings, replacement of fixtures and fittings, and other miscellaneous expenses that might be relevant in this regard.

Accounting for Leasehold Improvement

Leasehold Improvements can be considered to be either an asset or an expense. In the case where leasehold improvements are considered to be a fixed asset, there is a need to ensure that the expense meets the capitalization criteria.

During the course of the tenancy period, there is a lease agreement that is drawn which specifies which alterations or changes can be made within the structure of the property and if those expenses can be capitalized.

Normally, there is a capitalization limit that is set on the expenses that are incurred by the tenant, and these expenses, if have a useful life of more than one year, are normally considered to be capital expenditures.

Therefore, if the investment in leasehold improvement is considered to be a fixed asset by the tenant, then it is amortized over the useful life of the improvement.

However, it must be noted that upon the termination of the lease contract, all the leasehold improvements are considered to be the property of the property owner, unless stated otherwise.

Are Leasehold Improvements Fixed Assets?

  • The benefits of the leasehold improvements are classified to last for more than one year. In other words, the economic benefits resulting from the leasehold improvements are likely to span a period of more than 1 year (they are considered to be long-term), as opposed to short-term.
  • Leasehold improvements that are substantial, and significant in nature are often capitalized. This is also because of the fact that expensing them in a single year might often take an uncalled-for strain on the balance sheet, because of which they capitalized, and then duly amortized over the course of time.
  • Leasehold improvement expenses, which are one-time, and non-recurring are often capitalized. Regular leasehold improvements are not capitalized and are treated as expenses in most cases.

Depreciation

  • Useful Life Basis: In the case where the leasehold improvements are incurred, they are assumed to have a useful life of around 5 years or 10 years. Depending on the useful life of the asset, they are amortized and expensed every subsequent year.
  • Lease Term Basis: In the case where the tenant has borne for capitalized expenses, it can be seen that the expense is depreciated over the useful life of the lease agreement. If a lease lasts for a period of 10 years, then the capitalized expense will be depreciated or expensed over a period of 10 years.

How to account for tenant improvements

What are leasehold improvements on a balance sheet?

When the leasehold improvement meets the company’s criteria to capitalize as fixed assets, then in the balance sheet, leasehold improvement is to recognize at costs. Then the leasehold improvement will be reported at the net of depreciation.

A leasehold improvement is not showing the gross amount on the balance sheet and if we want to see the gross amount, we need to check the note of financial statements. The depreciation expenses of the leasehold improvement will be recognized as expenses in the income statement.

How to account for tenant improvements

Tenant improvement allowance accounting can be done a variety of ways, depending on who pays for the improvements and who oversees the improvements. The structuring of the transactions between the landlord and the tenant determines the accounting entries that will be made. The landlord could pay the tenant so that they can make the improvements themselves or they could pay for the improvements and let the tenant oversee the work. The tenant may also decide to pay for and supervise the improvements themselves, and then depreciate them (i.e. deduct from rental payments) over the course of their stay. Depending on which of these scenarios occurs, the accounting entries will differ slightly.

Tenant Improvement Allowance Accounting

A tenant incentive is a way for landlords to keep tenants satisfied and happy. Accounting for tenant improvements paid by the landlord is a great way to show this. The landlord could pay the tenant so they can make the improvements themselves or they could pay for the improvements and let the tenant oversee the work. The tenant may also decide to pay for and supervise the improvements themselves, and then the landlord will depreciate them over the course of their stay. There are different tenant improvement allowance journal entries depending on which of these scenarios we consider.

A Look at Depreciation

Generally speaking, the landlord will be in charge of depreciating the value of the improvements that have been made to the property. Say, for example, that the improvements had a total cost of $1,500. The landlord would take that figure and divide it over several years. The figure obtained would be deducted from the rental income every year. The number of years varies depending on whether the property is residential or non-residential. Generally, residential properties will be depreciated over a period of 27.5 years while non-residential properties will be depreciated over a period of 39 years. If the cost of the improvement was incurred on equipment, fixtures and furniture, which aren’t considered permanent improvements, then the depreciation period will be seven years.

