Cost Segregation for Franchise Build-Outs: QIP, Tenant Allowances, and First-Year Depreciation

A franchise build-out is one of the most cost-seg-friendly investments in small business. You are taking a raw or second-generation retail shell and installing everything from HVAC ductwork and grease traps to walk-in coolers, digital menu boards, and brand-specific millwork. Much of that spending lands on 39-year nonresidential real property by default, which means the tax code spreads your deduction over nearly four decades. A cost segregation study reclassifies the components that qualify as 5-year, 7-year, or 15-year property, and with 100% bonus depreciation now permanently restored under IRC 168(k), those reclassified dollars become a first-year write-off. On a $600,000 franchise build-out, the reclassification can easily move $200,000 or more into bonus-eligible classes, producing a six-figure depreciation deduction in year one.

What qualifies as Qualified Improvement Property?

QIP is defined in IRC 168(e)(6) as any improvement to an interior portion of a nonresidential building if the improvement is placed in service after the date the building was first placed in service. The key phrase is “interior portion.” Improvements to the building’s roof, HVAC system, fire protection system, security system, or elevator do not qualify as QIP under the statute’s explicit exclusion. Enlargements of the building also fail the test.

For a franchise build-out, QIP typically covers the core tenant improvements: interior walls and partitions (both structural and non-load-bearing), flooring (tile, epoxy, carpet), ceilings and ceiling tiles, interior lighting fixtures, plumbing specific to the interior layout (moving sinks, adding restroom fixtures), and drywall. These components recover over 15 years under MACRS and are eligible for 100% bonus depreciation, meaning the full cost is deductible in the year the improvement is placed in service.

The 15-year recovery period with bonus eligibility makes QIP significantly more valuable than the old 39-year default. Before the TCJA’s correction (which was itself a legislative fix to the so-called “retail glitch”), interior improvements sat on a 39-year schedule. Today, a $300,000 interior build-out classified as QIP generates a $300,000 first-year deduction rather than roughly $7,700 per year over 39 years.

One point that catches franchise owners off guard: the building must already be placed in service before the improvements are made. If you are building out a brand-new shell that has never been occupied, the initial interior finishing is part of the building itself, not QIP. QIP applies to improvements made after the building’s initial placement in service. In practice, most franchise build-outs in leased retail space satisfy this requirement because the landlord’s shell was placed in service (even if briefly) before the tenant’s build-out begins. But a build-to-suit arrangement where the entire building is constructed for the franchisee from the ground up requires more careful analysis of when the building itself was placed in service versus when the tenant improvements began.

How does cost segregation work on a franchise build-out?

A cost segregation study is an engineering-based analysis that identifies each component of a build-out and assigns it to the correct asset class under the Modified Accelerated Cost Recovery System (MACRS). The study is performed by an engineering firm (often one credentialed by the American Society of Cost Segregation Professionals), and the output is a detailed report mapping every dollar of the build-out to its proper recovery period.

In a typical franchise build-out, the study reclassifies components from the 39-year default into three shorter categories. Five-year property includes restaurant equipment (ovens, fryers, refrigerators, ice machines), point-of-sale systems, decorative lighting, signage (interior and exterior), specialty electrical circuits dedicated to equipment, and certain cabinetry that is not permanently affixed. Seven-year property covers furniture (tables, chairs, booths if they are not built-in), office furniture, and certain fixtures. Fifteen-year property captures land improvements (parking lot paving, landscaping, exterior lighting, sidewalks, fencing) and QIP as described above.

The percentage reclassified depends on the franchise concept and the build-out scope. A quick-service restaurant with a heavy equipment package and brand-specific finishes often sees 30-45% of the total build-out cost reclassified to bonus-eligible property. A retail or service franchise with less specialized equipment might reclassify 20-30%. Either way, the dollar impact on a $400,000 to $800,000 build-out is substantial.

For a deeper explanation of how cost segregation works across property types (including the lookback study option for properties you already own), see the cost segregation and bonus depreciation guide.

What happens when the landlord gives you a tenant allowance?

Most commercial leases for franchise locations include a tenant improvement allowance (TIA), sometimes called a tenant allowance or build-out contribution. The landlord pays the franchisee (or pays the contractor directly) a fixed dollar amount toward the build-out, typically ranging from $30 to $80 per square foot depending on the market and lease terms.

The tax treatment of the TIA depends on how the lease is structured. There are two common treatments, and the difference between them is significant.

