What are Leasehold Improvements and How to Account for Them?

If you are renting a commercial space as a small business, you may need to customise it as per your business needs. The change or improvement you made to enhance the rental property is called leasehold improvement. Let’s see what they are, whether they are amortised, and how to do accounts for them. Read on till the end to find out!

 

Understanding Leasehold Improvements

Also known as tenant improvements, it may refer to the alterations, additions, or installations made to customise a rental property as per the needs of the tenants. Here are some of the examples of these improvements:

• Interior walls and ceilings
• Flooring
• Electrical and plumbing additions
• Built-in cabinetry
• Kitchens and washrooms
• Putting customised fixtures

These improvements are generally made by a tenant or a landlord, and most of the time, they are paid for by the tenant. Normally, the useful economic life of such improvements is 5 to 10 years. So, you need to work out amortisation as per the economic life of the rental space.

Types of Leasehold Improvements

Leasehold improvements fall into several categories depending on the nature of the property, the industry and the needs of the tenant.

1. Structural Improvements

These involve permanent changes to the property’s interior structure. For example:

• Installing or moving walls and partitions
• Reinforcing flooring to handle heavy equipment
• Upgrading ceilings or stairways

Structural improvements are usually fixed and cannot be easily removed. Since they often extend the property’s useful life, they may be subject to stricter depreciation rules.

2. Electrical and Mechanical Systems

Modern businesses often need more than what the base property provides. Improvements may include:

• Upgraded lighting systems
• Additional power points or data cabling
• Heating, ventilation and air conditioning (HVAC) installations
• Enhanced security systems (alarms, CCTV, entry access)

These improvements directly support daily business operations and usually count as capital expenditure.

3. Interior Finishes and Fixtures

These are the most common types of leasehold improvements. It includes:

• New flooring (tiles or carpets)
• Painting and plastering walls
• Installing counters or reception desks
• Built in cabinets or storage spaces

Although some of these items may seem minor they still count as improvements if they become part of the property and cannot be removed without damage.

4. Specialised Business Fit-Outs

Industry specific businesses often require highly tailored improvements which include:

• Commercial kitchens in restaurants
• Treatment rooms in dental practices or clinics
• Changing rooms or shower facilities in gyms
• Soundproofing for studios

These improvements are essential for the business model and can involve significant upfront costs.

5. Accessibility and Compliance Upgrades

Sometimes improvements are made to ensure compliance with UK building regulations or health and safety standards. For example:

• Installing wheelchair ramps or lifts
• Improved washroom facilities
• Fire safety systems
• Emergency exits

Even though these changes may be legally required, they are still classed as leasehold improvements and depreciated accordingly.

Improvements To Leasehold Property Vs. Repairs

It’s worth noting that improvements increase the property’s value (capitalised & depreciated), while repairs restore the property to its original condition (deductible as an expense).

Example:

• Replacing broken lights = repair (expense).
• Installing an entirely new lighting system = improvement (capitalised).

Who Pays for Leasehold Improvements?

Who pays for the leasehold improvement depends on the lease agreement, which can be any of the following:

1. Tenant-funded: 

This one is the most common. The tenant pays for fit-outs and records them as leasehold improvements.

2. Landlord-funded:

Sometimes landlords offer a fit-out allowance or contribute to initial improvements. In this case, the landlord may capitalize the costs as part of the building.

3. Shared costs:

Occasionally, leasehold improvements can also have their costs split between the tenant and landlord. It depends on the specific terms of the lease agreement and the nature of the improvements

Accounting For Leasehold Improvements: How Does It Work?

From an accounting perspective, leasehold improvements are treated as fixed assets rather than expenses. This means you don’t deduct the full cost in one go. Instead, you record the cost on your balance sheet and spread it across its useful life through depreciation or amortisation.

This is important because it matches the cost of the improvement with the period you benefit from it. It also ensures accurate profit reporting.

Are Leasehold Improvements Amortised?

The improvements made to a rental property by a tenant are generally amortised, not depreciated. This is because the tenant doesn’t own the property and the improvements legally become part of the landlord’s building once installed. The tenant only has the right to use those improvements for the duration of the lease.

For example, if a tenant signs a 10-year lease and installs partition walls that are expected to last 10 years, but the lease ends in 4 years, the cost of those partitions must be amortised over 4 years (the shorter period). Once the lease ends, the partitions remain with the landlord, not the tenant.

In this way, leasehold improvements are written off over the shorter of their useful life or the remaining lease term, unlike movable assets (like furniture or equipment) which are usually depreciated separately.

How to Account for Leasehold Improvement?

The cost involved in purchasing things for leasehold improvement would be your assets (at least during the lease tenure). To account for these things in your accounting records, you need to have a basic understanding of accounting principles and be familiar with accounting software to carry out this task. With this knowledge, you can easily follow these steps:

• First, you need to create a new asset account on your balance sheet and name it as leasehold improvements, along with creating a contra account naming leasehold improvement depreciation (to keep track of its depreciation)
• Check your accounting software program’s instructions for adding additional/new accounts
• Aggregate all associated costs for the improvement
• Enter the total cost in your accounting records; normally, the transaction is debited to the new asset account and credited to your credit card account
• The new assets will be on your balance sheet until the end of the year when you will expense a portion of it as a depreciation expense.
• For recording depreciation, you need to debit a depreciation expense account and credit your leasehold improvement depreciation account.

By following this, you will be able to find the original cost of improvements, and it will allow you to keep track of your expenses separately. In this instance, you need to keep all your improvement receipts. This will allow you to provide evidence to HMRC if required. Once you make all your entries, you need to prepare a balance sheet and income statement to make sure that your entries are getting the desired results.

What Happens to Leasehold Improvements When You Move?

If you leave before the lease ends, improvements generally remain with the landlord and cannot be removed.

From an accounting perspective, any remaining net book value of those improvements must be written off in your profit and loss account.

For instance:

• You spent £50,000 on fit-outs.
• You’ve already depreciated £30,000.
• The remaining £20,000 carrying value is written off when you move out.

This is treated as a loss on disposal.

What Happens When the Lease Expires?

At the end of a lease, leasehold improvements usually revert to the landlord. The leaseholder may have the option to buy the freehold, negotiate a new tenancy agreement with the freeholder or extend the lease. It all depends on the conditions of the lease & any applicable legislation.

Quick Sum Up

So, we hope that you have enough information on what leasehold improvements are, how they are amortised, and how to account for leasehold improvements. These improvements are the modifications done to a leased property to meet the needs of the tenants. They are taken as assets and are amortised. With a basic knowledge of accounting principles and software, you can do accounting for them based on the above-given steps.

 

Disclaimer: This blog post is intended just for a general understanding of the topic.