Cash in Exchange for Work

In the scenario where the landlord gives the tenant cash for improvement work, the tenant is required to record that allowance as income, and then depreciate it over a given period. If the time happens to be longer than the period of the lease on the property, then the tenant will have to write the remaining amount off.

The landlord, on their part, will be required to amortize the amount over the term of the lease. Amortization is pretty much similar to depreciation in that it marks how much of an asset has been used up. The major difference, however, is that with amortization the asset is intangible while with depreciation it is tangible. In this case, the asset is the amount the landlord has spent on the rental property.

When the Landlord Makes the Improvements

If the landlord has made the allowance and still makes the improvements themselves, then they own those improvements. In this case, they will depreciate the cost of those improvements over the period of the lease. If another tenant moves into the property and doesn’t require further improvements, then the landlord can continue their depreciation schedule until they have exhausted the value of the improvements. Should the property be demolished before the value is used up, then the landlord is required to write off the remaining amount of the value. The tenant doesn’t make any entries in this scenario.

When Work Substitutes Rent

There is the scenario where the tenant makes the improvements themselves and deducts the cost of the improvements from their rent. In this case, they will enter the deductions as income in their accounts. The landlord will treat the rent as a cash payment but will still depreciate the amount associated with the improvements.

  • Internal Revenue Service: Residential Rental Property
  • Lease Ref: Tenant Improvement Allowance: A Complete Guide
  • HHCPA: Accounting for Lease Incentives and Tenant Allowances
  • Accounting Tools: Accounting for a tenant improvement allowance
  • Internal Revenue Service. “New Rules and Limitations For Depreciation and Expensing Under the Tax Cuts and Jobs Act.” Accessed April 30, 2020.

Nicky is a business writer with nearly two decades of hands-on and publishing experience. She's been published in several business publications, including The Employment Times and Business Idea Factory. She also studied business in college.

Definition & Examples of Tenants Improvements and Betterments

How to account for tenant improvements

Caiaimage / Agnieszka Olek / Getty Images

Marianne Bonner, CPCU, ARM, worked in the insurance industry for 30 years. Now she consults on and writes about commercial insurance.

Tenants improvements and betterments (TIBs) are upgrades made by business owners to properties they rent from a landlord. The term is most commonly used in commercial property insurance.

TIBs are paid for by the tenant, but they become part of the building. As such, the landlord generally obtains ownership of the upgrades once they've been installed unless a contract states otherwise.

What Is a Tenant Improvement and Betterment?

Many commercial property insurance policies define tenants improvements and betterments as fixtures, alterations, installations, or additions to a building that you occupy but don't own. TIBs are items you've purchased or installed at your expense, but that you can't legally remove.

As an example, we'll say that Larry owns Luxury Leathers, a leather goods shop located in a strip mall. He operates his business out of space he rents from the mall owner, Shopping Centers, Inc. Larry has made various improvements to his rental space since Luxury Leathers moved in two years ago, including new recessed lighting, new carpeting, and a small office constructed behind the retail area.

The office, lighting, and carpeting Larry has installed in his store are TIBs. They're now part of the building. Larry doesn't own them, so he can't take it with him if he moves to another location. He could damage the building if he attempted to remove them.

The tenant's interest in the property ceases when the lease terminates and the tenant moves out.

  • Acronym: TIBs

How TIBs Work

Completed TIBs are to be insured by the landlord. Shopping Centers, Inc., has insured the building under a commercial property policy, and the policy automatically covers any improvements to the building that are made during the policy period.

Larry knows that any TIBs he installs will become the property of his landlord, but he'll nonetheless have the use of those improvements for the remainder of his lease. Larry could lose his use interest in the property if the TIBs are damaged or destroyed by a fire or other peril, but he can also insure his interest in the improvements under a commercial property policy.

Larry maintains an insurable interest in the use of the improvements.

TIBs vs. Trade Fixtures

Tenants can't tear out TIBs they've installed, but they can remove trade fixtures. These are items installed by the tenant that the tenant expects to remove when they vacate the building. They are essential to the tenant's business and can be removed without damaging the property. Trade fixtures remain the property of the tenant, so the tenant is responsible for insuring them.  

