Tax Issues for Real Estate Leasing by Tax-Exempt Organizations

As described more fully in the first article in this series, 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.

Debt-Financed Property

The same section of the tax code that excludes rental income from real property from taxable income also provides that this exclusion will be negated in the case of unrelated income from debt-financed property. In addition, gain from the sale of debt-financed property that is not used in connection with the organization's exempt purposes will also be included in UBTI. It is important to note that income received by an exempt organization on account of debt-financed property will be included in the organization's UBTI regardless of whether the organization's activities constitute the regular conduct of a trade or business, unless, and to the extent that, one or more of the available exceptions applies. Property is considered to be debt-financed for this purpose if it is subject to any “acquisition indebtedness.” The term “acquisition indebtedness“ means, with respect to any debt-financed property, the unpaid amount of:

• The indebtedness incurred by the tax-exempt organization in acquiring or improving such property;
• The indebtedness incurred before the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement; and
• The indebtedness incurred after the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement and the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement.

'Indebtedness'

The term “indebtedness“ is not defined. However, the Code does provide that when property (regardless of how it was obtained) is acquired subject to a mortgage or other similar lien, the amount of the indebtedness secured by the mortgage or lien is considered as an indebtedness of the organization incurred in acquiring such property, even if the organization does not assume the mortgage or agree to pay the indebtedness. However, if the property was acquired by bequest or devise, the indebtedness secured by the mortgage shall not be considered to be indebtedness of the organization for a period of 10 years following the date of acquisition.

Where state law provides that a lien for taxes or a lien for assessments made by a state or a political subdivision thereof attaches to property prior to the time that such taxes or assessments become due or payable, then such lien shall be treated as similar to a mortgage, but only after the taxes or assessments become due and payable, and the organization has had an opportunity to pay such taxes or assessment in accordance with state law.

Computation of Taxable Income

The portion of gross income derived from debt-financed property that is to be taken into account in calculating UBTI is equal to the same percentage (but not in excess of 100% of the total gross income derived from or on account of the property as: 1) the average acquisition indebtedness for the taxable year with respect to the property is of; and 2) the average amount of the adjusted basis of the property during the period it is held by the organization during the taxable year.

For this purpose, “average acquisition indebtedness” means the average amount of outstanding principal indebtedness, determined on a monthly basis according to rules set forth in the applicable regulations, during the portion of the year that the organization holds the property, and the “average adjusted basis” is defined as the average of: 1) the adjusted basis of the property as of the first day during the taxable year that the organization holds the property; and 2) the adjusted basis of the property as of the last day during the taxable year that the organization holds the property.

In calculating UBTI, deductions that are directly connected with the debt-financed property, or with the income derived from the property, are allowed to the extent of the same percentage of gross income from the property that is includible in UBTI, as discussed above. Deductions are to be determined on a property-by-property basis. Thus, if the allowable deductions connected to one property are greater than the portion of gross income from that property that is to be taken into account, the excess cannot be used to offset the taxable income derived from another property. Any depreciation deduction that is allowed for the property must be computed by means of the straight-line method, for purposes of determining the amount of tax from debt-financed property, regardless of whether such method would otherwise be required.

Exceptions and Exemptions

The principal exception to the taxation of income from or on account of debt-financed property is that such income is taxable only to the extent that the use of the property is not substantially related to the organization's exempt purpose or function, the determination of which is to be made on the basis of all the facts and circumstances, including the portion of time the property is used for exempt purposes, the portion of the property so used, or a combination of both. Generally, if 85% or more of the use of debt-financed property is for exempt purposes, the use of the property will be considered to be substantially related to such exempt purposes. If that percentage falls below 85%, then the property will be considered to be debt-financed property (and the income therefrom taxable) to the extent that the use of the property is not substantially related to an exempt purpose of the organization.

If an exempt organization acquires real property with the intent of using it for exempt purposes commencing within 10 years of the date of acquisition, the property will not be treated as debt-financed: 1) as long as the organization does not abandon its intent to use the property for exempt purposes within 10 years; 2) if after the first five years, the organization establishes to the satisfaction of the IRS that it is reasonably certain the land will be so used; and 3) at the time of acquisition, the property is in the neighborhood of other real property owned by the organization that is used for exempt purposes. In the case of a church, a 15-year period is substituted for the 10-year period in the previous sentence, and there is no requirement that the church own other property in the neighborhood of the acquired property.

The Code provides three general exceptions to taxation of income derived from an unrelated business: 1) substantially all the work in carrying on the trade or business is performed for the organization without compensation; 2) the trade or business is carried on by the organization primarily for the convenience of its members, students, patients, officers, or employees (this exception is available only to 501(c)(3) organizations and state colleges or universities); and 3) a trade or business that consists of the selling of merchandise, substantially all of which has been received by the organization as gifts or contributions. Similarly, income derived from debt-financed property used in an unrelated business in any of these three circumstances will be exempt from taxation.

Income will not be taxed twice. That is, to the extent that income derived from property is already taxed as income from an unrelated business (typically because the property is used in the unrelated business), it will not also be taxed as income from debt-financed property. However, if such debt-financed property is sold, any gain on the sale of the property will nevertheless be included in the organization's UBTI to the same extent that it would have had the property that is sold not been used in the conduct of an unrelated business.

