Is a charter school's 25-year lease financing a student-housing apartment complex for international students an exempt improvement-to-realty contract?

Plain-English summary

The Texas Comptroller ruled that a charter school's 25-year lease financing a new student-housing apartment complex — built adjacent to its campus for international students in its Mandarin-immersion program — IS an exempt improvement-to-realty contract under Section 151.311, letting the landlord buy construction materials and qualifying services tax-free.

This case extends the same two-prong exempt-contract test (from Comptroller's Decision No. 28,391 (1993)) beyond a school building itself to ancillary student housing. The school qualified as an exempt entity under prong one. On prong two, the Comptroller again used its 22-year useful-life benchmark for non-componentized buildings and found the complex's 25-year lease term sufficiently long, with no early-termination provision cutting it short — so the school, not the landlord, gets the primary benefit of the improvements for their full useful life. The exemption applied even though the housing isn't classroom space, because it's part of the school's state-funded operations serving its enrolled international students.

What this means for you

Charter schools with international or boarding programs

The Section 151.311 exemption isn't limited to classroom buildings — it can extend to ancillary facilities like student housing, so long as the lease itself passes the same two-prong test (qualified exempt tenant + sufficiently long term relative to useful life, without undercutting early-termination rights).

Developers and landlords building ancillary facilities for tax-exempt schools

A build-to-suit lease for supporting facilities (not just the primary school building) can still qualify for tax-free purchasing under Section 151.311 if it meets the same lease-term-vs-useful-life standard applied to the school's main campus.

Accountants and tax professionals

Compare this ruling with a companion 2018 ruling on the same tenant's separate school building lease (also exempt, same 25-year/22-year analysis) — both apply the identical Comptroller's Decision No. 28,391 (1993) framework, showing the Comptroller applying the test consistently across a tax-exempt organization's related facilities.

Common questions

Q: Does the Section 151.311 improvement-to-realty exemption cover only classroom buildings?
A: No. As this ruling shows, it can extend to ancillary facilities like student housing, as long as the facility serves the exempt organization's operations and the lease independently passes the two-prong test.

Q: What made the 25-year term "sufficiently long" here?
A: It exceeded the Comptroller's 22-year useful-life benchmark for the type of building, and the lease had no early-termination right that would let the tenant exit before that useful life expired.

Q: Can another school with a similar off-campus facility rely on this ruling?
A: No. It's binding on the Comptroller only for the requesting taxpayer and facts presented, and cannot be relied on by any other taxpayer.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.311 (Taxable Items Incorporated Into or Used for Improvement of Realty of an Exempt Entity)
• Tex. Tax Code § 151.310 (Religious, Educational, and Public Service Organizations)
• 34 Tex. Admin. Code § 3.291(a)(5) (Contractors — exempt contract definition)
• 34 Tex. Admin. Code § 3.322 (Exempt Organizations)
• 34 Tex. Admin. Code § 3.1(d)(1) (prospective reliance); § 3.325 (Refunds and Payments Under Protest)
• Tex. Educ. Code §§ 12.106, 12.128 (charter school state funding; property status)
• Comptroller's Decision No. 28,391 (1993) (originating two-prong test)
• Comptroller's Decision No. 31,505 (1994) (five-year lease failed second prong)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201805019L

Original ruling text

May 30, 2018

RE: Private Letter Ruling No. 20170920091222

** Taxpayer No. **

Dear ***:

We issue this private letter ruling in accordance with Rule 3.1, Private Letter Rulings and General Information Letters.[ENDNOTE: 1] We are responding to your request dated Sept. 12, 2017 and email dated Nov. 2, 2017. Detrimental reliance relief is provided in accordance with Rule 3.10, Taxpayer Bill of Rights.

You requested guidance on the exemption in Section 151.311 (Taxable Items Incorporated Into or Used for Improvement of Realty of an Exempt Entity) for tangible personal property and taxable services purchased for use in the performance of a contract to improve realty for an organization exempt under Section 151.310 (Religious, Educational, and Public Service Organizations).

Facts Presented

** (Taxpayer) 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 Sept. 8, 2011. As of Aug. 19, 2013, Taxpayer met the qualifications for exemption from Texas Sales or Use Tax as outlined in Rule 3.322 (Exempt Organizations).

Taxpayer provided documentation regarding its charter and a Build to Suit Lease and Option (Lease). The facts are based on information contained within the documentation provided by Taxpayer. Our response is based on these facts as presented.

On May 26, 2013, Taxpayer entered into a charter contract with the Texas Education Agency (TEA) to operate an open-enrollment charter school through July 31, 2018. The TEA authorized Taxpayer’s campus located at **, CITY, Texas * (Campus). The Campus includes an elementary, middle, and high school.

As part of the curriculum, students at the Campus receive instruction in Mandarin Chinese and Taxpayer permits enrollment of students from China. Taxpayer leased a parcel of land adjacent to the Campus located at **, CITY, Texas *** for construction of an apartment complex for student housing for the international students to live in while they attend school (Complex).

