Depreciation Considerations for Tax-Exempt Tenants in Cost Segregation Studies

Leasing space to a tax-exempt tenant has many financial advantages -- the main advantage generally being stable, long-term tenants. However, the presence of a tax-exempt tenant can also significantly alter the depreciation profile of a property.

Cost segregation studies are a tax strategy used to accelerate depreciation through allocating various assets to their appropriate shorter recovery periods. However, a tax-exempt tenant may impede those benefits to an extent by mandating the use of the longer recovery periods of the Alternative Depreciation System (ADS), which would also remove bonus eligibility.

Understanding when and how these rules apply is essential for an accurate cost segregation study. 

What Is Tax-Exempt Use Property?

Under Internal Revenue Code Section 168(h), property is considered “tax-exempt use property” when it is leased to a tax-exempt entity. Tax-exempt entities include:

• Federal, state, and local governments and their agencies
• Organizations exempt under IRC Section 501(a) (charities, religious organizations, etc.)
• Certain foreign persons or entities
• Indian tribal governments

When property meets this definition, it generally must be depreciated using ADS rather than the General Depreciation System (GDS).

Why This Matters in Cost Segregation

The depreciation method applied has a significant impact on the yield of a study. 

If assets are treated using ADS in a tax-exempt use property:

• Recovery periods are lengthened
• Bonus depreciation is not permitted

Using ADS may cause a meaningful reduction in expected study benefit.

How to Determine Whether ADS Applies

The analysis is not always straightforward. Referring to EisnerAmper’s “ADS Flowchart for Tax Exempt Use Property” will be helpful in navigating this process. 

Sometimes ADS must be used – to depreciate tangible personal property in a tax-exempt tenant, for example.  The reverse of the Flowchart demonstrates the mechanics of the associated calculation. 

However, sometimes the tenant’s base building assets – and any Qualified Improvement Property (QIP) – may be depreciated using GDS.  This is a desirable outcome, as it puts bonus depreciation back in play.  (See front side of ADS Flowchart.)

To determine the depreciation methodology, 2 key questions must be posed:

Is the tenant’s lease considered “disqualified”?    

The lease is “disqualified” if any of the following are true:    

• Lease term of MORE than 20 years (including options to renew unless those options reset to FMV)
• Purchased with tax-exempt financing
• Agreement or option to purchase by the entity
• “Sale-Leaseback” with exempt entity

If the lease is disqualified, it’s possible that ADS depreciation may be mandated, but one final question will settle the matter:

Is more than 35% of the property’s net rentable floor space leased to tax-exempt entities?

• If yes, ADS is mandated
• If no, base building assets and QIP may be depreciated using GDS, and bonus depreciation is available

The determination is best approached as a step-by-step analysis using the EisnerAmper ADS Flowchart for Tax Exempt Use Property. This structured approach reduces the risk of misclassification and helps ensure consistency across engagements.

Planning Considerations

From a planning perspective, the presence of tax-exempt tenants should be evaluated early in the lifecycle of a transaction or study. Key considerations include:

• Lease structuring: Certain lease terms may inadvertently trigger disqualified lease treatment
• Tenant mix: Properties with a high concentration of tax-exempt tenants may yield limited cost segregation benefits
• Modeling assumptions: Projections should reflect ADS where applicable to avoid overstating tax savings
• Documentation: Clear support for allocations and classifications is critical in the event of IRS scrutiny

Leasing to tax-exempt tenants does not eliminate the value of a cost segregation study, but it may impact the benefit. Maximizing benefit requires a comprehensive engineering-based analysis combined with a strong understanding of the underlying tax law. 

The EisnerAmper team has the tax and technical knowledge needed to assess your situation and optimize outcomes. 

Explore two real-life tax-exempt use related case studies.    

Tax Exempt Use Property: Cost Segregation with a Tax-Exempt Owner or Tenant

Learn more