Leasehold Improvements Depreciation After Cost Seg 2026
Leasehold improvements are one of the most misunderstood pieces of the residential rental depreciation puzzle, and the confusion gets worse the moment a cost segregation study enters the picture. This guide walks through how short-term rental arbitrage operators and residential tenant-investors depreciate leasehold improvements after a cost segregation study, using the actual MACRS categories the IRS expects to see on a return.
- Leasehold improvements depreciation after cost segregation puts qualifying interior work into a 15-year MACRS bucket, not 27.5 or 39 years.
- STR arbitrage operators who lease a property and improve it can claim 100% bonus depreciation on qualifying 2026 placed-in-service improvements.
- The seven-day average rental rule determines whether your leasehold improvements get nonresidential (QIP-eligible) treatment at all - verify this first.
- A cost segregation study on tenant-paid improvements, not the landlord's building, is the correct scope for arbitrage operators.
Why this matters
Most cost segregation content assumes you own the building. Rental arbitrage operators don't. You lease a property from a landlord, sink cash into furniture, built-ins, flooring, and interior finish-out, then run it as an Airbnb or VRBO listing. Those dollars are leasehold improvements, and they get depreciated separately from the landlord's real property under a completely different set of rules.
Get the classification wrong and you either overstate your deduction (audit risk) or leave years of depreciation on the table because you defaulted to a 39-year commercial schedule out of caution. Virtual Cost Segregation builds engineering-based reports specifically for residential rental and short-term rental structures, and the same reclassification logic that applies to owned property applies to tenant-paid improvements when the fact pattern is right.
What you'll need
- A copy of your lease agreement showing the scope of tenant-funded improvements
- Itemized invoices or contractor bills for the buildout, separated from furniture and appliances
- Guest stay records for the past 12 months (average stay length drives classification)
- A cost segregation report scoped to the leasehold improvements, not the underlying structure
- Form 4562 for the tax year the improvements were placed in service
- Your CPA's sign-off before filing, since a report is a supporting document, not a filed return
The steps
1. Confirm your average stay qualifies as nonresidential
Before anything else, check whether your property's average guest stay is seven days or less. Under the seven-day average rental rule, a short-term rental with an average stay under that threshold is treated as nonresidential real property for depreciation purposes, not residential rental property.
This matters because Qualified Improvement Property (QIP) treatment, the category that unlocks 15-year MACRS and bonus depreciation eligibility for interior improvements, is defined around nonresidential real property. If your average stay runs longer than seven days, your leasehold improvements default to a slower recovery schedule and this whole strategy changes.
Common mistake: operators check occupancy percentage instead of average stay length. They're different numbers, and only average stay length controls this classification.
2. Separate leasehold improvement costs from personal property
Pull your buildout invoices apart into three buckets: structural leasehold improvements (drywall, electrical, flooring, built-in cabinetry), personal property (furniture, appliances, decor), and land improvements if you added any exterior work. Each bucket depreciates on a different schedule.
A cost segregation study exists to do this separation with engineering documentation behind it, not guesswork. Skipping this step is the single biggest reason arbitrage operators either under-claim or get flagged in a later review.
3. Order a cost segregation study scoped to your improvements
The study needs to be scoped to what you actually own for tax purposes: the leasehold improvements, not the landlord's building shell. Virtual Cost Segregation runs flat-fee studies for $2,200, delivered in 3 to 5 business days, with no site visit required for most residential properties.
The report documents which costs qualify for 5-year, 15-year, or longer recovery periods and gives your CPA a defensible basis for the classification if the return is ever reviewed.
4. Classify qualifying improvements as 15-year QIP
Once your average stay confirms nonresidential treatment, interior structural improvements that meet the QIP definition (improvements to the interior of a building, made after the building was first placed in service, excluding enlargements, elevators, escalators, or the internal structural framework) land in the 15-year MACRS class.
That 15-year classification is what makes bonus depreciation available. Improvements stuck in a 27.5 or 39-year bucket don't get the same acceleration.
5. Apply 100% bonus depreciation for 2026 placed-in-service assets
Under the One Big Beautiful Bill Act, bonus depreciation is restored to 100% for qualifying property placed in service after January 19, 2025, which covers essentially all of 2026. Fifteen-year QIP assets qualify for bonus depreciation, meaning a $60,000 leasehold buildout with $30,000 reclassified into 15-year property could produce a $30,000 first-year deduction instead of spreading it over a decade and a half.
Check the 100% bonus depreciation mechanics for the exact placed-in-service dates that qualify before you file.
Common mistake: assuming the landlord's building depreciation and your leasehold improvement depreciation offset each other on the same schedule. They don't. They're separate assets on separate returns.
