If a building owner leases space to a 501(c)(3) organization and pays for remodeling before the exempt tenant moves in, can the contractor's labor and materials be purchased tax-free?

Subject

Governmental Entities/Exempt Org — Leases Realty To Non — Exempt Lessor Who Makes Improvements To Realty Prior To Occupancy — Two Prong Test To Determine Primary Use And Benefit

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9403L1292F14

Plain-English Summary

A building owner ("Company B") bought an office building and master-leased it to EDUCATION CENTER, a 501(c)(3) organization formed for educational purposes. Before EDUCATION CENTER moved in, Company B hired a contractor to remodel part of the building for EDUCATION CENTER's use, and Company B asked the Comptroller whether it could give the contractor an exemption certificate so the labor and materials for that remodeling could be purchased tax-free.

The Comptroller ruled yes, because the lease showed the remodeling was for the primary use and benefit of the exempt tenant rather than the taxable building owner. The lease terms cited in the request explained why: the rent EDUCATION CENTER paid was set to match Company B's financing costs (so Company B made no profit on the arrangement), EDUCATION CENTER gained equity in the property as it made lease payments, and EDUCATION CENTER held an option to buy the building outright for a nominal price once the lease term and options ended. Because those lease terms meant EDUCATION CENTER — not Company B — was the real economic beneficiary of the improvements, Company B was allowed to issue the contractor (CONSTRUCTION COMPANY) an exemption certificate in lieu of tax for the remodeling labor and materials.

The Comptroller expressly noted the ruling was based on the specific facts submitted, and that "other facts, though similar, may yield different results" — signaling this is a fact-intensive, two-pronged inquiry into who truly uses and benefits from the improved space, not a blanket rule for every owner-lessor/exempt-tenant arrangement.

What This Means For You

If you own property and lease it to a 501(c)(3) or governmental exempt organization: Whether you can buy pre-occupancy remodeling tax-free depends on the specific economics of your lease. Terms that point toward the exempt tenant being the primary beneficiary — such as rent calibrated to just cover your financing costs with no profit margin, the tenant accruing equity through its payments, and a nominal-price purchase option — can support issuing the contractor an exemption certificate.

If you are a contractor performing remodeling for a building later occupied by an exempt organization: Ask the building owner whether they have obtained (or can support) a ruling like this one before accepting an exemption certificate in lieu of tax. The exemption here turned on specific facts about who truly benefited from the work, not simply on the eventual tenant's exempt status.

If your lease does not resemble this fact pattern: Because the Comptroller stressed that "other facts, though similar, may yield different results," an ordinary commercial lease to an exempt organization — without equity-building payments and a nominal purchase option — may not support the same tax-free treatment.

Q&A

Q: Why was the building owner (not the exempt organization) allowed to buy the remodeling tax-free?
A: The Comptroller found the remodeling was for the primary use and benefit of the exempt tenant, EDUCATION CENTER, even though Company B nominally owned the building. Because the lease was structured so EDUCATION CENTER gained equity through its payments and could purchase the building at a nominal price when the lease ended, EDUCATION CENTER — not Company B — was treated as the real party benefiting from the improvements.

Q: What lease features mattered to this ruling?
A: The letter highlights that EDUCATION CENTER accrued equity in the property as it made lease payments and had an option to buy the property at a nominal price once the lease term and options were over. The underlying request letter also described rent calibrated to match Company B's financing obligations, so Company B stood to make no profit from the lease.

Q: Does this mean any lease to a nonprofit tenant qualifies for tax-free remodeling?
A: No. The Comptroller stated the opinion was "rendered based on the facts you submitted" and that "other facts, though similar, may yield different results," so the outcome depends on the specific lease terms showing the exempt tenant is the primary beneficiary, not merely that the eventual occupant is a 501(c)(3) organization.

Original ruling text

March 3, 1994

Dear Mr. **:

Thank you for your recent letter regarding the tax treatment of remodeling a
portion of a building that has been leased to EDUCATION CENTER, a 501(c)(3)
organization. The text of your letter and the lease agreement you submitted
are included by reference.

The remodeling being purchased by the building owner is for the primary use and
benefit of the exempt entity. The exempt entity receives equity in the
property as it makes the lease payments, and, has the option to purchase the
property at a nominal price when the lease term and options are over.
Accordingly, COMPANY B, the owner of the building, may give CONSTRUCTION
COMPANY an exemption certificate in lieu of tax for purchase of the labor and
materials.

