Leasehold Improvements vs. Tenant Improvements vs. Build-out
There's really no difference between tenant improvements, leasehold improvements, and build-out in a commercial lease. It just depends on what industry you're in or who's looking at the issue. All three terms mean that work is being done to an office or a building to prepare it for the needs of a new tenant.
What's in a Name?
The term "tenant improvements" is most commonly used by commercial realtors. The concept can also be expressed from an accounting viewpoint as "leasehold improvements" and from a construction viewpoint as "build-out."
By any name, you'll have to make and pay for these changes as you start your business. Look for commercial space that doesn't need a lot of work to keep your startup costs low, or try to find a place where the landlord will let you do a lot of the work yourself.
What are Leasehold Improvements?
Leasehold improvements or build-outs are the structural changes you make to leased space to make it suitable for your unique business needs. Lighting changes, a reception area, offices, dressing rooms, and other special rooms or partitions might be necessary, as well as paint and carpeting or flooring.
These costs are sometimes paid upfront by the landlord then included in your monthly rent, and you might be able to make some changes yourself to save money.
Leasehold Improvements vs. Building Improvements
Leasehold improvements are made within the walls of a structure. They focus on a finite area of space, that which will be leased by a single tenant. Making these improvements is to the tenant's advantage because they will improve his business, not that of other tenants.
Improvements made to common areas would be considered building improvements, not leasehold improvements because they can be enjoyed by more than one tenant.
Effect of Leasehold Improvements on Business Startup—An Example
Mario and Eleanora are considering leasing an office for their new chiropractic practice. It used to be the office of a massage therapist so it doesn't need much work—just some paint, one wall torn out, and a little electrical work.
Other offices they've looked at needed a lot of work: tearing down and moving walls, electrical changes, plumbing fixes, HVAC repairs, and disability access changes.
They would have to pay to have any of these offices redone to fit their needs. They must make leasehold improvements. Obviously, absent other factors, it makes the most sense to go with the first office to keep their startup costs as low as possible.
Accounting for Leasehold Improvements
Leasehold improvements are considered business assets because they're attached to real property. They can, therefore, be depreciated. Keep information on and receipts for the cost of leasehold improvements for your tax advisor.
From an accounting standpoint, the work that's done to a building and to fixtures that are put in place and attached to the property—such as lights and plumbing—are considered assets of your business if you pay for them. You can treat them like other assets in every way, but you can't sell them unless you sell the whole building.
The Problem with Leasehold Improvements
Spending too much on leasehold improvements is a common mistake made by new business owners. Be wary of putting too much money into improvements to a leased business space. You can't take them with you, and the next person to rent that space might not want the same things you do.
If you have a retail space and add a fancy front desk for taking credit cards, the money you've spent on that front desk is not recoverable from a cost standpoint unless you can somehow pull it out. But you can't pull out lights and wiring and bathrooms.