Property Leased to a Tax-Exempt Entity: ADS, Bonus, and Section 179

When you lease real estate or equipment to a tax-exempt tenant, Internal Revenue Code Section 168(h) can reclassify your asset as “tax-exempt use property,” which changes the depreciation rules for property leased to a tax-exempt entity in three costly ways: you move from MACRS to the slower Alternative Depreciation System (ADS), you lose bonus depreciation, and you lose Section 179 expensing.¹ Whether the reclassification is automatic or conditional depends on the type of property and the terms of the lease.

Which Tenants Trigger the Rule

Section 168(h)(2) defines a tax-exempt entity broadly. The category covers the federal government, any state or local government and their agencies, any organization exempt from federal income tax under Section 501(a) (not just 501(c)(3) charities), and any foreign person or entity.¹ A foreign corporation leasing U.S. real estate can trigger the same treatment as a lease to a state university.

Personal Property Versus Real Property

The classification path splits by asset type. For tangible personal property such as equipment, vehicles, or furniture, the rule is blunt. Any portion leased to a tax-exempt entity is automatically treated as tax-exempt use property, with no further conditions to satisfy.¹

Nonresidential real property gets a two-part test. A building leased to a tax-exempt entity becomes tax-exempt use property only if the lease is a “disqualified lease” and more than 35% of the property, measured by net rentable floor space, is leased to tax-exempt entities under such leases.² If either condition is missing, the building keeps its normal depreciation treatment.

When the 35% line is crossed, the depreciation calculation splits. The portion leased to tax-exempt entities under disqualified leases moves to the 40-year ADS schedule, and the remainder stays on the standard 39-year MACRS recovery period.

What Makes a Lease Disqualified

Section 168(h)(1)(B)(ii) lists four disqualifying conditions. Only one has to apply for the entire lease to be tainted.¹

Part or all of the property was financed by an obligation with tax-exempt interest, and the tax-exempt entity or a related party participated in that financing.
The lease gives the tax-exempt entity or a related party a purchase or sale option at a fixed or determinable price, or the economic equivalent. Any fixed price triggers the rule, whether it sits above or below fair market value.
The lease term runs longer than 20 years.
The lease follows a sale or transfer of the property by the tax-exempt entity or a related party, where the entity used the property before that transaction. A narrow exception applies if the leaseback begins within three months of the entity’s first use of the property.

The sale-leaseback trigger frequently surprises investors in public-private partnerships. A developer who buys a building from a city agency and leases it back to that agency has a disqualified lease unless the three-month exception applies.

The Depreciation Change: ADS Is Mandatory

Once property is classified as tax-exempt use property, the owner must depreciate it under the Alternative Depreciation System. Standard MACRS is off the table.³ The recovery periods change as follows:

Nonresidential real property: 40 years under ADS, versus 39 years under MACRS. Both use straight-line depreciation.¹
Residential rental property: 30 years under ADS, versus 27.5 years under MACRS.⁴

There is also a floor. IRS Publication 946 specifies that the ADS recovery period for property leased to a tax-exempt organization, government, or foreign entity cannot be less than 125% of the lease term.³ Sign a 35-year lease, and your minimum ADS recovery period is 43.75 years rather than 40.

No Bonus Depreciation, No Section 179

The hit goes beyond a longer schedule. If ADS is required, you cannot claim the special depreciation allowance, commonly called bonus depreciation.³ For property that would otherwise qualify, first-year expensing of a large percentage of cost is gone.

Tax-exempt use property also does not qualify for the Section 179 election, which otherwise lets eligible businesses deduct the full cost of qualifying property in the year it is placed in service.³ Section 179 mostly reaches tangible personal property and certain improvements rather than buildings, so this exclusion matters most for equipment, fixtures, and other assets leased alongside real property.

Exceptions That Keep Property Out of TEUP Status

Short-Term Leases

A short-term lease does not, by itself, make property tax-exempt use property. For nonresidential real property, “short-term” means a lease of less than three years. The statute expressly provides that the secondary class-life test does not apply to nonresidential real property, so the threshold stays at three years regardless of the building’s ADS recovery period.¹

For other tangible property, the lease must satisfy two tests: the term must be less than three years, and it must be less than the greater of one year or 30% of the property’s present class life. Renewal options the lessee can exercise count toward the term, unless the renewal rent resets to fair market value at the time of renewal.

Use in an Unrelated Trade or Business

Property is not treated as tax-exempt use property if the tax-exempt entity uses it predominantly in an unrelated trade or business generating income subject to the unrelated business income tax under Section 511.¹ If the exempt organization pays tax on the income from the property, the mismatch that the rule targets disappears.

Qualified Technological Equipment

Computers, peripheral equipment, and certain high-technology medical equipment are exempt from the TEUP rules when the lease term is five years or less. For this carve-out, lessee renewal options at fair market rent are excluded from the lease term calculation, up to 24 months.¹

Partnerships With Tax-Exempt Partners

When property is leased to a partnership that has tax-exempt partners, the TEUP analysis is made partner by partner, not at the partnership level. Each tax-exempt partner’s proportionate share of the leased property is treated as if it were leased directly to that partner. The same approach applies to other pass-through entities and tiered structures. For foreign partnerships, the statute presumes that all partners are non-U.S. persons unless the taxpayer proves otherwise to the IRS’s satisfaction.¹

Tenant Improvements

Under Section 168(h)(1)(B)(iv), improvements to nonresidential real property are not treated as separate property for purposes of the disqualified lease and 35% threshold tests.¹ Improvements are folded into the analysis of the underlying building. If the lease is disqualified and the 35% threshold is met, tenant-funded improvements become part of the tax-exempt use property and must be depreciated under ADS along with the rest of the building.

Planning Levers That Matter

The conditions that create TEUP status have to be monitored throughout the life of the lease. A renewal that pushes the total term past 20 years, a financing restructuring that introduces tax-exempt bonds, or a change in tenant mix that crosses the 35% floor-space threshold can change the depreciation treatment going forward.

Keep the lease term under 20 years. A 19-year lease with a fair-market-value renewal option preserves flexibility without triggering the automatic disqualified-lease rule.
Avoid fixed or determinable price purchase and sale options. Even a reasonable-looking price disqualifies the lease.
Watch the 35% floor-space test in multi-tenant buildings. Replacing a taxable tenant with a government agency can push you over the line.
Price the depreciation cost into the rent when negotiating with a tax-exempt tenant. The value lost to a slower schedule, no bonus depreciation, and no Section 179 should be reflected in the gross rent.
Structure partnership allocations carefully when a tax-exempt entity is a partner, so that proportionate shares do not sweep the property into TEUP status.

1
Office of the Law Revision Counsel. 26 U.S.C. 168 – Accelerated Cost Recovery System
2
Internal Revenue Service. Rehabilitation Credit: Leases to Tax-Exempt Entities, Tax-Exempt Use Property
3
Internal Revenue Service. Publication 946 (2025), How To Depreciate Property
4
Internal Revenue Service. Publication 527 (2025), Residential Rental Property