Table of Contents
The term “unrelated business taxable income” generally means the gross income derived from any unrelated trade or business regularly carried on by the exempt organization, less the deductions directly connected with carrying on the trade or business. If an organization regularly carries on two or more unrelated business activities, its unrelated business taxable income is the total of gross income from all such activities less the total allowable deductions attributable to all the activities.
In computing unrelated business taxable income, gross income and deductions are subject to the modifications and special rules explained in this chapter. Whether a particular item of income or expense falls within any of these modifications or special rules must be determined by all the facts and circumstances in each specific case. For example, if the organization received a payment termed rent that is in fact a return of profits by a person operating the property for the benefit of the organization, or that is a share of the profits retained by the organization as a partner or joint venturer, the payment is not within the income exclusion for rents, discussed later under Exclusions.
Generally, unrelated business income is taxable, but there are exclusions and special rules that must be considered when figuring the income.
The following types of income (and deductions directly connected with the income) are generally excluded when figuring unrelated business taxable income.
-
Provides for the return to the exempt organization of securities identical to the securities loaned,
-
Requires payments to the organization of amounts equivalent to all interest, dividends, and other distributions that the owner of the securities is entitled to receive during the period of the loan,
-
Does not reduce the organization's risk of loss or opportunity for gain on the securities,
-
Contains reasonable procedures to implement the obligation of the borrower to furnish collateral to the organization with a fair market value each business day during the period of the loan in an amount not less than the fair market value of the securities at the close of the preceding business day, and
-
Permits the organization to terminate the loan upon notice of not more than 5 business days.
-
Amounts in respect of dividends, interest, and other distributions,
-
Fees based on the period of time the loan is in effect and the fair market value of the security during that period,
-
Income from collateral security for the loan, and
-
Income from the investment of collateral security.
-
The rent attributable to all the leased personal property increases by 100% or more because additional or substitute personal property is placed in service, or
-
The lease is modified to change the rent charged (whether or not the amount of rented personal property changes).
-
Stock in trade or other property of a kind that would properly be includable in inventory if on hand at the close of the tax year,
-
Property held primarily for sale to customers in the ordinary course of a trade or business, or
-
Cutting of timber that an organization has elected to consider as a sale or exchange of the timber.
-
The trade or business must have been operated by the order or by the institution since before May 27, 1959.
-
The trade or business must consist of providing services under a license issued by a federal regulatory agency.
-
More than 90% of the net income from the business for the tax year must be devoted to religious, charitable, or educational purposes that constitute the basis for the religious order's exemption.
-
The rates or other charges for these services must be fully competitive with the rates or other charges of similar taxable businesses. Rates or other charges for these services will be considered as fully competitive if they are neither materially higher nor materially lower than the rates charged by similar businesses operating in the same general area.
Dues received from associate members by organizations exempt under section 501(c)(5) or section 501(c)(6) may be treated as gross income from an unrelated trade or business if the associate member category exists for the principal purpose of producing unrelated business income. For example, if an organization creates an associate member category solely to allow associate members to purchase insurance through the organization, the associate member dues may be unrelated business income.
To qualify as allowable deductions in computing unrelated business taxable income, the expenses, depreciation, and similar items generally must be allowable income tax deductions that are directly connected with carrying on an unrelated trade or business. They cannot be directly connected with excluded income.
For an exception to the “directly connected” requirement, see Charitable contributions deduction, under Modifications, later.
To be directly connected with the conduct of an unrelated business, deductions must have a proximate and primary relationship to carrying on that business. For an exception, see Expenses attributable to exploitation of exempt activities, later.
Example 1.
A school recognized as a tax-exempt organization contracts with an individual to conduct a summer tennis camp. The school provides the tennis courts, housing, and dining facilities. The contracted individual hires the instructors, recruits campers, and provides supervision. The income the school receives from this activity is from a dual use of the facilities and personnel. The school, in computing its unrelated business taxable income, may deduct an allocable part of the expenses attributable to the facilities and personnel.
Example 2.
