Tax Issues for Real Estate Leasing By Tax-Exempt Organizations

The applicable Treasury Regulations under the federal Tax Code contain additional details to help determine whether rent receipts depend in whole or in part on the income or profits derived from any person from the property leased. These include the following (the regulations use the term “rents from real property” to mean rental income that is excluded from UBTI):

• Since no amount received with respect to any real property qualifies as “rents from real property” where the determination of the amount depends in whole or in part on the income or profits derived by any person from the property, even if a small portion of the rental formula is based in any person's profit from the property, then the entire rental income will be taxable. However, no amount received shall be excluded from the term “rents from real property” solely by reason of being based on a fixed percentage or percentages of receipts or sales (whether or not receipts or sales are adjusted for returned merchandise, or federal, state, or local sales taxes).
• Thus, “rents from real property” would include rents where the lease provides for differing percentages or receipts or sales from different departments or from separate floors of a retail store so long as each percentage is fixed at the time of entering into the lease and is not renegotiated during the term of the lease in a manner having the effect of basing the rent on income or profits.
• An amount received as rent that is based on a fixed percentage or percentages of the lessee's receipts or sales reduced by escalation receipts (including those determined under a formula clause) will qualify as “rents from real property.” Escalation receipts include amounts received by a prime tenant from subtenants by reason of an agreement that rent shall be increased to reflect all or a portion of an increase in real estate taxes, property insurance, operating costs of the prime tenant, or similar items customarily included in lease escalation clauses.
• An amount received as rent which consists, in whole or in part, of one or more percentages of the lessee's receipts or sales in excess of determinable dollar amounts may qualify as “rents from real property,” but only if: 1) the determinable amounts do not depend in whole or in part on the income or profits of the lessee; and 2) the percentages and the determinable amounts are fixed at the time the lease is entered into and are not renegotiated during the term of the lease in a manner having the effect of basing rent on income or profits.
• If a tax-exempt organization leases real property to a tenant under terms other than solely on a fixed sum rental (for example, a percentage of the tenant's gross receipts), and the tenant subleases all or a part of such property under an agreement which provides for a rental based in whole or in part on the income or profits of the sublessee, the entire amount of the rent received by the tax-exempt organization from the prime tenant with respect to such property is disqualified as “rents from real property.” The IRS has issued a number of favorable rulings, however, in which the rent is tied to cash flow rather than to profits.

IRS-Sanctioned Formula

In private rulings, the IRS has sanctioned several ways in which a prime lease to a tenant that subleases to others can structure a gross receipts formula for rent that will not result in the rental payments being characterized as based in whole or in part on profits. For example, the IRS has permitted a rental formula based on shifting percentages applied to gross sales of the preceding year. A rental formula may include a fixed-base rent, a percentage rent above some fixed base, additional rent such as from sharing of sale or refinancing proceeds, and reimbursement for all or part of increases in CAM (common area maintenance), real estate taxes, and property insurance. Inflation increases may be built into a rental formula.

In addition to structuring rental payments pursuant to a cash flow formula, a rental formula may also incorporate certain exclusions from rent without causing the rent to be characterized as based on net income or profits. For example, the regulations described above permit a rental formula to be based on a percentage of sales or receipts, even if such sales or receipts are adjusted for returned merchandise and federal, state or local sales taxes. The IRS has ruled privately that in determining percentage rentals, the following items may be excluded from gross income: “any amount received by the Prime Tenant from Space Tenants on account of real estate taxes, assessments, operating costs and common area charges under so-called escalation clauses or otherwise.” In addition, the IRS has permitted the exclusion of amounts received by a ground lessee from occupancy tenants as reimbursement for common area expenses.

The IRS has permitted the following exclusions from gross receipts in determining percentage rent: 1) escalation payments; 2) additional service adjustments; 3) amounts received by the lessee from sales of its interest in improvements located on the premises; 4) receipts from the lessee's other businesses where the only connection with the project is that the entity through which such business is conducted occupies space in the project; 5) proceeds from casualty insurance on the project; 6) subtenant security deposits; and 7) reimbursements of the lessee's costs of preparing, altering or restoring improvements on the project. The additional service adjustments are amounts which reimburse the lessee for costs in providing services and electric utilities outside of normal operating hours or over and above standard services.

