7897 / Is property leased to governments and other tax-exempt entities eligible for accelerated cost recovery?

Property leased to certain tax-exempt entities (tax-exempt use property) may not, in general, use the normal recovery periods and percentages.¹

A tax-exempt entity includes the following:

(1) the United States, any State or political subdivision thereof, or any agency or instrumentality of any of the above;

(2) an organization (other than a farmers’ cooperative) that is exempt from normal income tax;

(3) any foreign person or entity; and

(4) certain Native American tribal governments.²

The deduction for tax-exempt use property is determined by using a straight line method over the recovery period. The recovery period is the greater of the present class life (or 12 years for personal property with no present class life) or 125 percent of the lease term.³ Property is assigned to various class lives for purposes of depreciation in Revenue Procedure 87-56.⁴ Options to renew and successive leases may be aggregated with the original lease term for this purpose.⁵

Property is not tax-exempt use property if the tax-exempt entity uses it predominantly in an unrelated trade or business that is subject to income tax.⁶ Property is considered used predominantly in an unrelated trade or business if it is used in the unrelated trade or business more than 50 percent of the time it is used during a taxable year. If only a portion of the property is used in an unrelated trade or business, the remainder may be tax-exempt use property.⁷ Property leased to a foreign person or entity is not considered tax-exempt use property if more than 50 percent of the foreign person or entity’s gross income is subject to United States income tax.⁸

Property subject to a short-term lease is not treated as tax-exempt use property. A short-term lease is a lease that is for a term which is less than three years, and (if the leased property has a class life) less than the greater of 1 year or 30 percent of the property’s class life.⁹ The Internal Revenue Service may aggregate options to renew and successive leases with the original lease term for this purpose. The Tax Court has held that a lease term is determined by the “realistic contemplation of the parties at the time the property is first put into service.”¹⁰

Informal agreements to extend a lease term are included with the original lease term. Options to renew possessed by the lessor or lessee are included in the original lease term, whether exercised or not. Successive leases entered into at the same time concerning the same or substantially similar property may be treated as one lease. The leases will not be aggregated merely because the lessor and lessee entered into a new lease at fair market rental value at the end of the original lease term.¹¹

For leases entered into after April 19, 1995, an additional time during which the lessee may not be the lessee will nevertheless be included in the lease term if the lessee (or a related person) retains an obligation to pay rent or make a payment in the nature of rent with respect to such period. A payment in the nature of rent is a payment intended to substitute for rent or to pay or supplement the rental payments of another. For example, a payment in the nature of rent includes payments required to be made for such other period if (1) the leased property is not leased; (2) the leased property is leased for terms that do not meet certain conditions; or (3) there is a failure to pay rent. In addition, for leases entered into after April 25, 1996, if property is subject to one or more leases (including subleases) entered into as part of one transaction (or series of related transactions), the lease term includes all periods described in any of such leases.¹² No inference is intended with respect to leases entered into prior to such dates.¹³

For transfers made after April 19, 1995, if tax-exempt use property is transferred (directly or indirectly) in a like-kind exchange under IRC Section 1031 (see Q 710) among related persons and a principal purpose of the transfer or any related transaction is to avoid or limit the application of the alternative depreciation system for tax-exempt use property, property received in exchange for tax-exempt use property (tainted property) must be depreciated under the alternative depreciation system for tax-exempt use property using the same methods and periods previously used for the transferred tax-exempt property. Generally, this rule applies to the extent the basis of the tainted property does not exceed the basis of the transferred tax-exempt use property.¹⁴ No inference is intended with respect to transfers prior to such date.¹⁵

Deductions related to tax-exempt use property may be further limited to the amount of income from the property.¹⁶