Tax Issues for Real Estate Leasing by Tax-Exempt Organizations

As described more fully in the earlier article, the federal tax code imposes a tax (referred to as the unrelated business income tax, or “UBIT”), computed at the corporate income tax rate, on the unrelated business taxable income (“UBTI”) of most exempt organizations. An unrelated business is any trade or business, the conduct of which is not substantially related to the performance by such organization of the functions that constitute the basis of its exemption from tax. The tax code provides for the categorical exclusion from UBTI of income from certain enumerated sources or arising from certain activities, including all rents from real property, provided that the determination of the amount of such rent does not depend in whole or in part on the net income or profits derived by any person from the property leased.

Avoiding Participation in Development

The basic problem to be resolved when a tax-exempt organization desires to develop and lease vacant land for reasons other than its exempt purposes is that this involves two separate activities: 1) developing the property; and 2) leasing the property.

Whereas income from leasing the property (in the form of rent) is generally excluded from UBTI, the activity of developing the property is considered to be an unrelated business, and the income attributable to that activity is, therefore, taxable to the organization. Although an exempt organization rarely acts as a developer itself, it frequently enters into a relationship with a professional developer to improve the property. Therefore, it is important to structure the relationship between the exempt organization and the developer appropriately. A joint venture or partnership (including a limited liability company taxed as a partnership) between the developer and the tax-exempt landowner, which is often used by non-exempt landowners to develop and lease property, will not work in the case of a tax-exempt landowner. Since the net income, or profits, of a partnership are attributed pro rata to the partners, and since the IRS deems the right to receive a share of the profits to be equivalent to participation in the activity giving rise to the profits, regardless of any actual physical involvement, the portion of the profits allocable to the exempt entity will be treated as taxable income from the unrelated business of developing real estate.

Use of Ground Lease with Appropriate Rental Formulas

The most frequent alternative that is used by tax-exempt organizations to avoid UBTI in the development and leasing of land is a ground lease, whereby the organization leases the property to a developer, which will then develop the property (often involving subdivision) and sublease the parcels to the ultimate tenants. Because the whole purpose for developing the property is frequently so that the exempt organization can realize a greater return from rentals than it would from simply leasing or selling the vacant land, the rental terms in the ground lease are frequently complex so that the rental income will approximate what the organization would have received as its share of the profits under a joint venture with the developer. For example, in addition to a flat base rental amount each year, the lease may include additional rental amounts based on a calculation of completed square footage of improvements and/or a percentage of gross revenues received by the developer from the ultimate tenants (“percentage rent”), often reduced by certain expenditures of such tenants, including maintenance charges for common areas, taxes and other assessments, or similar amounts. Furthermore, the lease may designate certain dates on which the base rent will increase, either by an amount fixed or calculable under the lease, or to be renegotiated by the parties by agreement or appraisal.

As mentioned above, the most frequent alternative that is used by tax-exempt organizations to avoid UBTI in the development and leasing of land is a ground lease, whereby the organization leases the property to a developer, which will then develop the property (often involving subdivision) and sublease the parcels to the ultimate tenants. It is important to take care in drafting a ground lease, however, since the subtractions from percentage rent for costs realized by the ultimate tenants could make what started out as rent based on gross proceeds look very much like rent based on net income or profits, even if not so expressed in the lease. Even if an agreement is called a lease, and the payments are all termed “rent,” the IRS will recharacterize the arrangement as a joint venture, or partnership (and tax the profits received by all “partners”), if it concludes that the reality is that the two parties are sharing profits, regardless of the terminology of the agreement. A provision permitting the parties to renegotiate the base rent at some point in the future based either on agreement or on a reappraisal of the property, can also be a hidden time bomb. Unless the lease carefully sets appropriate parameters to the process, there is nothing to prevent the parties from basing their new agreement on net income, or the appraiser from using net income of any person as one of the bases of the appraisal.

The next article in this series will discuss the applicable Treasury Regulations and IRS rulings under the federal Tax Code, as well as other issues that arise if the property is developed and sold.

Michael J. Huft is counsel at the law firm Schiff Hardin LLP, where he concentrates his practice in the area of tax-exempt organizations.

The first article in this series, published in March 2009, examined the issues involved when a tax-exempt organization leases improved property to one or more parties, for example a research building owned by a university leased to one or more private businesses. The primary issue examined in that article was whether or not the lease payments to the university constituted, in whole or in part, payments for services provided to the tenants, rather than purely payments for the rental of real property.

