Loss-Trapping Rules Affect Not-for-Profit Leasing Arrangements

Under changes to "loss-trapping rules" (IRC Sec. 470), introduced by Section 470 of the American Jobs Creation Act of 2004, tax-exempt hospitals could lose the fixed priced purchasing option for certain leasing arrangements or face an increase in rents of as much as 15 percent, according to estimates by some companies.

Background on Loss-Trapping Rules

The loss-trapping rules (LTRs) were enacted to eliminate perceived tax abuses associated with highly structured, much publicized lease-in/lease-out (LILO) and sale-in/sale-out (SILO) transactions. The LTRs mitigate the benefits of leasing to tax-exempt entities by limiting a lessor's ability to use deductions associated with the ownership of equipment to the extent of the rental income generated in connection with the lease of the equipment. Significantly, however, Congress acknowledged the LTRs were not intended to "inhibit legitimate commercial leasing transactions that involve a significant and genuine transfer of the benefits and burdens of tax ownership between the taxpayer and the tax-exempt lessee." (1)

The LTRs apply to leases to tax-exempt entities that do not meet certain criteria. The criterion likely to be of most interest to providers pertains to property with a class life of more than seven years (other than fixed-wing aircraft and vessels), and says that if the lease includes an option for the lessee to purchase the property, the purchase price under the option must be the fair market value of the property at the time of exercise. Other criteria state:

Credit support must be limited to the lower of 20 percent of the equipment cost or 50 percent of the lowest fixed price purchase option;
If the lease is for a term longer than five years, the lessor must have a substantial equity investment, equal to at least 20 percent of its adjusted basis, in the property at the inception and throughout the term of the lease the lessee must not bear more than a minimal risk of loss.

Fixed Price Options

The leases of medical equipment by tax-exempt hospitals are not highly structured transactions. In fact, such leases are frequently executed without specific input from tax lawyers. However, many hospital executives frequently ask for a fixed purchase option price to ensure that if the hospital turns out to need the leased equipment that the "all in" cost of that equipment to the hospital is capped.

A fixed price purchase option is considered standard and customary in a lease of medical equipment. However, because medical equipment has a class life of nine years, the presence of the fixed price purchase option causes the lease to be subject to the LTRs despite the fact that the meets the criteria of a legitimate commercial leasing transaction that Congress did not want inhibited.

Technical Correction

Entities, including leasing companies, that are affected by these changes are asking Congress to make a technical correction to the AJCA changing the class life of medical equipment from nine years to seven years or less. The class life change will not undermine the intent of the LTRs. Moreover, the depreciation of medical equipment will not change as all equipment with a class life of more than four years but less than ten years is considered 5-year property. (2)

Healthcare financial executives whose organizations are affected by these changes also may wish to advise their members of Congress of the need for the class life change for medical equipment from nine years to seven years or less.