This opinion is rendered based on the facts you submitted. Other facts, though
similar, may yield different results.

If you have questions or need more information, please call or write. You may
reach me by calling toll free, (800) 531- 5441 (ext.34680). My direct line
number is (512) 463-4680. The number for FAX transmissions is (512) 475-0900.
You may write to me in care of Tax Administration Division.

Sincerely,

Al Van Allen
Tax Administration Division

February 22, 1994

VIA FEDERAL EXPRESS

Mr. Al Van Allen
Comptroller of Public Accounts
Tax Administration Department
111 West 6th Street
Austin, Texas 78701

Re: COMPANY B

Dear Mr. Van Allen:

**, a paralegal with our office, has spoken with you earlier
(February 17th) regarding our request to obtain a Texas Sales and Use Tax
Exemption Certificate with respect to materials (and labor, if possible)
purchased and incorporated into the work associated with the renovation of a
part of the old **'s building in ** which is being
converted into the EDUCATION CENTER.

The list of players are as follows:

1. COMPANY B: The Owner of the building;

2. EDUCATION CENTER: A 501(c)(3) Corporation which is the Master Tenant of the
   building; and

3. CONSTRUCTION COMPANY: The Contractor.

Basically, COMPANY B purchased the Building and master leased the building to
EDUCATION CENTER, a 501 (c)(3) Corporation established for educational purposes
(the "EDUCATION CENTER lease"). A copy of the Internal Revenue Service ruling
is enclosed. A copy of the EDUCATION CENTER lease is also enclosed herewith, as
well as the Construction Contract. EDUCATION CENTER has, in turn, leased a
portion of the premises to COMMUNITY COLLEGE and will be entering into license
agreements with other colleges and universities who desire educational space in
the EDUCATION CENTER.

The EDUCATION CENTER lease is nothing more than a financing vehicle for
EDUCATION CENTER. EDUCATION CENTER did not desire to purchase the building
because of the existence of asbestos in the building. The EDUCATION CENTER
Lease is structured in such a manner that COMPANY B, as Owner, does not stand
to make any profit from the EDUCATION CENTER Lease. In that regard, the
following lease provisions are noteworthy:

(i) the amount of rental payable thereunder by EDUCATION CENTER to COMPANY B
was calculated such that the rental obligations of EDUCATION CENTER match up to
the financial obligations of COMPANY B incurred or to be incurred by it to meet
its obligations under the EDUCATION CENTER lease, including the construction of
tenant improvements for the EDUCATION CENTER.

(ii) COMPANY B is required to pay $** per year in operating
expenses, being the amount of estimated operating expenses. EDUCATION CENTER
is obligated for any operating expenses in excess of the foregoing.

(iii) The EDUCATION CENTER Lease provides to EDUCATION CENTER the right to
acquire the EDUCATION CENTER Building at any time for $** so long
as EDUCATION CENTER has paid sufficient rental to discharge the debt incurred
by COMPANY B in connection with the EDUCATION CENTER Building and to return the
capital invested by private investors in COMPANY B to the extent such funds are
used in connection with the EDUCATION CENTER Building.

(iv) In order to account for any possible slippage in the match-up of the
obligations of EDUCATION CENTER to COMPANY B and the obligations of COMPANY B
to EDUCATION CENTER, EDUCATION CENTER was also granted a ten percent (10%)
profits interest in the sale, refinancing or syndication of the Adjoining
Building.

(v) Because EDUCATION CENTER is a not for profit corporation, the only remedy
of COMPANY B in the event of a default by EDUCATION CENTER is to terminate the
Lease, having expressly waived the right to seek any damages from EDUCATION
CENTER

(vi) To further ensure that COMPANY B will not make a profit from the EDUCATION
CENTER Lease, both the condemnation and casualty provisions require COMPANY B
to pay over to EDUCATION CENTER any condemnation proceeds or insurance proceeds
which are not required to retire debt incurred by COMPANY B for the EDUCATION
CENTER Building and the return of capital to the private investors of COMPANY B
EDUCATION CENTER will be obtaining the funds necessary to meet its obligations
under the EDUCATION CENTER use from foundation grants and pledges from
individuals and businesses. To assist you in your understanding of EDUCATION
CENTER, I have enclosed herewith a submittal by EDUCATION CENTER to
** Foundation for a grant.

Inasmuch as construction is underway, we would appreciate your response at your
earliest convenience. If you need anything further, please advise.

Very truly yours,

cc: **

NOTE: Previous Accession Number 9403178L