Leasehold improvements are a reliable source of complexity in business accounts. They're assets, but they don't belong to the tenant at lease end. They're depreciable, but the effective life rules and lease terms interact in ways that require careful judgement. And then there are makegood obligations and lease incentives from the landlord — both of which generate their own accounting obligations. This post covers each of these issues for Australian bookkeepers.
What Counts as a Leasehold Improvement?
A leasehold improvement is a modification made to a leased premises that enhances the utility of the space for the tenant's specific use. Common examples:
- Fit-outs: partitioning, built-in joinery, flooring, lighting
- Installation of specialist equipment affixed to the premises (not free-standing)
- HVAC systems installed by the tenant
- Shopfront modifications
- Bathroom or kitchen fitouts within a commercial space
Not leasehold improvements: free-standing furniture, equipment that can be removed without damage, IT equipment, and general repairs to restore the premises to its condition at commencement.
Asset vs Expense
The threshold question is whether the expenditure is capital (creating or improving an asset) or revenue (maintaining the existing condition). The general test under Australian tax law mirrors the accounting principle: expenditure is capital if it creates a new asset, improves an existing one, or provides an enduring advantage beyond the current year.
Minor fit-out items under the instant asset write-off threshold can be expensed immediately. For 2024–25 and 2026–27 the instant asset write-off threshold is $20,000 (per item) for small businesses (aggregated annual turnover under $10M). Items above this threshold must be capitalised.
If expenditure enhances an existing leasehold improvement (e.g., adding to an existing fit-out), it's capitalised as an addition to the existing asset.
Effective Life and Depreciation Under TR 2024/1
The ATO issues taxation ruling TR 2024/1 (the current ruling on effective life of depreciating assets). For leasehold improvements, there are two approaches:
Self-Assessment to Lease Term
Taxpayers can self-assess the effective life of a leasehold improvement to the remaining lease term (including any option periods the taxpayer is likely to exercise). This recognises that the economic benefit of the improvement is consumed over the lease, not over a longer physical life.
For example: a 5-year lease with a 5-year option, where the taxpayer intends to renew, gives a 10-year effective life for the fit-out. If the lease has 6 years remaining when the improvement is made, the effective life is 6 years.
Commissioner's Determination
Alternatively, taxpayers can use the ATO's published effective life figures. For general commercial fit-outs, the ATO typically assigns 10–15 years depending on the nature of the improvement.
Which to Use?
Self-assessment to the lease term is generally more favourable for tax purposes (shorter life = faster deduction). It's also more economically accurate. Document the election and the reasoning in the working papers.
Depreciation Method
Leasehold improvements can be depreciated using:
- Prime cost (straight-line): annual deduction = cost × (100% / effective life in years)
- Diminishing value: annual deduction = opening value × (200% / effective life in years)
Prime cost is more common for leasehold improvements as the future value is predictable (zero at lease end).
Accounting Treatment (AASB 16 Context)
Under AASB 16 Leases (mandatory for reporting entities), the right-of-use asset includes the initial direct costs and lease incentives received. Leasehold improvements are separate from the ROU asset — they're capitalised as a distinct asset and depreciated over their own effective life.
For non-reporting entities applying simplified approaches, leasehold improvements are simply capitalised assets depreciated to nil over the lease term.
Makegood Obligations
Most commercial leases require the tenant to restore the premises to its original condition at lease end — removing fit-outs, repairing structural modifications, and sometimes repainting. This is the makegood obligation.
Recognising the Makegood Provision
Under AASB 137 Provisions, a makegood provision must be recognised when:
- The entity has a present obligation (legal or constructive) from a past event — the execution of the lease
- An outflow of economic benefits is probable
- A reliable estimate can be made
The provision is recognised at the inception of the lease, not at lease end. The amount is the present value of the estimated future makegood cost.
Journal at lease commencement:
DR Leasehold Improvements (asset) $X,XXX ← adds the PV of makegood to asset cost
CR Makegood Provision (liability) $X,XXX
Adding the provision to the asset cost means it's depreciated over the lease term along with the improvement itself — the cost of the eventual makegood is recognised systematically over the period of benefit.
Each year, the provision is unwound (interest expense):
DR Finance Costs / Unwinding of Discount $XXX
CR Makegood Provision $XXX
At lease end, the actual makegood cost is measured against the provision. Any difference is a gain or loss.
Lease Incentives Received from the Landlord
Landlords frequently offer incentives to attract tenants — fit-out contributions, rent-free periods, or cash payments. These must be accounted for carefully.
Fit-Out Contributions (Cash)
If the landlord pays cash toward the tenant's fit-out, this is a lease incentive that reduces the cost of the fit-out for accounting and tax purposes:
DR Cash / Bank $X,XXX
CR Leasehold Improvements $X,XXX
The net cost of the fit-out is capitalised. Depreciation runs on the net cost.
For tax purposes, the ATO's view is that landlord contributions reduce the cost base of the leasehold improvement asset — consistent with the accounting treatment.
Rent-Free Periods
A rent-free period is a lease incentive that, under AASB 16, is factored into the measurement of the right-of-use asset and lease liability. For tax purposes, the rent deduction follows the actual cash payments — no accrual is required. This creates a temporary difference between accounting and tax treatment for the first few years of the lease.
GST on Lease Incentives
A cash lease incentive paid by a landlord to a tenant is generally not consideration for a taxable supply by the tenant — it's an inducement to enter the lease. Accordingly, no GST arises on the receipt of a cash incentive. The ATO confirmed this position in GSTR 2003/16. If, however, the incentive is specifically for the tenant to surrender a lease or vacate early, the analysis differs.
Year-End Checklist for Leasehold Improvements
- Confirm the effective life used for each leasehold improvement matches the remaining lease term (update if lease has been extended or renegotiated)
- Recalculate the makegood provision annually — update for changes in cost estimates and the unwinding of the discount
- Check whether any lease incentives received have been correctly netted against the asset cost
- Confirm the depreciation method and rate have not changed (a change in estimate, not a change in policy — prospective application only)
In ReconLink
Fit-out invoices typically arrive from multiple contractors over a short period and appear on your imported bank statement (CSV, Excel or PDF — or forwarded to your per-client email inbox) as separate payments to builders, electricians, and flooring companies. ReconLink's coding rules can tag these vendors to a "leasehold improvements — work in progress" account during construction, with a manual step to capitalise the WIP once the fit-out is complete. This prevents the component invoices from being expensed individually rather than capitalised.