For purposes of determining whether property is used in connection with either an organization's exempt purpose or its conduct of an unrelated business, the use of the property by an exempt organization that is related to the organization owning the property shall be treated as such use by the organization owning the property.

'Acquisition Indebtedness'

With certain exceptions, the term “acquisition indebtedness“ does not apply to indebtedness incurred by a “qualified organization” in acquiring or improving any real property (for this purpose, an interest in a mortgage is not treated as real property). For the purpose of this exemption, a “qualified organization” is: 1) an educational institution (i.e., schools, colleges, universities, and similar organizations) and their affiliated supporting organizations; 2) a qualified trust that is a stock bonus, pension, or profit-sharing plan; 3) exempt multi-parent title-holding organizations; and 4) certain retirement income accounts. This exemption does not apply if any of the following six conditions is true:

1. The price for the acquisition or improvement is not fixed as of the date of the acquisition or completion of the improvement;
2. The amount of any indebtedness (or other amount payable with respect to the indebtedness or the time for paying any such amount) is dependent in any way upon any revenue, income or profits derived from the real property;
3. The real property is at any time after the acquisition leased by the organization to the person selling the property to the organization or to certain persons or entities related to the seller;
4. In the case of real estate acquired by a qualified trust, the real estate is acquired from, or leased by the trust to, persons bearing certain relationships to the trust or the plan with respect to which the trust was formed (these relationships are described in the tax code at greater length than can be set forth here);
5. Any person described in the previous two bullet points provides the organization with financing in connection with the acquisition or improvement; or
6. The real property is held by a partnership, unless the partnership meets a series of requirements set forth in the tax code.

Finally, the term “acquisition indebtedness” does not include any indebtedness, the incurrence of which is inherent in the performance of the organization's exempt purpose, for example, the indebtedness incurred by an exempt credit union in accepting deposits from its members.

Conclusion

The subject of unrelated debt-financed income is complex, and the space available in this article is sufficient only for an overview. In specific circumstances, an organization should always consult its tax adviser.

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 three articles in this series (Commercial Leasing Law & Strategy, March, August, and September 2009) examined the issues involved when a tax-exempt organization leases improved property to one or more parties, or develops vacant land for lease or sale to third parties. The primary issues examined in those articles were how to structure the lease payments or the relationship with the developer of the land to avoid having payments to the tax-exempt organization subject to tax for engaging in a business unrelated to the organization's exempt purpose. In these earlier articles, a basic assumption was that the tax-exempt organization did not carry or incur any debt with respect to the real estate in question.

This article, the last in the series, examines the issues involved when a tax-exempt organization carries or incurs debt with respect to real estate from, or to which, it receives income unrelated to its exempt purposes. This is an important consideration, because the presence of such debt may negate any advantage obtained by the careful structuring of the transactions, as discussed in the earlier articles, with respect to avoiding tax on unrelated business income.

Review of UBIT

As described more fully in the first article in this series, 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.

Debt-Financed Property

The same section of the tax code that excludes rental income from real property from taxable income also provides that this exclusion will be negated in the case of unrelated income from debt-financed property. In addition, gain from the sale of debt-financed property that is not used in connection with the organization's exempt purposes will also be included in UBTI. It is important to note that income received by an exempt organization on account of debt-financed property will be included in the organization's UBTI regardless of whether the organization's activities constitute the regular conduct of a trade or business, unless, and to the extent that, one or more of the available exceptions applies. Property is considered to be debt-financed for this purpose if it is subject to any “acquisition indebtedness.” The term “acquisition indebtedness“ means, with respect to any debt-financed property, the unpaid amount of:

• The indebtedness incurred by the tax-exempt organization in acquiring or improving such property;
• The indebtedness incurred before the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement; and
• The indebtedness incurred after the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement and the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement.

'Indebtedness'

The term “indebtedness“ is not defined. However, the Code does provide that when property (regardless of how it was obtained) is acquired subject to a mortgage or other similar lien, the amount of the indebtedness secured by the mortgage or lien is considered as an indebtedness of the organization incurred in acquiring such property, even if the organization does not assume the mortgage or agree to pay the indebtedness. However, if the property was acquired by bequest or devise, the indebtedness secured by the mortgage shall not be considered to be indebtedness of the organization for a period of 10 years following the date of acquisition.

Where state law provides that a lien for taxes or a lien for assessments made by a state or a political subdivision thereof attaches to property prior to the time that such taxes or assessments become due or payable, then such lien shall be treated as similar to a mortgage, but only after the taxes or assessments become due and payable, and the organization has had an opportunity to pay such taxes or assessment in accordance with state law.

Computation of Taxable Income

The portion of gross income derived from debt-financed property that is to be taken into account in calculating UBTI is equal to the same percentage (but not in excess of 100% of the total gross income derived from or on account of the property as: 1) the average acquisition indebtedness for the taxable year with respect to the property is of; and 2) the average amount of the adjusted basis of the property during the period it is held by the organization during the taxable year.