The article herein examines the issues involved when a tax-exempt organization owns a tract of vacant land that it wishes to develop and lease, so as to realize a stream of income from the land greater than would be realized by a simple sale or lease of the unimproved property. The third and final article in this series will examine the special cautions that must be observed if the real estate is debt-financed.

Review of UBIT

As described more fully in the earlier article, the federal tax code imposes a tax (referred to as the unrelated business income tax, or “UBIT”), computed at the corporate income tax rate, on the unrelated business taxable income (“UBTI”) of most exempt organizations. An unrelated business is any trade or business, the conduct of which is not substantially related to the performance by such organization of the functions that constitute the basis of its exemption from tax. The tax code provides for the categorical exclusion from UBTI of income from certain enumerated sources or arising from certain activities, including all rents from real property, provided that the determination of the amount of such rent does not depend in whole or in part on the net income or profits derived by any person from the property leased.

Avoiding Participation in Development

The basic problem to be resolved when a tax-exempt organization desires to develop and lease vacant land for reasons other than its exempt purposes is that this involves two separate activities: 1) developing the property; and 2) leasing the property.

Whereas income from leasing the property (in the form of rent) is generally excluded from UBTI, the activity of developing the property is considered to be an unrelated business, and the income attributable to that activity is, therefore, taxable to the organization. Although an exempt organization rarely acts as a developer itself, it frequently enters into a relationship with a professional developer to improve the property. Therefore, it is important to structure the relationship between the exempt organization and the developer appropriately. A joint venture or partnership (including a limited liability company taxed as a partnership) between the developer and the tax-exempt landowner, which is often used by non-exempt landowners to develop and lease property, will not work in the case of a tax-exempt landowner. Since the net income, or profits, of a partnership are attributed pro rata to the partners, and since the IRS deems the right to receive a share of the profits to be equivalent to participation in the activity giving rise to the profits, regardless of any actual physical involvement, the portion of the profits allocable to the exempt entity will be treated as taxable income from the unrelated business of developing real estate.

Use of Ground Lease with Appropriate Rental Formulas

The most frequent alternative that is used by tax-exempt organizations to avoid UBTI in the development and leasing of land is a ground lease, whereby the organization leases the property to a developer, which will then develop the property (often involving subdivision) and sublease the parcels to the ultimate tenants. Because the whole purpose for developing the property is frequently so that the exempt organization can realize a greater return from rentals than it would from simply leasing or selling the vacant land, the rental terms in the ground lease are frequently complex so that the rental income will approximate what the organization would have received as its share of the profits under a joint venture with the developer. For example, in addition to a flat base rental amount each year, the lease may include additional rental amounts based on a calculation of completed square footage of improvements and/or a percentage of gross revenues received by the developer from the ultimate tenants (“percentage rent”), often reduced by certain expenditures of such tenants, including maintenance charges for common areas, taxes and other assessments, or similar amounts. Furthermore, the lease may designate certain dates on which the base rent will increase, either by an amount fixed or calculable under the lease, or to be renegotiated by the parties by agreement or appraisal.

As mentioned above, the most frequent alternative that is used by tax-exempt organizations to avoid UBTI in the development and leasing of land is a ground lease, whereby the organization leases the property to a developer, which will then develop the property (often involving subdivision) and sublease the parcels to the ultimate tenants. It is important to take care in drafting a ground lease, however, since the subtractions from percentage rent for costs realized by the ultimate tenants could make what started out as rent based on gross proceeds look very much like rent based on net income or profits, even if not so expressed in the lease. Even if an agreement is called a lease, and the payments are all termed “rent,” the IRS will recharacterize the arrangement as a joint venture, or partnership (and tax the profits received by all “partners”), if it concludes that the reality is that the two parties are sharing profits, regardless of the terminology of the agreement. A provision permitting the parties to renegotiate the base rent at some point in the future based either on agreement or on a reappraisal of the property, can also be a hidden time bomb. Unless the lease carefully sets appropriate parameters to the process, there is nothing to prevent the parties from basing their new agreement on net income, or the appraiser from using net income of any person as one of the bases of the appraisal.

The next article in this series will discuss the applicable Treasury Regulations and IRS rulings under the federal Tax Code, as well as other issues that arise if the property is developed and sold.

Michael J. Huft is counsel at the law firm Schiff Hardin LLP, where he concentrates his practice in the area of tax-exempt organizations.