An exempt organization with gross income from an unrelated trade or business pays its president $90,000 a year. The president devotes approximately 10% of his time to the unrelated business. To figure the organization's unrelated business taxable income, a deduction of $9,000 ($90,000 × 10%) is allowed for the salary paid to its president.
-
The unrelated business exploits the exempt activity.
-
The unrelated business is a type normally carried on for profit by taxable organizations.
-
The exempt activity is a type normally conducted by taxable organizations in carrying on that type of business.
-
The excess of these expenses, depreciation, and similar items over the income from, or attributable to, the exempt activity, or
-
The gross unrelated business income reduced by all other expenses, depreciation, and other items that are actually directly connected.
The sale of advertising in a periodical of an exempt organization that contains editorial material related to the accomplishment of the organization's exempt purpose is an unrelated business that exploits an exempt activity, the circulation and readership of the periodical. Therefore, in addition to direct advertising costs, exempt activity costs (expenses, depreciation, and similar expenses attributable to the production and distribution of the editorial or readership content) can be treated as directly connected with the conduct of the advertising activity. (See Expenses attributable to exploitation of exempt activities under Directly Connected, earlier.)
If gross advertising income is . . . | THEN UBTI is . . . |
---|---|
More than direct advertising costs | The excess advertising income, reduced (but not below zero) by the excess, if any, of readership costs over circulation income. |
Equal to or less than direct advertising costs |
Zero.
• Circulation income and readership costs are not taken into account. • Any excess advertising costs reduce (but not below zero) UBTI from any other unrelated business activity. |
-
The periodical was published by a taxable organization,
-
The periodical was published for profit, and
-
The member was an unrelated party dealing with the taxable organization at arm's length.
IF . . . | THEN the amount used to allocate membership receipts is . . . |
---|---|
20% or more of the total circulation consists of sales to nonmembers | The subscription price charged nonmembers. |
The above condition does not apply, and 20% or more of the members pay reduced dues because they do not receive the periodical | The reduction in dues for a member not receiving the periodical. |
Neither of the above conditions applies | The membership receipts multiplied by this fraction: |
Total periodical costs Total periodical costs Plus Cost of other exempt activities |
Example 1.
U is an exempt scientific organization with 10,000 members who pay annual dues of $15. One of U's activities is publishing a monthly periodical distributed to all of its members. U also distributes 5,000 additional copies of its periodical to nonmembers, who subscribe for $10 a year. Since the nonmember circulation of U's periodical represents one-third (more than 20%) of its total circulation, the subscription price charged to nonmembers is used to determine the part of U's membership receipts allocable to the periodical. Thus, U's allocable membership receipts are $100,000 ($10 times 10,000 members), and U's total circulation income for the periodical is $150,000 ($100,000 from members plus $50,000 from sales to nonmembers).
Example 2.
Assume the same facts except that U sells only 500 copies of its periodical to nonmembers, at a price of $10 a year. Assume also that U's members may elect not to receive the periodical, in which case their dues are reduced from $15 a year to $6 a year, and that only 3,000 members elect to receive the periodical and pay the full dues of $15 a year. U's stated subscription price of $9 to members consistently results in an excess of total income (including gross advertising income) attributable to the periodical over total costs of the periodical. Since the 500 copies of the periodical distributed to nonmembers represent only 14% of the 3,500 copies distributed, the $10 subscription price charged to nonmembers is not used to determine the part of membership receipts allocable to the periodical. Instead, since 70% of the members elect not to receive the periodical and pay $9 less per year in dues, the $9 price is used to determine the subscription price charged to members. Thus, the allocable membership receipts will be $9 a member, or $27,000 ($9 times 3,000 copies). U's total circulation income is $32,000 ($27,000 plus the $5,000 from nonmember subscriptions).
If an exempt organization publishes more than one periodical to produce income, it may treat all of them (but not less than all) as one in determining unrelated business taxable income from selling advertising. It treats the gross income from all the periodicals, and the deductions directly connected with them, on a consolidated basis. Consolidated treatment, once adopted, must be followed consistently and is binding. This treatment can be changed only with the consent of the Internal Revenue Service.