6. File Form 4562 and document the lease relationship
Form 4562 reports your depreciation deduction, and for leasehold improvements you'll need the lease term, the placed-in-service date of the improvements, and the recovery period assigned by the cost segregation study. Keep the lease agreement attached to your workpapers since an examiner reviewing a leasehold improvement deduction will ask who has the legal right to claim it.
7. Coordinate improvement depreciation with your material participation hours
If you're using the short-term rental loophole to offset W-2 income, your leasehold improvement depreciation only creates an active loss if you meet the material participation tests. Review the material participation days requirements alongside your depreciation schedule, because a passive loss classification defeats the purpose of accelerating the deduction in the first place.
Troubleshooting
The landlord is also depreciating the same square footage. This shouldn't happen if the lease clearly assigns tenant-funded improvements to you, but review your lease language and your landlord's depreciation schedule if there's any overlap. Only one party can claim a given improvement.
Your average stay crept above seven days mid-year. Recalculate at year-end. If the average moves above seven days, the property may need residential rather than nonresidential treatment for that tax year, which changes your QIP eligibility going forward.
The lease ends before the 15-year recovery period is complete. Unrecovered basis in abandoned leasehold improvements can often be written off in the year the lease terminates rather than continuing on a schedule for a property you no longer control. This is treated similarly to a partial disposition.
No clear documentation separating tenant improvements from personal property. Invoices that lump furniture, flooring, and electrical work into one line item make a defensible cost segregation study almost impossible. Get itemized invoices from contractors before the work starts, not after.
Missed depreciation from prior years. If you've been depreciating leasehold improvements incorrectly, or not accelerating them at all, catching up mid-stream requires a formal accounting method change rather than amended returns going back years. Review the Form 3115 catch-up process before you file this year's return.
Tools and resources
- Cost segregation study scoped to leasehold improvements (Virtual Cost Segregation, $2,200 flat fee)
- Form 4562 and supporting depreciation schedule
- Guest stay logs for the seven-day average calculation
- Lease agreement with itemized tenant improvement scope
- CPA review before filing, since the report is supplementary and not filed directly with the IRS
What to do next
If you're near the end of a lease term or considering walking away from a leased property, understand how remaining basis gets treated before you sign anything. The partial asset disposition process determines whether you can write off unrecovered leasehold improvement basis in the year you exit.
FAQ
Can you depreciate leasehold improvements after a cost segregation study?
Yes, a cost segregation study can reclassify tenant-funded leasehold improvements into 15-year MACRS property when the underlying rental qualifies as nonresidential real property. This applies to short-term rental arbitrage operators who lease and improve a property rather than own it outright.
What is Qualified Improvement Property in a short-term rental context?
QIP covers interior structural improvements made to a building after it was first placed in service, excluding enlargements or structural framework changes. A short-term rental with an average guest stay of seven days or less is treated as nonresidential real property, which makes its interior improvements eligible for QIP classification.
Does bonus depreciation apply to leasehold improvements in 2026?
Yes, bonus depreciation is restored to 100% for qualifying property placed in service after January 19, 2025, covering 2026 in full. Fifteen-year QIP assets, including many leasehold improvements, qualify for that 100% first-year deduction.
Who claims depreciation on leasehold improvements, the landlord or the tenant?
Whoever paid for and owns the improvement for tax purposes claims the depreciation, which for arbitrage operators is typically the tenant. The lease agreement should clearly assign the improvement costs to avoid both parties claiming the same asset.
How much does a cost segregation study cost for leasehold improvements?
Virtual Cost Segregation runs flat-fee studies at $2,200, delivered in 3 to 5 business days, scoped to whatever assets you own for tax purposes, including tenant-funded improvements. Pricing does not vary by finding amount.
What happens to leasehold improvement depreciation if the lease ends early?
Unrecovered basis in leasehold improvements can often be deducted in the year the lease terminates through a partial disposition, rather than continuing depreciation on a property you no longer control. Document the termination date and remaining basis with your CPA.
Does the seven-day average rental rule affect leasehold improvement classification?
Yes, it's the deciding factor. An average stay of seven days or less classifies the property as nonresidential real property, which is what allows leasehold improvements to qualify as 15-year QIP eligible for bonus depreciation.
One last thing
The detail most arbitrage operators miss is that the 15-year QIP clock resets on the improvement's own placed-in-service date, not the lease start date or the building's original construction year. A buildout finished in March 2026 gets its own 2026 placed-in-service date regardless of how long the lease or the building has existed, and that date is what determines bonus depreciation eligibility.