What Is the Section 168(h) Election?

The Section 168(h) election is a choice provided in the Internal Revenue Code that is relevant in partnership structures involving tax-exempt organizations. When a partnership has a tax-exempt partner, its property can be subject to less favorable depreciation rules. The election offers a path to alter how depreciation deductions are determined for the partnership’s property. This choice is relevant because the tax code has a distinct set of rules for property used by entities not subject to federal income tax, and the decision is made in the year the property is first put to use.

Understanding Tax-Exempt Use Property

A “tax-exempt entity” for these depreciation rules includes federal, state, and local governments, their agencies, and organizations exempt from tax under Section 501(c), such as charities and educational institutions. When these entities lease property or are partners in a partnership that owns property, the asset may be classified as “tax-exempt use property.” This classification requires the owner to use the Alternative Depreciation System (ADS) to calculate depreciation.

ADS requires an owner to spread depreciation deductions over a longer period than the more common Modified Accelerated Cost Recovery System (MACRS). For example, nonresidential real property is depreciated over 40 years under ADS, compared to 39 years under MACRS, and without accelerated methods. This slower depreciation reduces the annual tax deduction available to the property owner.

For nonresidential real property, the rules are more complex; the property becomes tax-exempt use property only if it is subject to a “disqualified lease.” A lease is considered disqualified if more than 35% of the property is leased to tax-exempt entities and certain other conditions are met.

Conditions for a disqualified lease include the tax-exempt entity participating in tax-exempt bond financing for the property, the lease involving a sale and leaseback of the property by the entity, or the lease containing a fixed purchase price option. These rules are designed to prevent tax-exempt entities from indirectly transferring depreciation benefits, which they cannot use, to a taxable entity.

The Mechanics of the 168(h) Election

The Section 168(h) election is made by a “tax-exempt controlled entity,” which is a corporation owned by one or more tax-exempt organizations. By making this election, the controlled entity chooses not to be treated as a tax-exempt entity for the purposes of determining if partnership property is “tax-exempt use property.”

The function of this election is to allow a partnership, in which the controlled entity is a partner, to avoid the Alternative Depreciation System (ADS). This is relevant if the partnership’s allocations of income and loss are not “qualified.” A qualified allocation is one where the tax-exempt partner is allocated the same percentage share of every partnership item, and that share remains constant. If allocations are not qualified, a portion of the partnership’s property is deemed tax-exempt use property.

By having the controlled entity make the election, the partnership can use the more accelerated MACRS depreciation for its property. The trade-off is that the tax-exempt parent organization must treat any dividends or interest it receives from the controlled entity, as well as any gain from selling its interest, as unrelated business taxable income (UBTI). UBTI is subject to income tax, which the tax-exempt organization would otherwise not pay.

Required Information and Statement

To make the Section 168(h) election, the tax-exempt controlled entity must prepare a specific statement to include with its tax return. This statement serves as the formal declaration of the election.

The statement must be titled “Election under Section 168(h)(6)(F)(ii)” to ensure it is correctly identified by the IRS. The entity must be clearly identified by its name, address, and taxpayer identification number. The statement also needs to include the taxable year for which the election is effective, which is the year the property was placed in service.

Making and Revoking the Election

Once the election statement is prepared, it must be attached to the tax-exempt controlled entity’s timely filed federal income tax return (e.g., Form 1120) for the year the property is placed in service. This includes any valid extensions for filing the return. The act of attaching the statement to the return constitutes the formal making of the election.

The tax-exempt parent organization may also need to attach a copy of the election statement to its own informational return, such as Form 990. This ensures all relevant parties and the IRS have a record of the choice.

Once the Section 168(h) election is made, it is irrevocable. The entity cannot change its mind in a subsequent year. Revoking the election requires obtaining consent from the IRS Commissioner, which is granted only in rare and unusual circumstances.