An exempt organization's periodical is published to produce income if:
-
The periodical generates gross advertising income to the organization equal to at least 25% of its readership costs, and
-
Publishing the periodical is an activity engaged in for profit.
Whether the publication of a periodical is an activity engaged in for profit can be determined only by all the facts and circumstances in each case. The facts and circumstances must show that the organization carries on the activity for economic profit, although there may not be a profit in a particular year. For example, if an organization begins publishing a new periodical whose total costs exceed total income in the start-up years because of lack of advertising sales, that does not mean that the organization did not have as its objective an economic profit. The organization may establish that it had this objective by showing it can reasonably expect advertising sales to increase, so that total income will exceed costs within a reasonable time.
Example.
Y, an exempt trade association, publishes three periodicals that it distributes to its members: a weekly newsletter, a monthly magazine, and a quarterly journal. Both the monthly magazine and the quarterly journal contain advertising that accounts for gross advertising income equal to more than 25% of their respective readership costs. Similarly, the total income attributable to each periodical has exceeded the total deductions attributable to each periodical for substantially all the years they have been published. The newsletter carries no advertising and its annual subscription price is not intended to cover the cost of publication. The newsletter is a service that Y distributes to all of its members in an effort to keep them informed of changes occurring in the business world. It is not engaged in for profit.
Under these circumstances, Y may consolidate the income and deductions from the monthly and quarterly journals in computing its unrelated business taxable income. It may not consolidate the income and deductions from the newsletter with the income and deductions of its other periodicals, since the newsletter is not published for the production of income.
-
Certain electric utility companies may elect a 5-year carryback period for NOLs arising in tax years 2003, 2004, and 2005. The NOL carryback amount is limited to 20% of the total capital expenditures for electric transmission property and pollution control facilities. The election may be made during any tax year ending after December 31, 2005, and before January 1, 2009.
-
Certain qualified Gulf Opportunity Zone (GO Zone) losses are eligible for a special 5-year carryback period. See section 1400N(k).
-
An organization may elect to treat any GO Zone public utility casualty loss as a special liability loss to which the 10-year carryback period applies. See section 1400N(j).
-
$1,000, or
-
Gross income derived from an unrelated trade or business regularly carried on by the local unit.
Example.
X is an association of churches and is divided into local units A, B, C, and D. Last year, A, B, C, and D derived gross income of, respectively, $1,200, $800, $1,500, and $700 from unrelated businesses that they regularly conduct. X may claim a specific deduction of $1,000 with respect to A, $800 with respect to B, $1,000 with respect to C, and $700 with respect to D.
An organization may have unrelated business income or loss as a member of a partnership, rather than through direct business dealings with the public. If so, it must treat its share of the partnership income or loss as if it had conducted the business activity in its own capacity as a corporation or trust. No distinction is made between limited and general partners.
Thus, if an organization is a member of a partnership regularly engaged in a trade or business that is an unrelated trade or business with respect to the organization, the organization must include in its unrelated business taxable income its share of the partnership's gross income from the unrelated trade or business (whether or not distributed), and the deductions attributable to it. The partnership income and deductions to be included in the organization's unrelated business taxable income are figured the same way as any income and deductions from an unrelated trade or business conducted directly by the organization.
Example.
An exempt educational organization is a partner in a partnership that operates a factory. The partnership also holds stock in a corporation. The exempt organization must include its share of the gross income from operating the factory in its unrelated business taxable income, but may exclude its share of any dividends the partnership received from the corporation.
An organization that owns S corporation stock must take into account its share of the S corporation's income, deductions, or losses in figuring unrelated business taxable income, regardless of the actual source or nature of the income, deductions, and losses. For example, the organization's share of the S corporation's interest and dividend income will be taxable, even though interest and dividends are normally excluded from unrelated business taxable income. The organization must also take into account its gain or loss on the sale or other disposition of the S corporation stock in figuring unrelated business taxable income.
