If a tenant makes a capital improvement to a leased property, is that income to the landlord?

Question

If a tenant makes a capital improvement to a leased property, is that income to the landlord?

For example, let's say I am renting a house to a family and at their own expense they build an addition onto the house and I do not pay them any compensation. They build it for their own use so long as they lease the house with the understanding that it is a betterment of my property.

Is this considered income to me as the landlord? In other words, let's say they spent $10,000 building the addition. Do I have to report that as $10,000 in income to myself? If so, do I report it when the addition is complete, or after they move out and it becomes "mine"? If I report it as income when they move out, then do I depreciate it first and only report say $7,500 in income? If so, how do I calculate the depreciation?

Answer 1

I am not a landlord, nor a tenant, nor a tax professional. This question intrigued me so I did some digging.

According to Plante Moran's site (tax professionals), the tax issue surrounding improvements made to a rental property can be tricky. Part of the issue is about ownership of the improvement/addition itself. In your case, the tenant would claim ownership of the addition, then claim it as an abandonment loss when they move out.

[...] if the tenant makes and owns the improvements it will use, isn’t reimbursed by the landlord, and the lease and other evidence doesn’t show the parties intended this as a substitute for rent, then the landlord has no taxable income. The tenant is treated as the owner of these improvements and may depreciate them. Upon the termination of the lease, the tenant may claim an abandonment loss for the remaining tax basis in these improvements if they’re left behind after the tenant vacates the space.

There are other issues that you may want to consider, that are not specifically related to answering your question.

• Allowing tenants to make large improvements to your property opens you up to liability issues if they hire a sub-par contractor or try to do it themselves. Maybe the work they do is fine while they're there, but after they leave it's found to not be to code or something happens that injures the next tenant.
• Be sure to get the entire agreement in writing. If things go south and they start claiming that you should be discounting rent or paying them back, it can turn into an expensive legal battle.
• Make sure that any work they do is 100% approved by you every step of the way. You won't want to have to pay to undo/redo all of the work they did when they move out.

Answer 2

As I understand it, anything that is attached to the land at the end of the lease becomes property of the landlord. In one case a tenant who installed a hard wired speaker system in his flat (apartment) was charged with criminal damage for ripping it out at the end of his lease (it had become the landlord’s property).

While any actions that the landlord takes to improve the value of the property have tax implications (capital improvements) it would be bad practice policy-wise to make the landlord accountable for any actions by the tenant outside of his control.

However if the landlord paid the tenant to make capital improvements either by contributing to the cost or giving the tenant a below-market rent then he would likely have to account for such capital improvements.

Answer 3

After studying this question further, my opinion is that it cannot be considered income, because (among other reasons) under no circumstances are capital improvements considered income, no matter what their source. For example, if a person gives a company to another person, this is not considered income to the recipient.

The only tax implication is that when the property is sold, the addition may result in an increased sale price which might translate into a capital gain.