When landlords are securing lease contracts for properties, they often include an allowance for the tenant to improve the property, this can be referred to as the tenant improvement allowance. Generous allowances often help landlords secure longer-term leases that benefit both parties throughout the rental period.
However, as with all aspects of property lease management, if not handled appropriately, these allowances can cause difficulties when it comes to accounting and proving compliance with accounting standards.
This blog will cover all the most commonly asked questions about tenant improvement allowances and how to account for them.
What are leasehold or tenant improvements?
Leasehold improvements or tenant improvements refer to the renovations or customizations made to a property to benefit the tenant. These alterations only apply to improvements made in the rented space (e.g. the office). They do not include building improvements made outside of that space (e.g. communal areas like the elevator, stairs, or other common areas).
What is a tenant improvement allowance?
A tenant improvement allowance is a fund the landlord provides to pay for improvements to the leased space. These allowances often pay for costs incurred when a new tenant moves to the new property, such as updating floors or windows.
What qualifies for the tenant improvement allowance?
Generally speaking, landlords allow tenant improvement allowances to cover both hard and soft costs of any renovation to the rented space.
Hard costs are improvements to the property that the tenant will leave behind that benefit the landlord. Examples of hard costs include new flooring, electrics, HVAC, windows, framing, and doors. Soft costs include things like management fees.
What doesn’t qualify for the tenant improvement allowance?
Usually, the tenant improvement allowance doesn’t cover expenses that cater to the tenant’s specific needs and fail to provide additional value for the landlord.
Similarly, tenant improvement allowances don’t cover removable alterations. Examples of expenses not covered are electronic equipment, fixtures, furniture and cabling for the internet.
How much is the typical allowance?
The amount available through a tenant improvement allowance varies and depends on the amount of work required and the specific renovation plans. Some properties may need very little work, and others will require a complete transformation. Without a detailed outline of the renovation, the allowance can be as low as ten or twenty dollars per square foot, which is unlikely to be adequate funding for new offices or commercial units.
Landlords decide on the exact allowance with the tenant funding any desired improvements that fall outside this budget. Usually, they will decide on an amount by assessing the real estate market, the client value, and the added value of the proposed renovations, e.g. they may be willing to give a larger allowance to companies converting a warehouse into a modern workspace.
Does it count as a loan?
No. Most tenant improvement allowances are not considered loans and do not need to be repaid by the tenant. It’s worth noting that a tenant improvement allowance can be combined with a loan from the landlord to create an “amortized tenant improvement allowance,” but this is something that is negotiated on a case-by-case basis between both parties. Typically, the amortization would be repaid over the term of the lease.
How do you account for tenant improvement allowances?
Accounting for tenant improvement leases depends on who funds the improvements and oversees the renovations. Sometimes the tenant is in charge of improvements, and other times the landlord. Below, we take a quick look at journal entries for each of these variations.
Tenant improvement allowance accounting if the landlord owns the improvements
The landlord owns the improvements if:
- The landlord funds the renovation and the tenant oversees the work.
- The landlord funds the renovation and oversees the work.
In either of these situations, the landlord must record tenant improvements as fixed assets. They must also account for the depreciating value of these assets over a specified period.
For instance, if renovations cost 25,000 dollars, this must be divided across the lease duration and then subtracted from the annual rental income.
Costs vary in their depreciation over time. For residential properties, hard costs depreciate over 27.5 years, and for commercial properties, they depreciate over 39 years. Soft costs (usually not covered) depreciate over seven years.
When a new tenant moves in during the period in which the asset’s depreciation is being accounted for, as long as they do not require any additional improvements, the landlord can continue to account for the previous depreciation schedule.
If there’s destruction or damage to the property, the remaining balance is recorded as a loss on the income statement.
Tenant improvement allowance accounting if the tenant owns the improvements
In this situation, the tenant should record the tenant improvement allowance as an incentive. The amount spent is amortized over the rental term. In cases where the rental period is too short, the tenant must write off the outstanding balance.
How do you track tenant improvement allowances?
Tenant lease improvements are considered assets, and accounting for them is crucial to remaining compliant with accounting standards like GASB 87, IFRS 16, and ASC 842. If you’ve multiple properties, keeping track of tenant improvement allowances and making sure they’re appropriately accounted for can become complicated fast. Visibility and tracking of improvements are essential for commercial properties where renovations are expensive. Failure to adequately record and depreciate these values can be detrimental to your company’s health.
Rather than worry about keeping track of all these figures manually, it’s advisable to invest in property lease management software. Purpose-built software will enable your team to make sure you’ve full visibility of all funds and have the tools to track and depreciate the value of assets over time without having to worry about data-entry mistakes and administrative bottlenecks.