The first treatment is that the TIA is taxable income to the franchisee under IRC 61. The franchisee receives cash (or a rent credit), includes it in gross income, and then capitalizes the full cost of the improvements on their own depreciation schedule. This is the default treatment when the allowance is structured as a cash payment with no strings attached or as a rent reduction. The franchisee gets the full depreciation deduction on the improvements, but they also recognize income equal to the allowance amount.

The second treatment uses the IRC 110 exclusion. Under Section 110, a “qualified lessee construction allowance” is excluded from the lessee’s gross income if three conditions are met: the allowance is used to construct or improve qualified long-term real property for use in the lessee’s trade or business at that location, the allowance is provided under a short-term lease (15 years or less, including renewal options), and the lessee’s ownership of the improvements reverts to the landlord at the end of the lease or the improvements are disposed of at that time. When Section 110 applies, the franchisee does not include the allowance in income, but the franchisee also does not depreciate the portion of the improvements funded by the excluded allowance. The landlord, rather than the tenant, depreciates those improvements.

The Section 110 exclusion is valuable when the franchisee’s marginal tax rate is high and the timing benefit of immediate income exclusion outweighs the lost depreciation deduction over 15 or 39 years. In practice, many franchise leases are structured so that the franchisee owns the improvements during the lease term and surrenders them at lease end, which aligns with Section 110’s requirements. But the lease must be 15 years or less (including all renewal periods), and the allowance must be used for qualified long-term real property (improvements to the building, not equipment or personal property). If the lease term with renewals exceeds 15 years, Section 110 does not apply, and the allowance is taxable income.

The practical decision requires comparing two scenarios: (1) include the TIA in income and take the full depreciation deduction on the improvements (potentially accelerated through cost segregation and bonus depreciation), or (2) exclude the TIA under Section 110 and forfeit the depreciation on the excluded portion. For a franchisee with a large build-out and access to bonus depreciation, the first option often produces a better result because the first-year depreciation deduction exceeds the TIA income. But every case depends on the specific numbers, the lease term, and the franchisee’s tax bracket.

How does the build-to-suit arrangement change the analysis?

In a build-to-suit lease, the landlord constructs the building (or substantially completes the interior build-out) to the franchisee’s specifications before the lease begins. The landlord owns the building and the improvements. The franchisee leases the completed space and begins operations.

The tax treatment depends on who is the “owner” of the improvements for federal income tax purposes. If the landlord owns the improvements (the typical build-to-suit structure), the landlord takes the depreciation deductions, and the franchisee’s rent payments are the deductible expense. The franchisee has no depreciable basis in the building or the build-out, which means no cost segregation opportunity on those components.

If the franchisee is treated as the owner of the improvements under the economic substance of the arrangement (for example, the lease requires the franchisee to maintain, insure, and replace the improvements, and the improvements have no residual value to the landlord at lease end), the franchisee may be able to claim depreciation. The IRS looks at factors including who bears the economic risk of the improvements, who benefits from any increase in value, and what happens to the improvements at lease expiration.

For most franchise tenants in a true build-to-suit, the landlord is the tax owner of the shell and the base building improvements. The franchisee’s depreciable basis is limited to any additional improvements the franchisee pays for beyond the landlord’s scope (equipment installation, brand-specific finishes, signage, furniture) and any amounts the franchisee contributes above the landlord’s construction budget. Those franchisee-funded items are depreciable by the franchisee and are excellent candidates for cost segregation.

Can I combine Section 179 and bonus depreciation?

IRC 179 allows a business to elect to expense the cost of qualifying property in the year it is placed in service, up to an annual dollar limit ($2,500,000 for 2025 under OBBBA, indexed for inflation). Section 179 applies to tangible personal property (equipment, furniture, fixtures) and to qualified real property (which includes QIP, roofs, HVAC, fire protection, and security systems for nonresidential buildings).

For a franchise build-out, Section 179 and bonus depreciation often overlap. Both allow first-year expensing of qualifying property. The practical difference is that Section 179 has a dollar cap and a phase-out threshold ($4,000,000 in total property placed in service for 2025), while bonus depreciation under IRC 168(k) has no dollar limit. Section 179 also cannot create or increase a net operating loss, while bonus depreciation can.

