Leasing to Tax-Exempt Entities
A tax-exempt entity is defined as:
- The United States, any state or its political subdivision, any U.S. possession, or any agency or instrumentality of the foregoing.
- An organization exempt from Federal income tax, including any organizations that were exempt at any time during the five-year period ending on the date the organization first used the property.
- Any foreign person or entity, defined as a foreign government, any international organization, any instrumentality of the foregoing, and any other person who is not a U.S. person. This does not apply where more than 50% of the gross income derived by the foreign person or entity is subject to Federal income tax.
- Any Indian tribal government under Code Sec. 7701(a)(40).
- You should also be aware that if you lease a property to a partnership with a partner that is a tax-exempt entity, a share of the property is treated as leased to that tax-exempt entity.
Once you identify that you are leasing to a tax-exempt entity, you will have to determine if this results in a disqualified lease under Code Sec. 168(h)(1)(A). A disqualified lease means any lease to a tax-exempt entity but only if:
- Part or all of the property was financed (directly or indirectly) by an obligation, the interest on which is exempt from tax under Sec. 103(a), and such entity (or related entity) participated in such financing;
- There is a fixed or determinable price purchase or sale option which involves such entity (or related entity) or there is the equivalent of such option;
- The lease has a term in excess of 20 years; or
- The lease occurs after a sale (or other transfer) of the property by, or lease of the property from, such entity (or a related entity) and such property has been used by such entity (or related party) before sale (or other transfer) or lease.
With regard to determining the lease term, for both residential rental property and nonresidential real property, options to renew will be taken into account unless the option is to renew at fair value, determined at the time of the renewal.
The special depreciation rules will apply only if the portion of the property leased to tax-exempt entities in a disqualified lease is more than 35% of the property.
If you lease office space to a tax-exempt entity that makes up 10% of your total space for lease in the building, excluding common area, and has a lease term of 25 years, you may think that you need to treat this as a disqualified lease. However, since the total space leased to the tax-exempt entity is less than 35% of the property, normal depreciation rules apply.
Tax-exempt use property must be depreciated under the MACRS alternative depreciation system (ADS) under Code Sec. 168(g)(1)(b). In this case, leasehold improvements done to a property that are deemed to be under a disqualified lease would be depreciated over 40 years or no less than 125% of the lease term.
In addition to having to follow special rules for depreciation, there may also be limitations on the expenses that can be deducted in excess of the taxpayer’s gross income from the lease.
Need More Information?
If you have any questions about this real estate update, please contact your local WithumSmith+Brown advisor or a member of WS+B’s Real Estate Services Group.
Rebecca Machinga, CPA, Partner
Practice Leader, Real Estate Services
The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals for your individual facts and circumstances.