When a taxable (non-exempt) lessor remodels facilities it leases to an exempt entity, how does the Comptroller decide whether the exempt lessee has 'primary use and benefit' of the remodeling services (making them exempt) versus the taxable lessor (making them taxable) — specifically, how is the 'long-term lease' prong measured?

Plain-English summary

When a taxable (non-exempt) landlord remodels a facility before leasing it to a tax-exempt entity (a government body or 501(c)(3)-type organization), whether the remodeling services get the exempt entity's tax-free treatment turns on who has the "primary use and benefit" of those services. Two prior Comptroller administrative hearings (28,391 from July 1993 and 31,505 from April 1994) established a two-prong test for this:

1. The lessee must be an "exempt entity" under Tax Code § 151.309 (governmental) or § 151.310 (exempt organizations), and
2. The lease must be long-term, "in reasonable relationship to the life of the improvements themselves."

A tax professional wrote in with two follow-up questions:

Question 1 — how is "long-term" measured? If a lease is 3 years and the lessor depreciates the improvements over that same 3-year lease term, does that satisfy the second prong? The Comptroller clarified: the second prong measures the actual useful life of the improvements, not the depreciation period the lessor happens to use for its own tax purposes. That said, since federal tax regulations set standard depreciation periods, if a lessor's depreciation schedule falls within those federal guidelines, the Comptroller said it would be "hard-pressed to disallow the exemption" — in practice, a depreciation period within normal federal guidelines is a strong (if not conclusive) proxy for meeting the life-of-improvements standard.

Question 2 — should two older rulings be treated as superseded now that the two-prong test (replacing an older five-factor test) is in place? The Comptroller agreed and had the two older rulings (9205L1176B08 and 9108L1124G05) formally marked as superseded as a direct result of this inquiry.

What this means for you

Governmental entities and exempt organizations leasing improved/remodeled facilities

If a private, taxable landlord is remodeling space specifically for your exempt organization's long-term occupancy, the remodeling services can potentially be exempt from Texas sales tax — but only if your lease term reasonably matches the useful life of the improvements being made, not just any arbitrary lease length.

Commercial landlords remodeling facilities for exempt-entity tenants

Structure your lease term to align with (or exceed) the improvements' actual useful life, and keep your depreciation schedule within standard federal guidelines — that alignment is what the Comptroller looks to in applying the second prong of the primary-use-and-benefit test.

Accountants and tax professionals researching older Comptroller guidance on exempt-entity leases

Be aware that rulings 9205L1176B08 and 9108L1124G05, which predate the two-prong test, were formally superseded as a result of this 2000 letter — don't rely on the older five-factor framework those rulings may have applied.

Common questions

Q: What is the "primary use and benefit" two-prong test for exempt-entity leases in Texas?
A: (1) The lessee must qualify as an exempt entity under § 151.309 or § 151.310, and (2) the lease term must be long-term in reasonable relationship to the useful life of the improvements.

Q: Does matching the lease term to the lessor's depreciation schedule satisfy the second prong?
A: Not automatically — the test measures the improvements' actual useful life, not the depreciation period. However, a depreciation schedule within standard federal guidelines makes it hard for the Comptroller to disallow the exemption in practice.

Q: Are older Comptroller rulings that used a different (five-factor) test for this issue still good law?
A: Two specific older rulings (9205L1176B08 and 9108L1124G05) were formally superseded as a result of this letter — don't rely on them for the current standard.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.309 (governmental exemption)
• Tex. Tax Code § 151.310 (exempt organization exemption)

Administrative decisions:

• Comptroller Hearing No. 28,391 (July 1993)
• Comptroller Hearing No. 31,505 (April 1994)
• Letter Ruling 9312L1283D02 (applied the two-prong test)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/200006420L

Original ruling text

June 21, 2000

From: Gilbert Zamora

To: "Vaclavik,Dale"

Subject: "Primary use and benefit" issue

Dear Dale:

Thank your for your email inquiry. Your situation and questions are restated
below, followed by my response.

Two hearings in the past, namely 28,391 (July 1993) and 31,505 (April 1994),
set out the (newly adopted) two prong test adopted by the tax division to
determine whether the exempt entity (lessee) or the taxable entity (lessor) has
the "primary use and benefit" of services purchased by the taxable entity to
remodel the leased facilities. The first prong is that the lessee must be an
"exempt entity" (under 151.309 or 151.310) and the second prong is that "the
lease should be long-term (in reasonable relationship to the life of the
improvements themselves)".

Question # 1. How has the department been interpreting the requirement that the
lease be ... "long term (in reasonable relationship to the life of the
improvements themselves)"?

If the lease term is 3 years and the improvements are being depreciated, by the
lessor, over the life of the lease (3 years) would this meet the second prong?
If not, how do we determine whether the lease meets this second prong?

Response: We have issued at least one ruling (9312L1283D02) that uses the
two-prong test as the basis for determining primary use and benefit.

The second prong of the two-prong test uses the measure of the "life" of the
improvements, rather than the period over which the improvements are
depreciated by the lessor. However, for practical purposes federal tax
regulations set out the time period over which improvements may be depreciated.
If the depreciation period is within these guidelines we would be hard-pressed
to disallow the exemption.

Question # 2. In light of the two prong test (as opposed to the older 5 factor
test) should the following older documents be superceded?

9205L1176B08
9108L1124G05

Response: I have asked that these letter rulings be shown as superceded.
Thanks for bringing these to our attention.

This opinion is based on the facts presented. Other facts though similar may
provide a different result.

I hope this information answers your questions. If you need additional
information, please call me toll-free at 1-800-531-5441, extension 3-4502. The
direct line is 512/463-4502. You may also write to Tax Policy Division,
Comptroller of Public Accounts. You may also e-mail our tax help section at:

Tax Policy Division