IRC Section 168(c)(1)(B) classifies Qualified Improvement Property (QIP) as 15-year depreciable property, a significant upgrade from prior law that required 39-year depreciation. Additionally, IRC Section 168(k) bonus depreciation permits 100% deduction of QIP cost in the year of acquisition through 2026, then phases down to 80% in 2027. A commercial landlord making $1 million in tenant improvements (flooring, painting, lighting, HVAC modifications, interior walls) can claim 100% deduction of the $1 million in year 1, creating $370,000 in federal tax savings at 37% marginal rate, plus immediate state tax savings.
Qualified Improvement Property Definition and Qualifying Expenditures
QIP is defined as any improvement to the interior (nonstructural) of a building. Examples include: flooring, carpeting, painting, lighting, interior walls and partitions, HVAC ductwork and diffusers, plumbing and fixtures, electrical systems inside walls, cabinetry and built-in fixtures, dropped ceilings and acoustic treatments. QIP excludes structural components (structural walls, roof, foundation, load-bearing walls), equipment not affixed to building (personal property like furniture or office equipment), and land improvements (parking lots, sidewalks). A tenant improvement allowance (TIA) from landlord to tenant for build-out of retail or office space is QIP if the expenses qualify. A restaurant tenant spending $500,000 on interior build-out (flooring, lighting, built-in counters, restroom fixtures, HVAC distribution) qualifies. The same tenant spending $500,000 on an external kitchen hood (structural/building system) or equipment (ovens, refrigeration) does not qualify.
Placed in Service Requirements and Substantial Completion
QIP must be placed in service (ready for use/occupancy) in the year the depreciation deduction is claimed. A commercial tenant completing build-out on December 15 and occupying space on December 20 has the QIP placed in service in December of that year. Depreciation deductions are claimed on the year-of-placement tax return, and bonus depreciation (100% in 2026, 80% in 2027) is taken in that year. If construction is not completed until January of the following year, the QIP is placed in service in that following year, and the deduction is deferred. This timing becomes critical for year-end planning. A landlord with substantial W-2 income or business income should accelerate tenant build-outs to be completed in December to claim bonus depreciation in the current year, creating immediate tax reduction.
Cost Basis Determination and Allocation
QIP cost basis includes all expenditures to acquire or improve the property, including: construction labor (both employee and contractor), materials and supplies, architectural and engineering fees, permits and approvals, project management, and any financing costs capitalized to basis. If landlord pays $700,000 to contractor for tenant improvement work and $50,000 in architectural fees, total QIP basis is $750,000. Cost basis does not include routine maintenance or repairs expensed immediately under IRC Section 162. The taxpayer must carefully allocate costs between QIP (capitalized and depreciable) and repairs (expensed immediately). A major renovation project often includes both: interior walls and flooring (QIP, capitalize) and painting and general maintenance (repairs, expense immediately). Detailed invoices and cost allocation between these categories is critical for IRS defense.
Bonus Depreciation and 100% Deduction Through 2026
Under IRC Section 168(k), qualified property (including QIP) placed in service after September 27, 2017 and before January 1, 2027 qualifies for 100% bonus depreciation. This means the entire cost basis is deductible in the year of placement in service, not depreciated over the 15-year MACRS life. A commercial building owner making $800,000 in QIP improvements with 100% bonus depreciation claims $800,000 deduction in year 1, reducing taxable income by $800,000 and federal tax by $296,000 (37% rate). Without bonus depreciation, the same cost would be depreciated at approximately $53,000 annually (15-year straight-line), reducing annual tax by only $19,600. Bonus depreciation accelerates the deduction 15 years forward, providing substantial present-value tax savings.
Bonus Depreciation Phase-Out and Planning for 2027+
Bonus depreciation phases down after December 31, 2026: 80% in 2027, 60% in 2028, 40% in 2029, 20% in 2030, and zero (no bonus) after 2030. A commercial property owner planning improvements in 2026 should accelerate completion before December 31 to claim 100% bonus depreciation. If completion is delayed to January 2027, only 80% bonus depreciation is available. A property owner with flexibility should defer improvements until after 2030 if expecting lower future income (lower marginal rates), or accelerate improvements before 2026 if expecting higher current income (higher marginal rates). The planning calculation: (future deduction value at lower rate) versus (current deduction value at higher rate). If current marginal rate is 37% and future marginal rate is expected to be 24%, the trade-off is (37% of $800,000 = $296,000 current) versus (24% of $800,000 = $192,000 future = $154,400 present value after 5 years at 7% discount). Current deduction is superior despite lower future marginal rate due to time value of money.
Coordination with Section 179 Expensing
IRC Section 179 permits immediate expensing (not depreciation) of qualified property up to $1,220,000 in 2026. QIP qualifies for Section 179 expensing as an alternative to bonus depreciation. However, bonus depreciation is superior because it applies without limitation to basis, whereas Section 179 is limited to $1,220,000 annually. If a building owner makes $2 million in QIP improvements: (1) Under bonus depreciation, the full $2 million receives 100% deduction in year 1, (2) Under Section 179 expensing, only $1,220,000 is expensed, and remaining $780,000 must be depreciated. Bonus depreciation is automatically applied by default unless the taxpayer elects out. The taxpayer might elect out of bonus depreciation to preserve Section 179 expensing capacity for personal property (machinery, vehicles, equipment) that has lower cost basis and would be depreciated over 3 to 7 years otherwise.
Tenant Reimbursement and Cost Allocation Issues
In a typical commercial lease, the landlord makes improvements and recovers cost through higher rent or tenant reimbursement. If tenant reimburses landlord for $500,000 in improvements, the landlord's cost basis is reduced to zero (or by the reimbursement amount), and no depreciation deduction is claimed. However, if the lease specifies that the landlord retains ownership of the improvements (not transferable to tenant), the tenant reimbursement is rental income to the landlord, and the landlord retains the $500,000 basis and claims depreciation. The lease language determines whether improvements are landlord property (depreciation available) or tenant property (no depreciation to landlord). A landlord should specify in the lease that all improvements remain landlord property, permitting depreciation and bonus deduction, while recouping cost through higher base rent or explicit improvement cost charge.
Case Study: Retail Build-Out and Bonus Depreciation
A commercial landlord completes tenant build-out of 5,000 square feet of retail space with total improvement cost of $300,000 (flooring, painting, lighting, restroom improvements, interior walls). The landlord claims 100% bonus depreciation on the $300,000 QIP, resulting in $300,000 deduction in year of placement in service. Federal tax savings: $111,000 (37% rate). State tax savings: approximately $24,000 (8% rate). Combined savings: $135,000. The same improvements without bonus depreciation would generate only $20,000 annual tax savings ($300,000 / 15 years x 37% = $7,400 annually), resulting in total federal tax savings of approximately $110,000 spread over 15 years (present value approximately $60,000). Bonus depreciation increases present-value tax benefit by approximately $75,000 compared to standard depreciation.