Suppose Larry installs new showcase cabinets in his store for displaying his leather goods. Both Larry and his landlord expect that Larry will take the showcases with him when he moves to another location. Even though the showcases are attached to the building, they're considered trade fixtures rather than TIBs. Other examples of trade fixtures are computers, vending machines, and machine shop equipment.

Tenants should ensure that their leases clearly specify what types of property qualify as trade fixtures. Otherwise, the landlord might refuse to allow the tenant to remove certain property when the lease expires.

Tenants Improvements and Betterments Trade Fixtures
Can't be removed Can be removed without causing damage
Owned by the landlord Owned by the tenant
Insured by the landlord Insured by the tenant

Who Pays for the Insurance?

TIBs can be insured by the tenant or the landlord, but a commercial lease should clearly state which party is responsible for providing insurance. Otherwise, disputes can arise over whose insurance (the landlord’s or the tenant’s) should apply to losses involving damaged TIBs.

The lease should also specify when ownership of TIBs passes from the tenant to the landlord. This often occurs when the improvements are installed in the building.

TIBs are often insured in conjunction with the building under the landlord's commercial property policy because they're owned by the landlord. Policies typically cover the building scheduled in the policy, completed additions, and fixtures, which include property that's permanently attached to the building.

An example of a fixture is a chandelier installed in the ceiling of a restaurant.

Suppose that the lease between Luxury Leathers and Shopping Centers, Inc., requires the landlord to insure TIBs. The office, carpeting, and recessed lights Larry has installed should qualify as covered property if Shopping Centers, Inc., is insured under a typical property policy.

Improvements made by a tenant increase the value of the landlord’s building. The value of the building will increase by $15,000 if a tenant spends $15,000 on TIBs. The building limit on the landlord’s policy should be increased by the value of the TIBs. Otherwise, the building may be underinsured and the landlord could incur a coinsurance penalty if a loss occurs.

The tenant need not insure these items if the lease requires that the landlord must repair or replace damaged TIBs. Otherwise, TIBs should be insured under the tenant's property policy.

Most commercial property policies automatically cover a tenant's use interest in TIBs as business personal property.

Replacement Cost and Actual Cash Value

Depending on your policy, TIBs might be covered on a replacement cost or actual cash value basis. Losses are typically covered in full only if you make repairs "promptly," but this term isn't clearly defined.

Your insurer might pay only a portion of their original cost if you don't repair TIBs promptly. The typical formula is original cost times the number of days from the date of loss to the expiration of your lease, divided by the number of days from installation of improvements to the expiration of the lease.

Suppose that Luxury Leathers signed a five-year lease on January 1, 2015. Larry completed the improvements on January 1, 2016. All the improvements were destroyed by a fire on January 1, 2017. Larry's insurer won't pay more than $11,250, based on the $15,000 cost of the TIBs:

$15,000 X 1095 (three times 365) divided by 1460 (four times 365) = $11,250  

Your insurer won't pay anything if your landlord repairs or replaces the damaged improvements.

Do Tenant Improvements Qualify for Bonus Depreciation?

Tenant or leasehold improvements are improvements made by a landlord to attract or retain a tenant. The tenant can request specific customizations to the space’s interior to better suit their needs or preferences. These improvements can be paid for by either the landlord or tenant. This is all negotiated and outlined in the signed lease agreement. However, there are tax implications to how these tenant improvements (TIs) are funded. There’s also a bit of confusion about qualified leasehold improvements. Namely, what they are, whether or not tenant improvements qualify for bonus depreciation or how long they can be depreciated for? This post is for informational purposes only. We are a commercial construction company, specializing in leasehold improvements and new construction. We ARE NOT tax professionals. This content does not substitute for the expertise of a qualified tax accountant on this matter.

HOW LONG CAN A TENANT DEPRECIATE LEASEHOLD IMPROVEMENTS?

The recovery period – or the depreciable life – of a non-residential real property has customarily been 39 years. But some recent changes have opened the door to new tax incentive opportunities that allow for a faster 15-year recovery of costs.

This is courtesy of a provision in the American Jobs Creation Act (AJCA) to encourage improvements to leased commercial spaces. The idea is this shorter recovery period will lead to more tenant improvement construction projects; creating jobs for area contractors and tradesmen.

