Does a 25-year build-to-suit lease for a Texas charter school's new high school campus qualify as an exempt contract, letting the for-profit landlord's contractors buy construction materials tax-free?

Plain-English summary

A Texas 501(c)(3) nonprofit that operates a state-chartered, open-enrollment charter school (part of the Texas public school system, funded through the state's Foundation School Program) needed a new high school campus. Rather than build it directly, the school entered into a build-to-suit lease with purchase option: a for-profit landlord agreed to construct the campus to the school's specifications and lease it back for an initial 25-year term, with the school able to exercise a purchase option starting after the first anniversary of occupancy. Under Texas Education Code Section 12.128, property leased this way by a charter holder is treated as state property held in trust for the students — meaning if the school closes, the state (through the Texas Commissioner of Education) takes over the property and any leasehold rights.

The school asked whether this build-to-suit lease qualifies as an "exempt contract" under Tax Code Section 151.311, which would let the landlord's construction contractors buy materials and taxable services tax-free for the project — even though the landlord itself isn't a tax-exempt entity. The Comptroller ruled yes, applying its long-standing two-prong test (first set out in Comptroller's Decision No. 28,391, 1993) for situations where a tax-exempt organization leases property from a non-exempt landlord who builds improvements before occupancy:

1. The lessee must qualify as exempt. The charter school is a qualified exempt entity under Section 151.310 — satisfied here.
2. The lease term must be long enough, relative to the improvements' useful life, to give the exempt entity the PRIMARY use and benefit. This is a fact-specific comparison. The school pointed to the state's own official depreciation schedule (Appendix A of the State Property Accounting Process User's Guide), which sets a 22-year (264-month) useful life for buildings. Since the lease ran 25 years (300 months) — longer than the building's expected useful life — the Comptroller found the lease sufficiently long to satisfy this prong.

Because both prongs were met, the build-to-suit lease is an exempt contract, and the landlord's contractors could buy construction materials/services for the project tax-free under Section 151.311. The Comptroller noted this specific fact pattern (an exempt lessee, non-exempt lessor, improvements built before occupancy) isn't addressed directly by statute or existing rule, so the ruling's reasoning will be folded into a future amendment to Rule 3.291 (Contractors) — and the Comptroller had already answered nearly identical fact patterns in four 2014 rulings cited in this letter. The ruling explicitly left open (and didn't approve or disapprove) any refund claim the school might separately pursue for tax already paid on construction materials, and it didn't rule on the "building shell" specifically since that wasn't requested.

What this means for you

Charter schools and other tax-exempt organizations using build-to-suit leases

You don't need to directly own or build your facility to get the Section 151.311 exemption on construction materials — a sufficiently long-term lease from a non-exempt landlord, tied to your organization's exempt status, can qualify. The key number to check is whether your lease term meets or exceeds the improvements' expected useful life (commonly benchmarked at 22 years for buildings under the state's own depreciation schedule, though this is a fact issue without a fixed legal standard).

Real estate developers and landlords building for exempt tenants

Structure lease terms with the useful-life comparison in mind if tax-exempt treatment on construction materials is part of your deal economics — a lease materially shorter than the building's useful life (the ruling cites a prior case where a 5-year lease failed this test against improvements with a longer life) will not qualify, even if the tenant itself is unquestionably exempt.

Accountants and tax professionals

The 22-year useful-life benchmark comes from an accounting reference (the State Property Accounting Process User's Guide), not a fixed statutory or rule standard — the Comptroller explicitly notes there's no established threshold for how long a lease must be relative to useful life, so each case still requires its own factual analysis, even though 22 years has now appeared as an accepted useful-life figure across multiple rulings on similar facts.

Common questions

Q: Does the exempt organization need to own the property to get this tax exemption on construction materials?
A: No. Section 151.311 doesn't require the exempt organization to own the real property — a sufficiently long lease from a non-exempt landlord can qualify under the two-prong test.

Q: What lease term is "long enough"?
A: There's no fixed legal threshold. This ruling found a 25-year (300-month) lease sufficient because it exceeded the building's referenced 22-year (264-month) useful life; a prior case found a 5-year lease insufficient against improvements with a longer useful life.

Q: Does this ruling authorize a tax refund for materials already purchased?
A: No. The Comptroller explicitly stated it wasn't addressing the validity of any refund claim — that would be a separate process under Rule 3.325, requiring a properly completed assignment of right to refund for materials the school didn't directly pay tax on.