For most single-unit franchise build-outs, bonus depreciation is the more powerful tool because it has no cap and can generate a loss. Section 179 is useful as a supplement when the franchisee wants to selectively expense certain assets (for example, to manage taxable income in a particular year without triggering a large loss). For multi-unit operators placing multiple locations in service in the same year, the Section 179 dollar limit applies across all locations combined, while bonus depreciation applies to each asset individually with no aggregate cap. The multi-unit operator tax planning guide covers the stacking strategies for operators opening several locations at once.

What about improvements I make after the initial build-out?

Improvements made to the interior of the building after the initial build-out also qualify as QIP, provided they meet the same definition: improvement to the interior of a nonresidential building placed in service after the building was first placed in service. A franchise remodel three years after opening, a kitchen expansion, or a dining room refresh all qualify. The original build-out does not consume the QIP classification for future improvements.

Each subsequent improvement has its own placed-in-service date and its own depreciation schedule. With permanent 100% bonus depreciation, each improvement is fully deductible in the year it is placed in service. This is particularly relevant for franchise concepts that require periodic remodels (every 7 to 10 years is common in restaurant franchises). The remodel cost qualifies as QIP to the extent it improves the interior of the building, and the franchisee can expense the full cost in the remodel year through bonus depreciation.

Exterior improvements (new drive-through lanes, parking lot expansions, patio additions) do not qualify as QIP but may qualify as 15-year land improvements, which are also eligible for bonus depreciation. Equipment replacements (new ovens, POS systems, coolers) are tangible personal property with 5-year or 7-year recovery periods, also bonus-eligible.

The ongoing deductibility of these costs is separate from the franchise royalties and operating fees that are expensed as ordinary business deductions under IRC 162. Capital improvements are depreciated; operating fees are expensed currently. The distinction matters for both the income statement and the tax return, and the franchise bookkeeping guide covers how to track both categories properly.

What happens to depreciation if I close or relocate?

If a franchise location closes and the leasehold improvements are abandoned (not transferred to the landlord as part of the lease termination), the remaining adjusted basis of the improvements is deductible as a loss in the year of abandonment under IRC 165. The loss is ordinary, not capital, because the improvements were used in a trade or business.

If the improvements revert to the landlord at lease termination (as most commercial leases provide), the franchisee’s remaining basis in the improvements is deductible in the year the lease ends. This is straightforward when the franchisee has been depreciating the improvements on their own return. If Section 110 was elected and the landlord was depreciating the improvements, the franchisee has no remaining basis to deduct.

For franchisees who took bonus depreciation on the full build-out in year one, the remaining adjusted basis at closure is zero (or close to it), so there is no additional deduction at lease termination. The tax benefit was already captured in the first year. This is one of the reasons aggressive first-year depreciation through cost segregation and bonus depreciation is attractive for franchise operators: even if the location underperforms and closes early, the tax benefit from the build-out was already realized.

If you are selling or transferring the franchise rather than closing it, the franchise transfer and resale tax treatment guide covers the purchase price allocation and the buyer’s new depreciation schedule on the acquired assets.

What should I do next?

The build-out phase is when the depreciation strategy is set. Getting the classification right before the first tax return is filed avoids the need for a Form 3115 correction later. If you are planning a franchise build-out or recently completed one, the priorities are straightforward: engage a cost segregation firm before the first return is filed, structure the tenant allowance with your CPA before signing the lease, and coordinate the entity structure with the entity selection guide so the depreciation deductions flow to the right taxpayer.

• Cost segregation and bonus depreciation (general guide), the full explanation of how cost seg works, when it pays for itself, and the lookback option for properties you already own
• Franchise entity structure: LLC, S-Corp, and multi-unit strategies, how to structure the entity so depreciation deductions offset the right income
• Multi-unit operator tax planning, stacking Section 179 and bonus depreciation across multiple locations
• Franchise tax deductions: royalties, fees, and operating costs, the ongoing deductions that complement the build-out depreciation
• Initial franchise fee amortization under IRC 197, how the franchise fee itself is amortized separately from the build-out costs
• Franchise startup costs under IRC 195, the pre-opening costs that are deducted or amortized in the first year

Related guides:

• Franchise Bookkeeping Chart Of Accounts Royalties
• Franchise Employee Retention Payroll Tax
• Franchise Entity Structure Llc Scorp Multi Unit
• Franchise Exit Strategy Retirement Succession
• Franchise Fdd Tax Review Disclosure Document

Related guides:

• Tax Treatment of Leasehold Improvements: Depreciation Rules for Tenants and Landlords

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.