QUALIFIED LEASEHOLD IMPROVEMENTS MUST MEET THE FOLLOWING CRITERIA

  • The improvements must be made as specified in the lease
  • The improvements are in some way attached to the structure of the building. They must be considered real property under Section 1250 of the Internal Revenue Code (IRC)
  • The improvements were made by the lessee, not the building owner
  • The improvements were made to an area exclusively occupied by the lessee or any sublessee of that portion of the interior
  • The building owner and lessee aren’t related in any way
  • The improvements were made in a building in service for more than 3 years

There are a few special qualifiers for restaurants and retail properties.

A qualified restaurant property falls under Section 1250 of the IRC and devotes more than 50% of the building’s square footage to meal prep or dining.

A qualified retail property is Section 1250 property and it must be open to the general public and primarily sell goods (tangible personal property) not services.

LEASEHOLD IMPROVEMENTS NOT QUALIFIED FOR SHORTER LIFE

  • Elevators and escalators
  • Structural components benefiting a common area
  • Expanding the building itself
  • Internal structure framework

Originally set to expire on 12/31/2006, these AJCA provisions were continuously extended. The 15-year recovery period for qualified leasehold improvements was eventually made permanent through the Protecting Americans from Tax Hikes (PATH) Act of 2015.

But qualified leasehold improvements placed into service from 10/21/2004 to 1/1/2018 are likely assigned a 39-year-old recovery period in tax records. Many taxpayers haven’t changed this and aren’t correctly recording depreciation on taxpayer’s Form 4562. Don’t let this tax incentive slip by you.

What does “placed-in service” mean? It’s the point in time where an asset or a property or eligible improvements to the property can be depreciated or given a tax credit for the first time for accounting purposes. This date marks the start of the property’s depreciation period.

The Tax Cuts and Jobs Act (TCJA) has also led to several changes to federal income tax depreciation rules. For starters, the TCJA has made it so property placed in service between 9/28/2017 and 12/31/2017 is now eligible for a 100% first-year bonus depreciation.

This means the entire cost of the eligible tenant improvements can be written off in year one.

However, a TCJA drafting oversight excluded qualified property placed in service after 2017 from the list of properties with a 15-year depreciation period. Congress intended for its inclusion and will likely fix this legislative glitch through legislation.

Once corrected, qualified improvements placed in service following 2017 will be eligible for bonus depreciation. Until then, these property improvements must be assigned a 39-year depreciation period and aren’t eligible for bonus depreciation per current law.

Triple net lease properties are rich in opportunity for both property owners and tenants alike. As an investor, you can create a reliable income stream from your property, and as a tenant you can establish a footprint for your business.

However, there are going to be expenses associated to maintaining your triple net property, from standard operating expenses to structural repairs to keep the building updated, safe, and profitable.

While these expenses are a given in any triple net deal, the division of financial responsibility between the property owner and the tenant tend to be a bit murkier and we are often asked questions such as: What am I, as the property owner, responsible for a triple net investment? Which costs can/should I pass through to tenants (and how do I do that fairly?)

To help address such questions in the owner/tenant responsibility debate, here are four key triple net lease tenant improvement factors that you should consider when you’re negotiating a net lease or entering an existing NNN lease by investing in a new commercial property.

Which Triple Net Property Repairs Are (Generally) Owner Responsibilities?

As the triple net property owner (unless otherwise specified in the NNN lease), you’ll generally be responsible for maintaining and repairing these 3 main aspects of your building:

  • Roof (repairs, maintenance, upgrades)
  • Exterior Walls
  • Utility Repairs and Upkeep (for major things such as plumbing and electricity)

What Operating Costs Are Typically Passed Through to Tenants?

One of the key advantages for triple net property investors is that you can use your property to generate income, without all the day-to-day tasks and expenses related to property ownership and landlord duties. This is because you can pass along building upkeep duties and expenses to the tenants who will be occupying and running their business from your building location. These expenses and responsibilities often fall under tenant responsibilities in NNN leases as costs of operation for the business.

