Cost Segregation for Restaurants: Kitchen Equipment, QIP, and the Leasehold Question

Restaurants present a cost segregation situation that most property types do not: a large share of the opportunity exists even when the operator does not own the building. Roughly two-thirds of the independent restaurant owners we work with lease their space, and their buildout is still fully eligible for component analysis.

Owned restaurant real estate reclassifies 28% to 38% of depreciable basis. Tenant buildouts, analyzed on their own, frequently reclassify 50% or more, because a buildout contains almost no building shell.

Kitchen Equipment and Its Infrastructure

Walk-in coolers and freezers, cooking lines, fryers, ovens, ranges, hoods, dishwashing systems, prep tables, and refrigerated cases are five-year property under IRC Sec. 168(e)(3)(B). This is uncontroversial.

What often gets missed is the infrastructure. The dedicated makeup air unit serving a hood, the grease interceptor, the gas piping serving cooking equipment, the dedicated electrical panels and circuits feeding the kitchen, and the reinforced floor structure supporting heavy equipment are all analyzed for functional connection to the equipment. Much of it reclassifies alongside the equipment it serves.

Refrigeration is a common error. A walk-in cooler box is equipment. The condensing unit on the roof serving only that walk-in is equipment. The building's rooftop HVAC serving the dining room is structure. Studies that fail to distinguish these are the ones adjusted on examination.

Front of House

Dining room components reclassify heavily. Decorative lighting, booth and banquette seating that is not structurally integrated, bar equipment and undercounter refrigeration, point-of-sale systems and their wiring, sound and audiovisual systems, millwork and casework that is removable, wall coverings, and specialty floor finishes are all five-year or seven-year property.

Restrooms, general lighting, the roof, and the structural shell remain 39-year property.

Qualified Improvement Property

Interior improvements to nonresidential real property placed in service after the building was first placed in service qualify as qualified improvement property under IRC Sec. 168(e)(6). QIP carries a 15-year recovery period and is eligible for bonus depreciation.

This matters for restaurant renovations. A buildout in an existing building that does not enlarge the building, is not an elevator or escalator, and is not internal structural framework generally qualifies as QIP. That gives a 15-year, bonus-eligible classification to interior work that would otherwise sit at 39 years.

The practical sequence in a study is to first identify components that qualify as 5-year or 7-year personal property, then classify remaining qualifying interior improvements as 15-year QIP, leaving only true structure at 39 years.

Worked Example: Tenant Buildout

An operator spends $1,450,000 building out a leased 5,200 square foot restaurant. The study identifies five-year property of $551,000 (38%), seven-year property of $87,000 (6%), fifteen-year QIP of $522,000 (36%), and 39-year structural improvements of $290,000 (20%).

Reclassified and QIP basis of $1,160,000 is fully deductible in year one under IRC Sec. 168(k). The remaining $290,000 is amortized over the lease term or depreciated over 39 years depending on the improvement. First-year depreciation approaches $1,167,000 on a $1.45 million buildout.

Leasehold Improvements and Lease Term

One trap: improvements made by a tenant are depreciated over the applicable recovery period under IRC Sec. 168, not over the lease term, for tax purposes. Book treatment often amortizes over the lease, which creates a book-tax difference that surprises owners reviewing their own financials.

If the lease terminates and the improvements are abandoned, the remaining tax basis is generally deductible as an abandonment loss under IRC Sec. 165 in the year of abandonment. Restaurant operators who close a location should not simply stop depreciating the buildout, they should claim the loss.

Using the Deduction

A restaurant is an operating business, so the loss is non-passive for an owner who materially participates under Treasury Regulation Sec. 1.469-5T. That makes this one of the more usable accelerated deductions available.

Restaurant group owners with multiple locations should also review entity structure, since a large first-year loss interacts with basis and at-risk limitations under IRC Sec. 704(d) and Sec. 465 before Sec. 469 is ever reached. Our guides on restaurant owner tax strategy and commercial cost segregation cover the surrounding planning.

Frequently Asked Questions

Can I do cost segregation if I lease my restaurant space?

Yes. Your buildout is your depreciable asset and it can be analyzed on its own. Tenant buildouts often reclassify more than owned buildings, frequently over 50%, because a buildout is nearly all interior improvement and equipment with almost no building shell.

What is qualified improvement property and does my buildout qualify?

QIP under IRC Sec. 168(e)(6) is interior improvement to nonresidential property made after the building was first placed in service. It carries a 15-year life and is bonus eligible. Most restaurant interior work qualifies, excluding building enlargement, elevators and escalators, and internal structural framework.

Is the hood makeup air unit equipment or building HVAC?

A dedicated makeup air unit serving only the kitchen hood is generally analyzed with the equipment it serves. The rooftop unit conditioning the dining room is structural. The distinction is functional, and studies that blur it are the ones adjusted on examination.

What happens to my buildout if I close the location?

The remaining tax basis is generally deductible as an abandonment loss under IRC Sec. 165 in the year you abandon the improvements. Operators frequently just stop depreciating instead of claiming the loss, which leaves a substantial deduction unclaimed.

Can I use the loss against my other income?

A restaurant is an operating trade or business, so if you materially participate under Treas. Reg. Sec. 1.469-5T the loss is non-passive. Before Sec. 469 applies you must also have sufficient basis under Sec. 704(d) and amount at risk under Sec. 465 to absorb the loss.

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