In addition, the IRS has permitted a percentage formula based on the tenant's gross sales reduced by: 1) returns and refunds in fact made by the tenant; 2) exchange of merchandise between stores of the tenant where such exchanges are made solely for the convenient operation of the tenant's business and not for the purpose of consummating a sale that has theretofore been made; 3) sales of fixtures after substantial use thereof in the conduct of the tenant's business on the premises; and 4) the amount of any city, county, state or federal sales or excise taxes on such sales, which is both added to the selling price (or absorbed therein) and paid to the taxing authority by the tenant.

Additional Issues if the Property Is Developed and Sold

Space does not permit a full discussion here of the issues involved where the exempt organization wishes to develop and then sell its vacant land, but the underlying problem is similar. Although gain from the sale of real property is excluded from UBTI (with the important proviso that the property is not subdivided into, or otherwise sold as, a sufficiently large number of lots so that the organization is treated as being in the business of selling lots), engaging in the business of developing the property will give rise to taxable income. The most common solution is also to lease to the developer ' making sure the rental provisions follow the guidelines discussed above ' who will then sell the individual lots. The goal is to devise a workable rental formula that will afford a return to the exempt organization of an amount that would mimic its share of the profits without actually being so characterized. Alternatively, the parties can use a deferred sales contract, whereby the developer would make payments to the organization only as the units begin to be sold, again using a sales formula to afford an adequate return to the organization without causing it to be treated as participating in the profits from the development activities.

The final article in this series will examine the special cautions that must be observed if the real estate is debt-financed.

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 (March 2009) examined the issues involved when a tax-exempt organization leases improved property to one or more parties. The primary issue examined in that article was whether or not the lease payments constituted, in whole or in part, payments for services provided to the tenants, rather than purely payments for the rental of real property.

Part Two, published last month, reviewed “UBIT,” the unrelated business income tax that the federal tax code imposes, computed at the corporate income tax rate, on the unrelated business taxable income (“UBTI”) of most exempt organizations. The article began a discussion of 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 article herein continues the discussion.

Internal Revenue Service Approach

The applicable Treasury Regulations under the federal Tax Code contain additional details to help determine whether rent receipts depend in whole or in part on the income or profits derived from any person from the property leased. These include the following (the regulations use the term “rents from real property” to mean rental income that is excluded from UBTI):

• Since no amount received with respect to any real property qualifies as “rents from real property” where the determination of the amount depends in whole or in part on the income or profits derived by any person from the property, even if a small portion of the rental formula is based in any person's profit from the property, then the entire rental income will be taxable. However, no amount received shall be excluded from the term “rents from real property” solely by reason of being based on a fixed percentage or percentages of receipts or sales (whether or not receipts or sales are adjusted for returned merchandise, or federal, state, or local sales taxes).
• Thus, “rents from real property” would include rents where the lease provides for differing percentages or receipts or sales from different departments or from separate floors of a retail store so long as each percentage is fixed at the time of entering into the lease and is not renegotiated during the term of the lease in a manner having the effect of basing the rent on income or profits.
• An amount received as rent that is based on a fixed percentage or percentages of the lessee's receipts or sales reduced by escalation receipts (including those determined under a formula clause) will qualify as “rents from real property.” Escalation receipts include amounts received by a prime tenant from subtenants by reason of an agreement that rent shall be increased to reflect all or a portion of an increase in real estate taxes, property insurance, operating costs of the prime tenant, or similar items customarily included in lease escalation clauses.
• An amount received as rent which consists, in whole or in part, of one or more percentages of the lessee's receipts or sales in excess of determinable dollar amounts may qualify as “rents from real property,” but only if: 1) the determinable amounts do not depend in whole or in part on the income or profits of the lessee; and 2) the percentages and the determinable amounts are fixed at the time the lease is entered into and are not renegotiated during the term of the lease in a manner having the effect of basing rent on income or profits.
• If a tax-exempt organization leases real property to a tenant under terms other than solely on a fixed sum rental (for example, a percentage of the tenant's gross receipts), and the tenant subleases all or a part of such property under an agreement which provides for a rental based in whole or in part on the income or profits of the sublessee, the entire amount of the rent received by the tax-exempt organization from the prime tenant with respect to such property is disqualified as “rents from real property.” The IRS has issued a number of favorable rulings, however, in which the rent is tied to cash flow rather than to profits.