In a triple net lease, operating costs, maintenance fees, and improvement responsibilities are typically passed along to a tenant operating their business in the commercial space, including (but not limited to):

  • Security Improvements or Systems
  • Major Building Improvements (Less Capital Improvement Expenditures)
  • Janitorial Services and Expenses
  • Association Fees
  • Building Management Fees
  • Parking Lot Maintenance (Upkeep, Repairs, Re-Paving)
  • Lighting
  • Landscaping
  • Inspection Fees

How Should You Divide Capital Improvement Costs?

The division of improvement costs between the landlord and the tenant is often based whether or not the expense is related to capital improvement of the building. These types of improvements are frequently deemed the responsibility of the tenant or will be passed through to the tenant in the form of increased rent. To keep things fair, and ensure that they can take full advantage of the improvements or repairs they’ve funded, a tenant may request amortization to spread out the cost of the improvement over the lifespan of that improvement.

However, the definition of capital and non-capital improvements is another murky area, so it’s prudent to understand what’s outlined specifically in any NNN lease you’re taking over with a new commercial property purchase. Likewise, in a new or renewing lease, it’s vital to understand which items you are passing through to the tenant and ensure the terms are very specific.

What Ultimately Determines Financial Responsibility in Triple Net Lease Improvements?

If there’s one certainty in net lease real estate, it’s this: negotiation. While there are generally things that owners are financially responsible for with regard to building upkeep and repairs (as well as items commonly passed through to tenants to maintain and fund), each triple net property deal will be unique according to what’s been negotiated in the deal.

Triple net leases can vary dramatically, depending on what deal is negotiated and how financial responsibilities are outlined in the lease. Working with an NNN lease expert whenever you’re investing in a new commercial property is key to ensuring your profitability, and also avoiding excess or surprise expenses on your property.

If you’re bringing a tenant into a property you own under a NNN lease agreement, then you can benefit from working with a net lease advisor to properly structure your lease according to your exact goals and specifications. You’ll also need to vet your prospective tenants carefully to ensure that they have reliable credit profiles, proven business success, and plans to operate a business in your property with longevity.

Sands Investment Group has extensive expertise in triple net real estate, and we know exactly how to advise clients on the best way to handle triple net lease tenant improvements. In fact, we’re the fastest growing net lease investment company in America, with over 1,500 transactions in 48 states (to the tune of $3.5 Billion) since 2010, so we know what deals will turn your best profit, while offering fair, attractive tenant terms.

Leasehold improvements, also called “build out” expenses, are improvements made to space rented for your business that will be used exclusively by your business. Leasehold improvements can be minor changes, such as painting or flooring, or major changes, such as constructing, moving or removing walls. The Internal Revenue Service (IRS) considers leasehold improvements capital assets, meaning the improvement has a useful life of greater than one year. You expense capital assets over the useful life of the asset as designated by the IRS.

Create an account called “Leasehold Improvements” in the assets section of your accounting general ledger.

Record the entire cost of the leasehold improvements as an increase to the leasehold improvements account.

Record the entire cost of the leasehold improvements as a decrease to the business checking account.

Create an account called “Leasehold Improvements Accumulated Depreciation” in the assets section of your accounting general ledger.

Review the IRS regulations for calculating depreciation on leasehold improvements at the end of the calendar year. The regulations can change from year to year; in some years, the IRS gives special consideration to certain types of depreciation, allowing you to deduct more than the regular deduction would normally be if you meet the criteria set forth in that year’s allowance.

Calculate depreciation for the year based on the IRS regulations.

Record the depreciation for the year as an increase to the leasehold improvements accumulated depreciation account.

Record the depreciation for the year as an increase to the depreciation expense account in the expense section of the accounting general ledger.

  • Internal Revenue Service: Publication 946
  • “Principles of Accounting”; A. Douglas Hillman, Richard F. Kochanek and Corine T. Norgaard; 1991
  • If you are not certain how to calculate depreciation on leasehold improvements, hire a tax professional to assist you with the proper calculation.
  • Depreciation and amortization software eliminate the manual component of calculating depreciation and help prevent errors in calculation. Many reasonably priced options are available for small business use.

Kaye Morris has over four years of technical writing experience as a curriculum design specialist and is a published fiction author. She has over 20 years of real estate development experience and received her Bachelor of Science in accounting from McNeese State University along with minors in programming and English.