The unrelated business taxable income of a foreign organization exempt from tax under section 501(a) consists of the organization's:
-
Unrelated business taxable income derived from sources within the United States, but not effectively connected with the conduct of a trade or business within the United States, and
-
Unrelated business taxable income effectively connected with the conduct of a trade or business within the United States, whether or not this income is derived from sources within the United States.
To determine whether income realized by a foreign organization is derived from sources within the United States or is effectively connected with the conduct of a trade or business within the United States, see sections 861 through 865 and the related regulations.
The following discussion applies to:
-
Social clubs described in section 501(c)(7),
-
Voluntary employees' beneficiary associations (VEBAs) described in section 501(c)(9),
-
Supplemental unemployment compensation benefit trusts (SUBs) described in section 501(c)(17), and
-
Group legal services organizations (GLSOs) described in section 501(c)(20).
These organizations must figure unrelated business taxable income under special rules. Unlike other exempt organizations, they cannot exclude their investment income (dividends, interest, rents, etc.). (See Exclusions under Income, earlier.) Therefore, they are generally subject to unrelated business income tax on this income.
The unrelated business taxable income of these organizations includes all gross income, less deductions directly connected with the production of that income, except that gross income for this purpose does not include exempt function income. The dividends received deduction for corporations is not allowed in computing unrelated business taxable income because it is not an expense incurred in the production of income.
Example.
A private golf and country club that is a qualified tax-exempt social club has nonexempt function income from interest and from the sale of food and beverages to nonmembers. The club sells food and beverages as a service to members and their guests rather than for the purpose of making a profit. Therefore, any loss resulting from sales to nonmembers cannot be used to offset the club's interest income.
Unrelated business taxable income of a veterans' organization that is exempt under section 501(c)(19) does not include the net income from insurance business that is properly set aside. The organization may set aside income from payments received for life, sick, accident, or health insurance for the organization's members or their dependents for the payment of insurance benefits or reasonable costs of insurance administration, or for use exclusively for religious, charitable, scientific, literary, or educational purposes, or the prevention of cruelty to children or animals. For details, see section 512(a)(4) and the regulations under that section.
The exclusions for interest, annuities, royalties, and rents, explained earlier in this chapter under Income, may not apply to a payment of these items received by a controlling organization from its controlled organization. The payment is included in the controlling organization's unrelated business taxable income to the extent it reduced the net unrelated income (or increased the net unrelated loss) of the controlled organization. All deductions of the controlling organization directly connected with the amount included in its unrelated business taxable income are allowed.
-
For an exempt organization, its unrelated business taxable income, or
-
For a nonexempt organization, the part of its taxable income that would be unrelated business taxable income if it were exempt and had the same exempt purposes as the controlling organization.
-
For an exempt organization, its NOL, or
-
For a nonexempt organization, the part of its NOL that would be its NOL if it were exempt and had the same exempt purposes as the controlling organization.
-
For a corporation, the controlling organization owns (by vote or value) more than 50% of the stock,
-
For a partnership, the controlling organization owns more than 50% of the profits or capital interests, or
-
For any other organization, the controlling organization owns more than 50% of the beneficial interest.
Investment income that would otherwise be excluded from an exempt organization's unrelated business taxable income (see Exclusions under Income earlier) must be included to the extent it is derived from debt-financed property. The amount of income included is proportionate to the debt on the property.
In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the tax year (or during the 12-month period before the date of the property's disposal, if it was disposed of during the tax year). It includes rental real estate, tangible personal property, and corporate stock.
For any debt-financed property, acquisition indebtedness is the unpaid amount of debt incurred by an organization:
-
When acquiring or improving the property,
-
Before acquiring or improving the property if the debt would not have been incurred except for the acquisition or improvement, and
-
After acquiring or improving the property if:
-
The debt would not have been incurred except for the acquisition or improvement, and
-
Incurring the debt was reasonably foreseeable when the property was acquired or improved.
-
The facts and circumstances of each situation determine whether incurring a debt was reasonably foreseeable. That an organization may not have foreseen the need to incur a debt before acquiring or improving the property does not necessarily mean that incurring the debt later was not reasonably foreseeable.
