Property Leased to a Tax-Exempt Entity: ADS Rules and TEUP Exceptions

When you lease real estate or equipment to a tax-exempt tenant, the depreciation rules for property leased to a tax-exempt entity can reclassify your asset as “tax-exempt use property” under Internal Revenue Code Section 168(h). That reclassification forces you onto the Alternative Depreciation System, stretches your recovery period, and shuts you out of bonus depreciation and Section 179 expensing.¹ The result is a slower recovery of your basis and a smaller tax shield each year.

Who Counts as a Tax-Exempt Entity

Section 168(h)(2) sweeps in more than charities. The definition 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 your U.S. building triggers the same analysis as a state university.

When the Classification Kicks In

The trigger differs by asset type.

For tangible personal property, any portion leased to a tax-exempt entity is automatically tax-exempt use property. No additional conditions.¹

For nonresidential real property, two things must both be true. The lease must be a “disqualified lease,” and more than 35% of the building’s net rentable floor space must be leased to tax-exempt entities under such leases.²

What Makes a Lease Disqualified

Only one of these conditions has to apply for the 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 this, whether it’s above or below fair market value.
The lease term runs longer than 20 years.
The lease is a sale-leaseback: the tax-exempt entity (or a related party) sold or transferred the property after having used it, and now leases it back. A narrow exception applies if the leaseback begins within three months of the entity’s first use of the property.

The 35% Floor Space Threshold

Cross 35% and the depreciation splits. The portion leased to tax-exempt entities under disqualified leases moves to the ADS track; the remainder stays on standard MACRS. Stay at or below 35% and the whole building keeps its normal treatment, even if a disqualified lease exists.¹ The measurement is by net rentable floor space, not rent dollars or headcount.

How ADS Depreciation Changes the Math

Once property is classified as tax-exempt use property, MACRS is off the table. You depreciate under ADS, using straight-line.³

The recovery periods stretch:

Nonresidential real property: 40 years under ADS, versus 39 years under standard MACRS.¹
Residential rental property: 30 years under ADS, versus 27.5 years under MACRS.⁴

There is also a floor. For property leased to a tax-exempt organization, government, or foreign entity, the ADS recovery period cannot be less than 125% of the lease term.³ A 35-year lease sets your minimum recovery period at 43.75 years, not 40.

No Bonus Depreciation

Publication 946 is direct on this point: if you are required to use ADS, you cannot claim the special depreciation allowance, commonly called bonus depreciation.³ For property that would otherwise qualify for a large first-year write-off, that first-year deduction disappears entirely.

No Section 179 Expensing

Tax-exempt use property also does not qualify for the Section 179 election, which lets eligible businesses expense the full cost of qualifying property in the year it is placed in service.³ Section 179 does not apply to buildings themselves in most cases, but the exclusion still bites on equipment, fixtures, and other assets leased alongside the real property.

Exceptions That Keep You Out of TEUP Status

Short-Term Leases

Property is not tax-exempt use property merely because of a short-term lease.¹ For nonresidential real property, “short-term” means a term of less than three years, and the statute confirms that the secondary class-life test does not apply here. For other tangible property, both conditions must be met: the term must be less than three years and less than the greater of one year or 30% of the property’s present class life.

When you calculate the lease term, include any renewal options the lessee can exercise, unless the renewal rent resets to fair market value at that time. A below-market renewal option effectively extends the term.

Property Used in an Unrelated Trade or Business

If the tax-exempt entity uses the property predominantly in an unrelated trade or business that generates income subject to unrelated business income tax under Section 511, the property is not treated as tax-exempt use property.¹ The exempt organization is paying tax on the income, so the mismatch that Section 168(h) is designed to prevent doesn’t exist.

Qualified Technological Equipment

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

Tax-Exempt Partners in a Partnership

The analysis flows down to the partner level. Each tax-exempt partner’s proportionate share of the leased property is treated as if leased directly to that partner.¹ If a tax-exempt university holds 20% of a partnership that owns a building, 20% of that building runs through the TEUP tests. The same approach applies to other pass-through entities and tiered structures.

Tenant Improvements Get Pulled In

Under Section 168(h)(1)(B)(iv), improvements to nonresidential real property are not analyzed as a separate property for the disqualified lease and 35% threshold tests. They fold into the underlying building.¹ If the underlying lease is disqualified and the 35% line is crossed, tenant-funded improvements ride the same 40-year ADS schedule as the building. Some lessors require the tenant to remove improvements at lease expiration to avoid locking that residual value into the slower schedule.

How to Stay Out of TEUP Status

The triggers must be monitored across the life of the lease. A renewal that pushes the term past 20 years, a refinancing that introduces tax-exempt bonds, or a change in tenant mix that crosses the 35% line can change your depreciation treatment mid-stream. Practical levers:

Keep lease terms under 20 years. A 19-year lease with a fair-market-value renewal option preserves flexibility without triggering the automatic disqualification.
Avoid fixed-price purchase or sale options. Any fixed or determinable price disqualifies the lease, regardless of how the price compares to fair market value.
Watch the 35% floor-space threshold in multi-tenant buildings. Replacing a taxable tenant with a government agency can push you over.
Price the depreciation cost into the rent. Slower recovery, no bonus, and no Section 179 all reduce the after-tax yield on the deal.
Structure partnership allocations so a tax-exempt partner’s share doesn’t inadvertently classify a larger slice of the property as TEUP.

If a sale-leaseback with a tax-exempt seller is on the table, remember the three-month window: the leaseback has to begin within three months of the entity’s first use of the property, or the transaction is disqualified from the start.

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