Tax Treatment of Leasehold Improvements: Outright vs. Spread-Out Method

A lessor who receives a building or permanent improvement built by a lessee — one that stays with the property rather than being removed at lease-end — reports the resulting income under one of two methods allowed by Revenue Regulations No. 2: the outright method, recognizing the improvement’s full fair market value as income in the year it is completed, or the spread-out method, allocating its estimated value at lease termination evenly across the remaining lease term.

What counts as a leasehold improvement for BIR purposes #

A leasehold improvement is a building, structure, or permanent fixture that a lessee constructs or installs on property it does not own, under an agreement with the lessor, where the improvement is not subject to removal by the lessee. Because the improvement will belong to and benefit the lessor once the lease ends, the lessor effectively receives additional, non-cash income equal to the improvement’s value — and the BIR treats that value as taxable, not as a gift or a mere capital contribution from the lessee.

Common examples include a commercial building a retail tenant constructs on land it leases long-term, a warehouse a logistics tenant erects on an industrial lot, or a permanent structural renovation a restaurant tenant installs that cannot practically be removed at the end of the lease. Movable fixtures the lessee is entitled to remove — shelving, signage bolted for the tenant’s own use, or equipment the lease explicitly lets the tenant take — generally fall outside this rule, because they do not automatically transfer value to the lessor at lease-end. Whether an improvement is properly a capital asset or an ordinary asset in the hands of the party holding it after transfer follows the same real-property classification rules discussed in Capital Asset vs. Ordinary Asset for Real Property Under RR 7-2003.

The lessor’s two options: outright vs. spread-out #

Revenue Regulations No. 2 gives the lessor a choice between two income-recognition methods for the same improvement, and the lessor picks whichever one it will use — the BIR does not impose one over the other. As reproduced from the regulation’s text on lessee improvements:

“When buildings are erected or improvements made by a lessee in pursuance of an agreement with the lessor, and such buildings or improvements are not subject to removal by the lessee, the lessor may at his option report the income therefrom upon either of the following bases: (a) The lessor may report as income at the time when such buildings or improvements are completed the fair market value of such buildings or improvements subject to the lease, or (b) The lessor may spread over the life of the lease the estimated depreciated value of such buildings or improvements at the termination of the lease and report as income for each year of the lease an aliquot part thereof.”

Under the outright method, the lessor recognizes the entire fair market value of the completed improvement as gross income in the single taxable year construction finishes. Under the spread-out method, the lessor instead estimates what the improvement will be worth (after depreciation) when the lease ends, and reports that value in equal annual installments across the years remaining in the lease term. Both methods tax the same underlying value — they differ only in when the income lands on the lessor’s return, which is why the choice matters for cash flow and year-to-year tax planning rather than for the total amount ultimately taxed.

If the lease is cut short before its original term for reasons beyond the lessor’s control, a lessor using the spread-out method generally reports the remaining, not-yet-recognized value as additional income in the year of termination — the value of the buildings or improvements to the extent it exceeds the amount already reported as income in prior years. This keeps the deferred portion from escaping taxation simply because the lease ended earlier than planned.

A worked example comparing both methods side by side #

Suppose a lessee completes a permanent structure on the lessor’s land, and the parties’ lease has 20 years remaining at completion. The improvement’s estimated depreciated value at lease termination is ₱1,500,000. Under the outright method, the lessor reports the improvement’s fair market value in the year of completion — for illustration, assume that value is also ₱1,500,000 at completion, so the lessor reports the full ₱1,500,000 as income in that single year. Under the spread-out method, the lessor instead divides the ₱1,500,000 estimated termination value by the 20 years remaining: ₱1,500,000 ÷ 20 = ₱75,000 of income reported per year, for 20 consecutive years.