Q: Can another charter school or exempt organization rely on this ruling?
A: No. This is a private letter ruling binding only on the Comptroller as to this taxpayer and these facts, though the Comptroller notes it has reached the same conclusion on similar facts in multiple other 2014-2015 rulings and plans to memorialize this reasoning in a future Rule 3.291 amendment.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.311 (exempt contracts for realty improvements)
• Tex. Tax Code §§ 151.309, 151.310 (governmental/exempt organization exemptions)
• 34 Tex. Admin. Code Rule 3.291(a)(5) (exempt contract definition)
• 34 Tex. Admin. Code Rule 3.322 (exempt organizations)
• 34 Tex. Admin. Code Rule 3.325 (refunds and payments under protest)
• Tex. Educ. Code §§ 12.105, 12.106, 12.128 (charter schools; Foundation School Program; charter-held property as state property)

Prior authority discussed:

• Comptroller's Decision No. 28,391 (July 7, 1993), STAR Document No. 9307H1248D05 (two-prong test established)
• Comptroller's Decision No. 31,505 (April 20, 1994), STAR Document No. 9404H1297E01 (5-year lease failed second prong)
• STAR Document Nos. 201411982L, 201411981L, 201411980L, 201409958L (2014 rulings on similar facts)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201509416L

Original ruling text

September 2, 2015

RE: Private Letter Ruling # 143430052

Dear *****:

We issue this private letter ruling in accordance with Rule 3.1 in response to
your request dated December 3, 2014. Detrimental reliance is provided in
accordance with Rule 3.10, the Taxpayer Bill of Rights.

You requested guidance on the ’ interpretation of the exemption in Texas Tax Code
Section 151.311 for tangible personal property and taxable services purchased for use
in the performance of a contract to improve real property for an organization exempt
under Tax Code Section 151.310. The Comptroller’s office has addressed similar facts
presented by this inquiry; most recently in other private letter rulings, particularly
STAR DOCUMENT NOS. 201411982L, 201411981L, 201411980L, and 201409958L,
all issued in 2014. However, we issue this private ruling because guidance on this issue
is not expressly provided in statute or agency rule.

Relevant Facts Presented

**, is a Texas non-profit corporation granted tax-exempt status by the
Internal Revenue Service pursuant to Section 501(c)(3) of the Internal Revenue
Code. On August 19, 2013, ** met the qualifications for exemption from
Texas Sales or Use Tax outlined in Rule 3.322 (Exempt Organizations).

** received a charter from the Texas Education Agency to operate an
open-enrollment charter school. * recently has had a new facility
constructed at *, CITY, Texas for a high school campus (“Campus”).
* entered into a build-to-suit lease and purchase option (“Lease”)
[ENDNOTE 1] with * (“Landlord”), where Landlord agreed to construct
the Campus per *’s specifications and to lease the Campus to
* for an initial term of twenty-five (25) years. Under the Lease,
** has the option to purchase the Campus after the first anniversary
date of the Commencement Date, as defined in the Lease, through the fourth
anniversary of the Commencement Date.

Under the Lease, Landlord is required to implement a construction program to
build the Campus to **’s specifications, with the cost incorporated
into the Lease and paid for by * either in monthly payments, or by
exercising its option to purchase. The Lease requires Landlord to make all
improvements described within the exhibits to the Lease. Campus was improved
for, leased by, and used by **** as an open-enrollment charter school.
Texas Education Code Section 12.105 states that an open-enrollment charter
school is part of the Texas public school system.

** receives its funding from the State of Texas (“State”) through a
funding system known as the Foundation School Program as authorized by Texas
Education Code Section 12.106. ** used state funds to lease the
Campus. Texas Education Code Section 12.128 states that property, whether
purchased or leased, is considered public property for all purposes allowed by
state law and is deemed to be state property held in trust by the charter
holder for the benefit of the students and may be used only for a purpose for
which a school district may use school district property.

The charter holder—in this case, **—holds the state-owned property in
trust for the benefit of the attending students. If ** closes or
ceases to exist, the Texas Commissioner of Education, on behalf of the State,
takes immediate possession and assumes control over the property, including
leasehold rights under Texas Education Code Section 12.128(c)(1).

Requested Ruling and Analysis

Our restatement of the ruling you requested is shown below, followed by our
response and analysis.

Is the build-to-suit lease at issue an exempt contract as contemplated by Texas
Tax Code Section 151.311, thereby allowing the tax-free purchase of taxable
items by the taxable entity for incorporation into property leased by the
tax-exempt entity?