Example 1.
Y, an exempt scientific organization, mortgages its laboratory to replace working capital used in remodeling an office building that Y rents to an insurance company for nonexempt purposes. The debt is acquisition indebtedness since the debt, though incurred after the improvement of the office building, would not have been incurred without the improvement, and the debt was reasonably foreseeable when, to make the improvement, Y reduced its working capital below the amount necessary to continue current operations.
Example 2.
X, an exempt organization, forms a partnership with A and B. The partnership agreement provides that all three partners will share equally in the profits of the partnership, each will invest $3 million, and X will be a limited partner. X invests $1 million of its own funds in the partnership and $2 million of borrowed funds.
The partnership buys as its sole asset an office building that it leases to the public for nonexempt purposes. The office building costs the partnership $24 million, of which $15 million is borrowed from Y bank. The loan is secured by a mortgage on the entire office building. By agreement with Y bank, X is not personally liable for payment of the mortgage.
X has acquisition indebtedness of $7 million. This amount is the $2 million debt X incurred in acquiring the partnership interest, plus the $5 million that is X's allocable part of the partnership's debt incurred to buy the office building (one-third of $15 million).
Example 3.
A labor union advanced funds, from existing resources and without any borrowing, to its tax-exempt subsidiary title-holding company. The subsidiary used the funds to pay a debt owed to a third party that was previously incurred in acquiring two income-producing office buildings. Neither the union nor the subsidiary has incurred any further debt in acquiring or improving the property. The union has no outstanding debt on the property. The subsidiary's debt to the union is represented by a demand note on which the subsidiary makes payments whenever it has the available cash. The books of the union and the subsidiary list the outstanding debt as interorganizational indebtedness.
Although the subsidiary's books show a debt to the union, it is not the type subject to the debt-financed property rules. In this situation, the very nature of the title-holding company and the parent-subsidiary relationship shows this debt to be merely a matter of accounting between the two organizations. Accordingly, the debt is not acquisition indebtedness.
Example.
Four years ago a university borrowed funds to acquire an apartment building as housing for married students. Last year, the university rented the apartment building to the public for nonexempt purposes. The outstanding principal debt becomes acquisition indebtedness as of the time the building was first rented to the public.
Example.
To house its administration offices, an exempt organization bought a building using $600,000 of its own funds and $400,000 of borrowed funds secured by a pledge of its securities. The office building was not debt-financed property. The organization later sold the building for $1 million without repaying the $400,000 loan. It used the sale proceeds to buy an apartment building it rents to the general public. The unpaid debt of $400,000 is acquisition indebtedness with respect to the apartment building.
-
Deeds of trust,
-
Conditional sales contracts,
-
Chattel mortgages,
-
Security interests under the Uniform Commercial Code,
-
Pledges,
-
Agreements to hold title in escrow, and
-
Liens for taxes or assessments (other than those discussed earlier in this paragraph).
-
The mortgage was placed on the property more than 5 years before the date the organization received it, and
-
The donor held the property for more than 5 years before the date the organization received it.
-
Substituting liens to secure the debt,
-
Substituting obligees whether or not with the organization's consent,
-
Renewing, extending, or accelerating the payment terms of the debt, and
-
Adding, deleting, or substituting sureties or other primary or secondary obligors.
Example.
An organization has an outstanding principal debt of $500,000 that is treated as acquisition indebtedness. The organization borrows another $100,000, which is not acquisition indebtedness, from the same lender, resulting in a $600,000 note for the total obligation. A payment of $60,000 on the total obligation would reduce the acquisition indebtedness by $50,000 ($60,000 x $500,000/$600,000) and the excess debt by $10,000.
Certain debt and obligations are not acquisition indebtedness. These include the following.
-
Debts incurred in performing an exempt purpose.
-
Annuity obligations.
-
Securities loans.
-
Real property debts of qualified organizations.
-
Certain Federal financing.