Both methods report the same underlying ₱1,500,000 of value — the outright method concentrates it in year one, while the spread-out method distributes it as ₱75,000 annually. A lessor already carrying substantial taxable income in the completion year might prefer spreading the amount out to avoid a one-year spike; a lessor that wants the matter closed immediately, with no multi-year schedule to maintain, might prefer the outright method.

How the lessee treats the same improvement #

On the lessee’s side, the cost of erecting the building or making the permanent improvement is a capital investment, not a deductible business expense — the lessee cannot write off the construction cost outright the way it would an ordinary operating expense. Instead, the lessee recovers the cost over time through an annual deduction, in lieu of ordinary depreciation, computed as the improvement’s cost divided by the number of years remaining on the lease — or, where the improvement’s own useful life is shorter than the remaining lease term, over that shorter useful life instead. In practical terms: the lessee amortizes the improvement over the shorter of (a) the improvement’s remaining useful life or (b) the remaining term of the lease, because the lessee will only benefit from the improvement for as long as it occupies the property.

This mirrors the same logic used elsewhere in BIR practice for matching a deduction to the period an asset actually benefits the taxpayer — the same reasoning that limits deductibility to property actually used in the business and properly reflected on the books, as discussed in Casualty Loss Deduction for Typhoon, Flood, and Fire Damage: BIR Rules. If the lease ends before the improvement is fully amortized — again, for reasons outside the lessee’s control — the lessee generally may deduct the remaining unamortized balance in the year the lease terminates, since the improvement no longer has any remaining useful period to the lessee.

Frequently asked questions #

What is the tax treatment of leasehold improvements under BIR rules? #

Under Revenue Regulations No. 2, a lessor who receives a building or permanent improvement built by a lessee — one the lessee will not remove at the end of the lease — has two reporting options: report the fair market value of the improvement as income outright in the year it is completed, or spread the improvement’s estimated depreciated value at lease termination evenly over the remaining lease term and report an equal amount of income each year.

Which is better for a lessor: the outright method or the spread-out method? #

It depends on the lessor’s cash flow and income projections. The outright method recognizes all the income in one year, which can push the lessor into a higher taxable income for that year alone. The spread-out method levels the income across the remaining lease term, which can smooth taxable income year to year but requires tracking the allocation for the full remaining term. The choice is at the lessor’s option, and BIR examiners expect consistent application once chosen.

Can a lessor switch between the outright and spread-out method mid-lease? #

The method is generally chosen when the lessor first reports income from the improvement and should be applied consistently afterward. Philippine tax practice treats leasehold-improvement income reporting like other accounting method elections — changing it after the fact is not simply a matter of preference and should be discussed with a tax professional rather than switched unilaterally.

How does the lessee treat the cost of building an improvement on leased property? #

The lessee capitalizes the construction or installation cost as a capital investment rather than deducting it outright as a business expense. The lessee then claims an annual deduction equal to the cost divided by the shorter of the improvement’s remaining useful life or the remaining term of the lease, in lieu of ordinary depreciation.

What happens to the reported income if the lease ends early? #

If a lease under the spread-out method ends before its original term for reasons outside the lessor’s control, the lessor generally recognizes as additional income, in the year of termination, the excess of the improvement’s value at that point over the amount already reported as income in prior years. This prevents income from permanently escaping taxation simply because the lease ended sooner than expected.

Summary #

A lessor receiving a permanent, non-removable improvement from a lessee has a genuine choice under Revenue Regulations No. 2: recognize the improvement’s fair market value as income outright in the year it is completed, or spread its estimated depreciated value at lease termination evenly across the remaining lease term. Neither method changes the total value ultimately taxed — they differ only in timing, which makes the decision a matter of cash-flow and income-smoothing planning rather than tax minimization. On the other side of the same transaction, the lessee capitalizes the improvement’s cost and recovers it through annual deductions over the shorter of the improvement’s useful life or the remaining lease term, rather than expensing the cost immediately. Both sides should document the chosen method and the underlying valuation at the time the improvement is completed, since that documentation is what supports the position if the return is later examined.