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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?

  • Interesting question... I'll admit I don't know much here, but I would tend to think that it might depend on whether you increase the rent or not. Since the property now is more valuable, if the rent stays the same then the tenant are reaping the benefit now, rather than the owner. Just my reasoning, though, not sure if that's how it really works. – Norm Apr 18 '18 at 19:09
  • Consider this - A tenant willing to put their own money towards improving the property is a tenant worth keeping That aside, improvements to the property itself from my understanding belong to the property holder - unless a legal agreement is reached between them beforehand. This should be covered in the terms of their lease. – Zibbobz Apr 18 '18 at 20:50
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    Did the tenants or landlord pull the required permits? – Andy May 25 at 15:20
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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.
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  • At first, I was confused by the part about depreciating the improvements, because the question is about home rentals. The article is talking about business tenants.The comment about depreciating the improvements doesn’t apply to home rentals. – prl Apr 20 '18 at 7:23
  • @prl - I guess I was thinking that any rental property is really a business asset and that the same general guidelines would apply. TurboTax has an article about depreciation on rental homes, maybe some of that applies to this? turbotax.intuit.com/tax-tips/rental-property/… I have no 1st-hand experience with being a landlord, so I might be misinterpreting some of the business characteristics. – BobbyScon Apr 20 '18 at 13:13
  • Sorry, my previous comment was supposed to say “confused by the part about the tenant depreciating the improvements”. A rental home is a business asset for the landlord, but not for the tenant. – prl Apr 20 '18 at 15:28
  • @prl - Yes, I'm not entirely clear on that part myself. The asset in question is an addition to a rental property, which if the owner paid for they would depreciate. I was under the impression that the tenant would be able to claim the asset for the duration of their use of the property. It depends on the asset as well, though, as there are definitions of what is can be depreciated and what cannot. – BobbyScon Apr 20 '18 at 17:53
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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.

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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.

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  • Wouldn't this be a massive tax loophole though? I could pay my landlord in shares of stock and he wouldn't have any income tax due? That can't be right, can it? – David Schwartz May 26 at 19:10
  • @DavidSchwartz That is payment in kind which is taxable. If the tenants were making the capital improvements <i>in lieu of rent</i> then it would be taxable at fair market value. But if the tenants are making it for their own enjoyment, then it is not a payment. Likewise, if you give shares of stock in lieu of salary, then it is taxable as income. But if it is a gift, then it is not taxable as income. – Five Bagger May 26 at 19:20
  • You said that capital improvements are never considered income under any circumstances. Then you respond that, I think, a capital improvement is taxable if it's a payment in kind. Both of those things can't be true. (And nothing about this question suggests it's not a payment in kind.) Also, an employer giving an employee shares of stock is taxable whether it's in lieu of income or not for the same reason that tipping a waiter or waitress is always taxable income regardless of whether the tip is in lieu of other payments. It would just be too huge a tax loophole. – David Schwartz May 26 at 19:41
  • @DavidSchwartz Well, I guess its not the capital improvement that is taxable as income, but the work done. So, for example, let's say that a tenant does $10,000 worth of work in lieu of rent, and this results in the house increasing $25,000 in capital value. Then only the $10,000 is considered taxable income. The capital improvement is not taxable, except as a capital gain when it is realized. Shares of stock given as a gift are not taxable as income. Of course, it is unlikely that the IRS would accept an employer giving a "gift" of stock to an employee. – Five Bagger May 26 at 19:48
  • I think the tricky bits are going to be figuring out whether or not this should be considered being in lieu of rent and figuring out what value to assign to it. I agree that if it's taxable, it would be because it was in effect a payment to the landlord. – David Schwartz May 26 at 20:09

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