Response: This question is not addressed by statute or rule and the response
provided will be memorialized in a future amendment to Rule 3.291 (Contractors).
The build-to-suit lease at issue is an exempt contract as contemplated by Texas Tax
Code Section 151.311 because it is a contract to improve real property for the primary
use and benefit of an exempt entity. Tangible personal property or taxable services
meeting the requirements expressed in Texas Tax Code Section 151.311 are exempt
from Texas Sales or Use Tax.

Texas Tax Code Section 151.311 provides, in part, that the purchase of tangible
personal property for use in the performance of a contract for an improvement
to realty for an organization exempted under Texas Tax Code Sections 151.309 or
151.310 is exempt if the tangible personal property is incorporated into realty
in the performance of the contract. Texas Tax Code Section 151.311 further
provides that the purchase of a taxable service for use in the performance of a
contract for an improvement to realty performed for such an organization is
exempt if the service is performed at the job site and if the contract
expressly requires the specific service to be provided or purchased by the
person performing the contract or the service is integral to the performance of
the contract.

Rule 3.291(a)(5) defines an exempt contract to include a contract for the
improvement of real property with an entity that is exempt under Texas Tax Code
Section 151.309 or 151.310. The Rule further provides that an example of an
exempt contract is a contract with a non-exempt entity to improve real property
for the primary use and benefit of an organization exempted under Section
151.309 or 151.310.

Texas Tax Code Section 151.311 does not require that the real property be owned
by the exempt organization. For situations involving an exempt lessee and a
non-exempt lessor, the Comptroller’s office developed a two-prong test to
determine whether improvements to real property are for the primary use and
benefit of the exempt entity. The test was first set forth in COMPTROLLER’S
DECISION NO. 28,391 (July 7, 1993), STAR DOCUMENT NO. 9307H1248D05.

First, the lessee must qualify for exempt status under Texas Tax Code Section
151.309 or 151.310. Based on the facts presented, ***** is a qualified
tax-exempt entity under Section 151.310; therefore, it meets the first prong of
the test.

Second, the term of the lease must be sufficiently long in relationship to the
life of the improvements themselves. This test has been consistently applied
by the Comptroller. See for example, COMPTROLLER’S DECISION NO. 31,505
(April 20, 1994), STAR DOCUMENT NO. 9404H1297E01, which found extensive
renovations and improvements failed to meet the second prong of the test
because the life of the improvements exceeded the term of the lease, which
was only five (5) years.

Determining the life of the real property improvements for the second prong of
the test is a fact issue, and the Comptroller’s office has not developed a
standard for when the test is met. ***** references Appendix A, titled
“Class Codes”, of the State Property Accounting Process User’s Guide for
depreciation of state capital assets that sets 264 months (22 years) as the
useful life for buildings and building improvements. [ENDNOTE 2]

The Campus’s expected useful life of 22 years is less than the 25 year (300
month) term of the Lease. Therefore, the 25 year term of the Lease is
sufficiently long to ensure that ***** will have the primary use and
benefit of the improvements under the Lease. The second part of the test is
met, and the Lease is exempt under Texas Tax Code Section 151.311.

This ruling does not address the validity of any refund claim that might be
submitted by **. * may request a refund of Texas Sales and
Use Tax paid on taxable items purchased for construction of the Campus.
**** must obtain a properly completed assignment of right to refund for
items on which it did not directly pay the Texas Sales and Use Tax that are
part of any refund request. Any refund request is subject to the requirements
of Rule 3.325 (Refunds and Payments Under Protest).

If you have questions about this private letter ruling, please email us at
https://www.window.state.tx.us/taxhelp/ and reference Private Letter Ruling

143430052.

Sincerely,

Tax Policy Division

ENDNOTES:

1. The Association of Corporate Counsel defines a build-to-suit (or
   design-build) lease to be “essentially a landlord/developer’s agreement to
   construct a purpose built building, usually for a single tenant. The landlord
   will typically own or ground lease the lands (and once constructed, the
   building) and has the option of re-letting the building to a new tenant upon
   the expiry of the term of the build-to-suit lease to the original tenant.
   Build-to-suit leases typically are for a longer term than a normal lease in
   order to permit the landlord to recoup its investment over the duration of the
   lease term.”

2. In its request for a Private Letter Ruling, ** does not request a
   determination for the “building shell”. The guidance provided in this response
   does not approve or disapprove of **’s depreciation methodology or its
   choice of applicable class codes or descriptions.