For this purpose, “average acquisition indebtedness” means the average amount of outstanding principal indebtedness, determined on a monthly basis according to rules set forth in the applicable regulations, during the portion of the year that the organization holds the property, and the “average adjusted basis” is defined as the average of: 1) the adjusted basis of the property as of the first day during the taxable year that the organization holds the property; and 2) the adjusted basis of the property as of the last day during the taxable year that the organization holds the property.

In calculating UBTI, deductions that are directly connected with the debt-financed property, or with the income derived from the property, are allowed to the extent of the same percentage of gross income from the property that is includible in UBTI, as discussed above. Deductions are to be determined on a property-by-property basis. Thus, if the allowable deductions connected to one property are greater than the portion of gross income from that property that is to be taken into account, the excess cannot be used to offset the taxable income derived from another property. Any depreciation deduction that is allowed for the property must be computed by means of the straight-line method, for purposes of determining the amount of tax from debt-financed property, regardless of whether such method would otherwise be required.

Exceptions and Exemptions

The principal exception to the taxation of income from or on account of debt-financed property is that such income is taxable only to the extent that the use of the property is not substantially related to the organization's exempt purpose or function, the determination of which is to be made on the basis of all the facts and circumstances, including the portion of time the property is used for exempt purposes, the portion of the property so used, or a combination of both. Generally, if 85% or more of the use of debt-financed property is for exempt purposes, the use of the property will be considered to be substantially related to such exempt purposes. If that percentage falls below 85%, then the property will be considered to be debt-financed property (and the income therefrom taxable) to the extent that the use of the property is not substantially related to an exempt purpose of the organization.

If an exempt organization acquires real property with the intent of using it for exempt purposes commencing within 10 years of the date of acquisition, the property will not be treated as debt-financed: 1) as long as the organization does not abandon its intent to use the property for exempt purposes within 10 years; 2) if after the first five years, the organization establishes to the satisfaction of the IRS that it is reasonably certain the land will be so used; and 3) at the time of acquisition, the property is in the neighborhood of other real property owned by the organization that is used for exempt purposes. In the case of a church, a 15-year period is substituted for the 10-year period in the previous sentence, and there is no requirement that the church own other property in the neighborhood of the acquired property.

The Code provides three general exceptions to taxation of income derived from an unrelated business: 1) substantially all the work in carrying on the trade or business is performed for the organization without compensation; 2) the trade or business is carried on by the organization primarily for the convenience of its members, students, patients, officers, or employees (this exception is available only to 501(c)(3) organizations and state colleges or universities); and 3) a trade or business that consists of the selling of merchandise, substantially all of which has been received by the organization as gifts or contributions. Similarly, income derived from debt-financed property used in an unrelated business in any of these three circumstances will be exempt from taxation.

Income will not be taxed twice. That is, to the extent that income derived from property is already taxed as income from an unrelated business (typically because the property is used in the unrelated business), it will not also be taxed as income from debt-financed property. However, if such debt-financed property is sold, any gain on the sale of the property will nevertheless be included in the organization's UBTI to the same extent that it would have had the property that is sold not been used in the conduct of an unrelated business.

For purposes of determining whether property is used in connection with either an organization's exempt purpose or its conduct of an unrelated business, the use of the property by an exempt organization that is related to the organization owning the property shall be treated as such use by the organization owning the property.

'Acquisition Indebtedness'

With certain exceptions, the term “acquisition indebtedness“ does not apply to indebtedness incurred by a “qualified organization” in acquiring or improving any real property (for this purpose, an interest in a mortgage is not treated as real property). For the purpose of this exemption, a “qualified organization” is: 1) an educational institution (i.e., schools, colleges, universities, and similar organizations) and their affiliated supporting organizations; 2) a qualified trust that is a stock bonus, pension, or profit-sharing plan; 3) exempt multi-parent title-holding organizations; and 4) certain retirement income accounts. This exemption does not apply if any of the following six conditions is true:

1. The price for the acquisition or improvement is not fixed as of the date of the acquisition or completion of the improvement;
2. The amount of any indebtedness (or other amount payable with respect to the indebtedness or the time for paying any such amount) is dependent in any way upon any revenue, income or profits derived from the real property;
3. The real property is at any time after the acquisition leased by the organization to the person selling the property to the organization or to certain persons or entities related to the seller;
4. In the case of real estate acquired by a qualified trust, the real estate is acquired from, or leased by the trust to, persons bearing certain relationships to the trust or the plan with respect to which the trust was formed (these relationships are described in the tax code at greater length than can be set forth here);
5. Any person described in the previous two bullet points provides the organization with financing in connection with the acquisition or improvement; or
6. The real property is held by a partnership, unless the partnership meets a series of requirements set forth in the tax code.

Finally, the term “acquisition indebtedness” does not include any indebtedness, the incurrence of which is inherent in the performance of the organization's exempt purpose, for example, the indebtedness incurred by an exempt credit union in accepting deposits from its members.

Conclusion

The subject of unrelated debt-financed income is complex, and the space available in this article is sufficient only for an overview. In specific circumstances, an organization should always consult its tax adviser.

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