-
It must be the sole consideration (other than a mortgage on property acquired by gift, bequest, or devise that meets the exception discussed under Property acquired subject to mortgage or lien, earlier in this chapter) issued in exchange for the property received.
-
Its present value, at the time of exchange, must be less than 90% of the value of the prior owner's equity in the property received.
-
It must be payable over the lives of either one or two individuals living when issued.
-
It must be payable under a contract that:
-
Does not guarantee a minimum nor specify a maximum number of payments, and
-
Does not provide for any adjustment of the amount of the annuity payments based on the income received from the transferred property or any other property.
-
Example.
X, an exempt organization, receives property valued at $100,000 from donor A, a male age 60. In return X promises to pay A $6,000 a year for the rest of A's life, with neither a minimum nor maximum number of payments specified. The amounts paid under the annuity are not dependent on the income derived from the property transferred to X. The present value of this annuity is $81,156, determined from IRS valuation tables. Since the value of the annuity is less than 90 percent of A's $100,000 equity in the property transferred and the annuity meets all the other requirements just discussed, the obligation to make annuity payments is not acquisition indebtedness.
-
A qualified retirement plan under section 401(a),
-
An educational organization described in section 170(b)(1)(A)(ii) and certain of its affiliated support organizations,
-
A title-holding company described in section 501(c)(25), or
-
A retirement income account described in section 403(b)(9) in acquiring or improving real property in tax years beginning on or after August 17, 2006.
-
The acquisition price is not a fixed amount determined as of the date of the acquisition or the completion of the improvement. However, the terms of a sales contract may provide for price adjustments due to customary closing adjustments such as prorating property taxes. The contract also may provide for a price adjustment if it is for a fixed amount dependent upon subsequent resolution of limited, external contingencies such as zoning approvals, title clearances, and the removal of easements. These conditions in the contract will not cause the price to be treated as an undetermined amount. (But see Note 1 at the end of this list.)
-
Any debt or other amount payable for the debt, or the time for making any payment, depends, in whole or in part, upon any revenue, income, or profits derived from the real property. (But see Note 1 at the end of this list.)
-
The real property is leased back to the seller of the property or to a person related to the seller as described in section 267(b) or section 707(b). (But see Note 2 at the end of this list.)
-
The real property is acquired by a qualified retirement plan from, or after its acquisition is leased by a qualified retirement plan to, a related person. (But see Note 2 at the end of this list.) For this purpose, a related person is:
-
An employer who has employees covered by the plan,
-
An owner with at least a 50% interest in an employer described in (a),
-
A member of the family of any individual described in (a) or (b),
-
A corporation, partnership, trust, or estate in which a person described in (a), (b), or (c) has at least a 50% interest, or
-
An officer, director, 10% or more shareholder, or highly compensated employee of a person described in (a), (b), or (d).
-
-
The seller, a person related to the seller (under section 267(b) or section 707(b)), or a person related to a qualified retirement plan (as described in (4)) provides financing for the transaction on other than commercially reasonable terms.
-
The real property is held by a partnership in which an exempt organization is a partner (along with taxable entities), and the principal purpose of any allocation to an exempt organization is to avoid tax. This generally applies to property placed in service after 1986. For more information, see section 514(c)(9)(B)(vi) and section 514(c)(9)(E).
Note 1.
Qualifying sales by financial institutions of foreclosure property or certain conservatorship or receivership property are not included in (1) or (2) and, therefore, do not give rise to acquisition indebtedness. For more information, see section 514(c)(9)(H).
Note 2.
For purposes of (3) and (4), small leases are disregarded. A small lease is one that covers no more than 25% of the leasable floor space in the property and has commercially reasonable terms.
In addition, acquisition indebtedness does not include indebtedness incurred by a small business investment company licensed under the Small Business Investment Act of 1958 after October 22, 2004, if such indebtedness is evidenced by a debenture issued by such company and held or guaranteed by the Small Business Administration. However, this provision does not apply to any small business investment company during any period that any organization which is exempt from tax (other than a governmental unit) owns more than 25% of the capital or profits interest in such company, or organizations which are exempt from tax (including governmental agencies other than any agency or instrumentality of the United States) own, in the aggregate, 50% or more of the capital or profits interest in such company.