On Jan. 28, 2014, Taxpayer entered into the Lease with COMPANY (Landlord) to finance construction of the Complex. Under the Lease, Landlord owned or agreed to acquire a site for the Complex, construct the Complex per Taxpayer’s specifications, and lease the Complex to Taxpayer for a term beginning on the Completion of Landlord Improvements, as defined in the Lease, and continuing for a period of 25 years ending on the Expiration Date, as defined in the Lease. Per the Lease, Substantial Completion was to occur no later than July 31, 2014. Under the Lease, Taxpayer has an option to purchase the Complex during the period described in the Lease.

The site of the Complex requires the construction of a new facility on previously unimproved real property. The Lease requires Landlord to implement the construction projects and make all of the improvements to the Complex described within Exhibit B to the Lease. The costs of the improvements are incorporated into the Lease and paid for by Taxpayer in monthly installments using funds received from the State of Texas (State). All construction plans are subject to Taxpayer’s approval, and Landlord shall adopt any changes to the plans requested by Taxpayer unless the changes would not comply with applicable governmental rules and regulations.

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

Taxpayer holds the deemed state-owned property in trust from the benefit of the attending students. If Taxpayer 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).

Questions, Rulings, and Analysis

Our restatement of your questions is shown below, followed by our responses and analysis.

Question One: Is the Lease between Taxpayer and Landlord an exempt contract under Section 151.311?

Ruling One: The Lease is an exempt contract under Section 151.311 because it is a contract to improve realty for the primary use and benefit of an exempt entity.

Question Two: Can Landlord issue exemption certificates in lieu of paying tax on purchases of taxable items for use in performance of the exempt contract with Taxpayer?

Ruling Two: Landlord may issue exemption certificates in lieu of paying tax on purchases of taxable items for use in performance of the exempt contract. Taxable items include tangible personal property incorporated into the realty in the performance of the exempt contract; tangible personal property, other than machinery and equipment, necessary and essential for the performance of the exempt contract and completely consumed at the job site; and taxable services that meet the requirements in Section 151.311(c).

Analysis:

In relevant part, Section 151.311 addresses contracts for an improvement to realty for an organization exempted from sales and use tax under Section 151.310. Section 151.311 does not require that the exempt organization own the real property improvements. The Section may apply where the exempt organization leases the real property.

An “exempt contract” includes a contract with a non-exempt entity to improve real property for the primary use and benefit of an organization exempted under Section 151.310. See Rule 3.291(a)(5) (Contractors). The Comptroller 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 (1993).

First, the lessee must qualify for exempt status. Based on the facts presented, Taxpayer is a qualified tax-exempt entity under Section 151.310; therefore, Taxpayer 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. The Comptroller has consistently applied this test. See, for example, Comptroller’s Decision No. 31,505 (1994), 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 years.

Determining the life of the real property improvements for the second prong of the test is a fact issue, and the Comptroller has not developed a standard for when the test is met. Taxpayer did not state the Complex’s expected useful life. The Comptroller’s State Property Accounting Process User’s Guide – Appendix A – Class Codes (Class Codes) provides guidance when calculating the expected useful life for building improvements. According to the Class Codes, the useful life for buildings and building improvements – non-componentized is 264 months (22 years).

Using the Class Codes guideline, the Complex’s expected useful life of 22 years is less than the 25-year term found in the Lease. Therefore, the 25-year term of the Lease is sufficiently long to ensure that Taxpayer has the primary use and benefit of the improvements under the Lease. The second prong of the test is met, and the Lease is exempt under Section 151.311.

Section 151.311 creates an exemption from sales tax on the purchase of tangible personal property that is incorporated into the realty in the performance of an exempt contract. Section 151.311(a). Section 151.311 also exempts the purchase of tangible personal property, other than machinery or equipment and its accessories and repair and replacement parts, in the following circumstances: (1) the tangible personal property is necessary and essential for the performance of the exempt contract; and (2) the tangible personal property is completely consumed at the job site. Section 151.311(b).

The statute further provides that the purchase of a taxable service for use in the performance of an exempt contract is exempt if the service is performed at the job site and either (1) the contract expressly requires the specific service to be provided or purchased by the person performing the contract, or (2) the service is integral to the performance of the contracts. Section 151.311(c).

Under Rule 3.1(d)(1), these rulings may be relied on prospectively from the date of this response and do not address the validity of any refund claim that might be submitted by Taxpayer. Any refund request is subject to the requirements of Rule 3.325 (Refunds and Payments Under Protest).

Comptroller’s Decisions cited are on the Comptroller’s State Tax Automated Research (STAR) system. The Texas Tax Code, Texas Administrative Code, and the STAR system are accessible at www.comptroller.texas.gov/taxes/.

If you have questions about this private letter ruling, please email us through our website at https://comptroller.texas.gov/web-forms/tax-help/ and reference Private Letter Ruling No. 20170920091222.

Sincerely,

Tax Policy Division – Indirect Taxes

Texas Comptroller of Public Accounts

ENDNOTE:

1 Unless otherwise indicated, all references to “Section” are to the Texas Tax Code, and all references to “Rule” are to Title 34 of the Texas Administrative Code.