Frequently, nonprofit organizations looking for ways to supplement their programs or business turn to the rental of unused or underutilized space as an additional source of revenue. Beware, however. Generating revenue through the rental of property that is financed with a mortgage is the most common way unrelated business tax is generated. Income derived from the rental of real property is usually excluded from tax, but income generated by debt-financed property is always subject to unrelated business income tax. Organizations are often surprised to discover unrelated business income is taxed at the same rates as for-profit corporations.
Debt-financed property is considered any property held to produce income, and the property has debt attached to it. This debt can be the result of acquiring the property or improving the property (IRC Sec. 514(b)(1)).
As with every rule, there are several exceptions; two of the most common are: 1) substantially all of a property’s use is directly related to the exercise or performance of an organization’s exempt purpose, or 2) the property is rented to a related entity to the organization.
“Substantially all” of a property’s use typically means greater than or equal to 85% of the property. This is usually measured by square footage of the property. For example, Organization A owns a building with 3 floors; each floor is 2,500 square feet or a total of 7,500 square feet. Organization
A rents a portion of the 1st floor (1,000 square feet) as retail space to a local entrepreneur, and the remainder of the building is used by Organization A to further its exempt purpose. Organization A’s rental income is not considered debt-financed property and is not subject to UBIT, as 86.67% of the building is used for exempt purposes.
Organizations are considered to be related, if:
- One organization has control of the other organization; such as one board has the right to appoint or approve the other organization’s board of directors.
- More than 50% of one organization’s members are members of the other organization.
- Both organizations are local entities directly affiliated with a common state, national, or international organization that is also exempt.
- One entity is an exempt title holding company, and the other organization receives profits from the first.
Debt-financed property can be a complicated process requiring careful consideration of all the facts, and the above discussion is just an overview. We would be happy to assist you with any questions you may have regarding debt-financed property specifically or unrelated business tax in general.