Certain property is excepted from treatment as debt-financed property.
-
A comparison of the time the property is used for exempt purposes with the total time the property is used,
-
A comparison of the part of the property that is used for exempt purposes with the part used for all purposes, or
-
Both of these comparisons.
-
It has a volunteer workforce,
-
It is carried on for the convenience of its members, or
-
It consists of selling donated merchandise.
-
One organization is an exempt holding company and the other receives profits derived by the exempt holding company,
-
One organization controls the other as discussed under Income From Controlled Organizations earlier in this chapter,
-
More than 50% of the members of one organization are members of the other, or
-
Each organization is a local organization directly affiliated with a common state, national, or international organization that also is exempt.
Example.
An exempt hospital leases all of its clinic space to an unincorporated association of physicians and surgeons. They, under the lease, agree to provide all of the hospital's outpatient medical and surgical services and to train all of the hospital's residents and interns. In this case the rents received are not unrelated debt-financed income.
Example.
A university tries to buy land contiguous to its present campus, but cannot do so because the owners either refuse to sell or ask unreasonable prices. The nearest land of sufficient size and utility is a block away from the campus. The university buys this land. Under these circumstances, the contiguity requirement is unreasonable and not applicable. The land bought would be considered neighborhood land.
Internal Revenue Service
Commissioner, TE/GE
Attention: T:EO:RA
P.O. Box 120, Ben Franklin Station
Washington, DC 20044
Example.
In January 1997, Y, a calendar year exempt organization, acquired real property contiguous to other property that Y uses in furtherance of its exempt purpose. Assume that without the neighborhood land rule, the property would be debt-financed property. Y did not satisfy the IRS by January 2002 that the existing structure would be demolished and the land would be used in furtherance of its exempt purpose. From 2002 until the property is converted to an exempt use, the income from the property is subject to the tax on unrelated business income. During July 2006, Y will demolish the existing structure on the land and begin using the land in furtherance of its exempt purpose. At that time, Y can file claims for refund for the open years 2003 through 2005.
Further, Y also can file a claim for refund for 2002, even though a claim for that tax year may be barred by the statute of limitations, provided the claim is filed before the close of 2007.
-
The period during which the organization must demonstrate the intent to use acquired property for exempt purposes is increased from 10 to 15 years, and
-
Acquired property does not have to be in the neighborhood of other property used by the organization for exempt purposes.
For each debt-financed property, the unrelated debt-financed income is a percentage (not over 100%) of the total gross income derived during a tax year from the property. This percentage is the same percentage as the average acquisition indebtedness with respect to the property for the tax year is of the property's average adjusted basis for the year (the debt/basis percentage). Thus, the formula for deriving unrelated debt-financed income is:
average acquisition
indebtedness |
x |
gross income
from debt-financed property |
|
average adjusted basis |
Example.
X, an exempt trade association, owns an office building that is debt-financed property. The building produced $10,000 of gross rental income last year. The average adjusted basis of the building during that year was $100,000, and the average acquisition indebtedness with respect to the building was $50,000. Accordingly, the debt/basis percentage was 50% (the ratio of $50,000 to $100,000). Therefore, the unrelated debt-financed income with respect to the building was $5,000 (50% of $10,000).
Example.
On July 7, an exempt organization buys an office building for $510,000 using $300,000 of borrowed funds. The organization files its return on a calendar year basis. During the year the only adjustment to basis is $20,000 for depreciation. Starting July 28, the organization pays $20,000 each month on the mortgage principal plus interest. The debt/basis percentage for the year is calculated as follows:
Month | Debt on first day of each month property is held |
July | $300,000 |
August | 280,000 |
September | 260,000 |
October | 240,000 |
November | 220,000 |
December | 200,000 |
Total | $1,500,000 |
Average acquisition
indebtedness: $1,500,000 ÷ 6 months |
$250,000 |
Basis | |
As of July 7 | $510,000 |
As of December 31 | 490,000 |
Total | $1,000,000 |
Average adjusted basis:
$1,000,000 ÷ 2 |
$500,000 |
Debt/basis percentage | |
$250,000 ÷ $500,000 | = 50% |
The deductions allowed for each debt-financed property are determined by applying the debt/basis percentage to the sum of allowable deductions.
