Leasing to Tax-Exempt Entities – Consider the Depreciation Impacts
March 02, 2023
By Avi Jacob
Leasing property to tax-exempt entities certainly comes with benefits. Whether it is meeting internal company social governance goals by leasing to a 501(c)(3) or reaping the benefits of low-risk long term governmental leases, a tax consequence needs to be accounted for: What depreciable lives are to be used for the associated assets?
Tax-exempt use property carries specified depreciation rules, which can be found in IRC Sec. 168(g)(3). Tax-exempt use property must be depreciated using the greater of either the alternative depreciation system (“ADS”) defined depreciable life under IRC Section 168(g)(2) or 125% times the length of the lease term inclusive of pre-negotiated options.
IRC Sec. 168(h)(1) further defines tax-exempt use property as follows:
- Property other than nonresidential real property – that portion of any tangible property other than nonresidential real property leased to a tax-exempt entity.
- Nonresidential real property – that portion of the property leased to a tax-exempt entity under a disqualified lease.
Both categories have their own methodologies to consider when determining how to depreciate their assets.
For the property other than nonresidential real property, the tax-exempt depreciation rules generally lead to some unpleasant results. For example, if you have a ten-year lease in place, the general depreciation system (“GDS”) five-year personal property would now the get depreciated over 12.5 years (10 years x 125% = 12.5). Additionally, under the same rules, the 15-year land improvements would now get depreciated over 20 years, as the land improvement’s respective ADS useful life as 20 years is greater than the 12.5 years calculated for the personal property. It is also important to note that due to the mandatory use of ADS lives, such property is not eligible for bonus depreciation.
For nonresidential real property, two important items must be evaluated to determine whether the property would be able to use the more advantageous GDS depreciable lives. The first item evaluated is whether the leases are considered disqualified leases.
Disqualified leases are any leases of the property to a tax-exempt entity, but only if:
- Part or all the property was financed (directly or indirectly) by an obligation the interest on which is exempt from tax under IRC Sec. 103(a) and such entity (or a related entity) participated in such financing;
- Under such lease there is a fixed or determinable price purchase or sale option which involves such entity (or a related entity) or there is the equivalent of such an option;
- Such lease has a lease term in excess of 20 years; or
- Such lease occurs after a sale (or other transfer) of the property by, or lease of the property from, such tax-exempt entity (or related entity) and such property has been used by such entity (or related entity) before such sale (or other transfer) or lease.
The most common item above that real estate investors run into is whether the lease term exceeds 20 years. To determine the length of the lease and whether it is more than 20 years, options to extend are evaluated. If the option to renew resets to fair market value, then these options are not included in the 20-year calculation. If the options have pre-negotiated terms, then they must be included.
If there are no disqualified leases, then the nonresidential real property, along with its remaining assets, would receive normal GDS depreciable life treatment. Great, we can rest easy now. But what if we conclude from the above that we do in fact have disqualified leases? Are we now stuck with this slow depreciating asset? Not necessarily.
Once you have determined that some of your leases are in fact disqualified leases, the Internal Revenue Code has several exceptions to the tax-exempt use property rules. The 35% threshold test states that even with disqualified leases, if less than 35% of the net rentable space is occupied by tax-exempt tenants, you may still use GDS depreciation rules to depreciate the nonresidential real property along with the remaining tangible property that isn’t directly or indirectly leased to the tax-exempt tenant. For example, if you have a tax-exempt tenant who only occupies 10% of your total net rentable space, normal GDS depreciation rules would apply.
Short-term leases of less than three years are also not subject to these rules.