How Unrelated Business Income Tax Applies to Debt-Financed Property

July 24, 2014

This is the fourth article in a series exploring the world of unrelated business income. Insights provided by Gelman, Rosenberg & Freedman’s Nonprofit Tax Principals, Stephen Kelin and Richard Locastro.

If a tax-exempt entity engages in a business that is unrelated to its primary purpose, the general rule is that income will be considered unrelated business taxable income and any net income will be subject to the unrelated business income tax (UBIT).

The tax law contains a number of exclusions, including for dividends, interest and rents from real property. However, when debt is incurred by an exempt organization to acquire an income-producing asset, with some exceptions, UBIT is applicable to that portion of the income or gain that is debt-financed.

This type of income is often referred to as unrelated debt-financed income (UDFI). Assets that are most commonly debt-financed are real properties, but they could include stocks or other investments that were bought with borrowed funds, including those bought through the use of “margin” accounts at a brokerage.

Income-producing property is considered debt-financed property if, at any time during the tax year, there was “acquisition indebtedness” outstanding on the property. Acquisition indebtedness includes debt incurred before, during or after the acquisition (or improvement) of property if the indebtedness would not have been incurred but for the acquisition. Indebtedness incurred after the acquisition is considered acquisition indebtedness only if the debt was reasonably foreseeable when the property was acquired.

As stated above, a portion of the income activity is treated as taxable. That portion is the percentage that the “average acquisition indebtedness” is of the “average basis.” This percentage can never be more than 100 percent.

Generally, the average acquisition indebtedness is computed by averaging the monthly indebtedness during the year. The average basis is computed by averaging the beginning-of-the-year and end-of-the-year basis amounts.

Assume an exempt organization owns a residential rental property that produces $25,000 of gross rental income per year. After allowable deductions, including depreciation, the property has a profit of $5,000. Also assume the property was purchased for $200,000 and paid for with cash of $40,000 and a bank mortgage for $160,000.

During the year, $8,000 of the mortgage was paid off, and the $5,000 of net income included a depreciation deduction of $4,000. Thus, the average acquisition indebtedness is $156,000, calculated as ($160,000 + $152,000)/2. (The required monthly calculation will produce a slightly different amount.)

The average basis is $198,000, calculated as ($200,000 + $196,000)/2. The debt-financed portion is 78.79 percent. The debt financed – and thus taxable – income of the $5,000 is $3,940.

If income-producing property is disposed of at a gain and there was acquisition indebtedness outstanding for that property at any time during the 12-month period before the disposition, the property is debt-financed property. In determining the taxable portion, the average acquisition indebtedness is the highest amount of indebtedness during the 12-month period ending with the date of sale.

There are a number of exceptions to the debt-financed property rules, including:

• Property that is substantially used (generally 85 percent or more) in furtherance of the exempt purpose of the organization. None of the activity is taxable under the debt-financed rules.
• Property used in an activity that is not an unrelated business because:
  • Substantially all of the work is performed by volunteers without compensation;
  • The business is carried on primarily for the convenience of members, students, patients, officers or employees; or
  • The business involves the selling of merchandise, substantially all of which was received as gifts or contributions.
• Property acquired for future use by the exempt organization, often referred to as the “neighborhood land exception.”

Mortgaged property acquired by bequest or devise is not treated as having acquisition indebtedness for 10 years. Likewise, mortgaged property acquired by gift is not treated as having acquisition indebtedness for 10 years after receipt of the gift, if the mortgage was more than five years old before the gift and the property was held by the donor for more than five years before the gift.

However, these exceptions do not apply if the exempt organization assumes the debt secured by the property. The debt is considered assumed if the exempt organization is legally required to pay a portion of the debt. If the organization does not assume the debt, the fact that it makes the mortgage payments is irrelevant.

When a tax-exempt organization invests in a partnership, it can have taxable unrelated debt-financed income under two scenarios:

• First, any debt incurred by the organization in acquiring the partnership interest is treated as acquisition indebtedness.
• Second, any debt incurred by the partnership to acquire income-producing assets will likely generate UDFI.

Under either of these scenarios, there will be taxable income unless one of the exclusions discussed above applies.