The allowable deductions are those directly connected with the debt-financed property or with the income from it (including the dividends-received deduction), except that:
-
The allowable deductions are subject to the modifications for computation of the unrelated business taxable income (discussed earlier in this chapter), and
-
The depreciation deduction, if allowable, is computed only by use of the straight-line method.
To be directly connected with debt-financed property or with the income from it, a deductible item must have proximate and primary relationship to the property or income. Expenses, depreciation, and similar items attributable solely to the property qualify for deduction, to the extent they meet the requirements of an allowable deduction.
For example, if the straight-line depreciation allowance for an office building is $10,000 a year, an organization can deduct depreciation of $10,000 if the entire building is debt-financed property. However, if only half of the building is debt-financed property, the depreciation allowed as a deduction is $5,000.
Example.
X, an exempt educational organization, owned debt-financed securities that were capital assets. Last year, X sold the securities at a loss of $20,000. The debt/basis percentage for computing the loss from the sale of the securities is 40%. Thus, X sustained a capital loss of $8,000 (40% of $20,000) on the sale of the securities. Last year and the preceding 3 tax years, X had no other capital transactions. Under these circumstances, the $8,000 of capital loss may be carried over to succeeding years without further application of the debt/basis percentage.
Example.
Last year, Y, an exempt organization, received $20,000 of rent from a debt-financed building that it owns. Y had no other unrelated business taxable income for the year. The deductions directly connected with this building were property taxes of $5,000, interest of $5,000 on the acquisition indebtedness, and salary of $15,000 to the building manager. The debt/basis percentage with respect to the building was 50%. Under these circumstances, Y must take into account, in computing its unrelated business taxable income, $10,000 (50% of $20,000) of income and $12,500 (50% of $25,000) of the deductions directly connected with that income.
Thus, Y sustained an NOL of $2,500 ($10,000 of income less $12,500 of deductions), which may be carried back or carried over to other tax years without further application of the debt/basis percentage.
When only part of the property is debt-financed property, proper allocation of the basis, debt, income, and deductions with respect to the property must be made to determine how much income or gain derived from the property to treat as unrelated debt-financed income.
Example.
X, an exempt college, owns a four-story office building that it bought with borrowed funds (assumed to be acquisition indebtedness). During the year, the lower two stories of the building were used to house computers that X uses for administrative purposes. The two upper stories were rented to the public and used for nonexempt purposes.
The gross income X derived from the building was $6,000, all of which was attributable to the rents paid by tenants. The expenses were $2,000 and were equally allocable to each use of the building. The average adjusted basis of the building for the year was $100,000 and the average acquisition indebtedness for the year was $60,000.
Since the two lower stories were used for exempt purposes, only the upper half of the building is debt-financed property. Consequently, only the rental income and the deductions directly connected with this income are taken into account in computing unrelated business taxable income. The part taken into account is determined by multiplying the $6,000 of rental income and $1,000 of deductions directly connected with the rental income by the debt/basis percentage.
The debt/basis percentage is the ratio of the allocable part of the average acquisition indebtedness to the allocable part of the property's average adjusted basis: that is, in this case, the ratio of $30,000 (one-half of $60,000) to $50,000 (one-half of $100,000). Thus, the debt/basis percentage for the year is 60% (the ratio of $30,000 to $50,000).
Under these circumstances, X must include net rental income of $3,000 in its unrelated business taxable income for the year, computed as follows:
Rental income treated as gross income
from an unrelated trade or business (60% of $6,000) |
$3,600 |
Less the allowable portion of
deductions directly connected with that income (60% of $1,000) |
600 |
Net rental income included by X in
computing its unrelated business taxable income from debt-financed property. |
$3,000 |
More Online Publications |