IRS-Sanctioned Formula

In private rulings, the IRS has sanctioned several ways in which a prime lease to a tenant that subleases to others can structure a gross receipts formula for rent that will not result in the rental payments being characterized as based in whole or in part on profits. For example, the IRS has permitted a rental formula based on shifting percentages applied to gross sales of the preceding year. A rental formula may include a fixed-base rent, a percentage rent above some fixed base, additional rent such as from sharing of sale or refinancing proceeds, and reimbursement for all or part of increases in CAM (common area maintenance), real estate taxes, and property insurance. Inflation increases may be built into a rental formula.

In addition to structuring rental payments pursuant to a cash flow formula, a rental formula may also incorporate certain exclusions from rent without causing the rent to be characterized as based on net income or profits. For example, the regulations described above permit a rental formula to be based on a percentage of sales or receipts, even if such sales or receipts are adjusted for returned merchandise and federal, state or local sales taxes. The IRS has ruled privately that in determining percentage rentals, the following items may be excluded from gross income: “any amount received by the Prime Tenant from Space Tenants on account of real estate taxes, assessments, operating costs and common area charges under so-called escalation clauses or otherwise.” In addition, the IRS has permitted the exclusion of amounts received by a ground lessee from occupancy tenants as reimbursement for common area expenses.

The IRS has permitted the following exclusions from gross receipts in determining percentage rent: 1) escalation payments; 2) additional service adjustments; 3) amounts received by the lessee from sales of its interest in improvements located on the premises; 4) receipts from the lessee's other businesses where the only connection with the project is that the entity through which such business is conducted occupies space in the project; 5) proceeds from casualty insurance on the project; 6) subtenant security deposits; and 7) reimbursements of the lessee's costs of preparing, altering or restoring improvements on the project. The additional service adjustments are amounts which reimburse the lessee for costs in providing services and electric utilities outside of normal operating hours or over and above standard services.

In addition, the IRS has permitted a percentage formula based on the tenant's gross sales reduced by: 1) returns and refunds in fact made by the tenant; 2) exchange of merchandise between stores of the tenant where such exchanges are made solely for the convenient operation of the tenant's business and not for the purpose of consummating a sale that has theretofore been made; 3) sales of fixtures after substantial use thereof in the conduct of the tenant's business on the premises; and 4) the amount of any city, county, state or federal sales or excise taxes on such sales, which is both added to the selling price (or absorbed therein) and paid to the taxing authority by the tenant.

Additional Issues if the Property Is Developed and Sold

Space does not permit a full discussion here of the issues involved where the exempt organization wishes to develop and then sell its vacant land, but the underlying problem is similar. Although gain from the sale of real property is excluded from UBTI (with the important proviso that the property is not subdivided into, or otherwise sold as, a sufficiently large number of lots so that the organization is treated as being in the business of selling lots), engaging in the business of developing the property will give rise to taxable income. The most common solution is also to lease to the developer ' making sure the rental provisions follow the guidelines discussed above ' who will then sell the individual lots. The goal is to devise a workable rental formula that will afford a return to the exempt organization of an amount that would mimic its share of the profits without actually being so characterized. Alternatively, the parties can use a deferred sales contract, whereby the developer would make payments to the organization only as the units begin to be sold, again using a sales formula to afford an adequate return to the organization without causing it to be treated as participating in the profits from the development activities.

The final article in this series will examine the special cautions that must be observed if the real estate is debt-financed.

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