Debt-Financed Income and UBTI

Editor: Joel E. Ackerman, CPA, MST

Two exempt organizations meet the requirements of Sec. 501(c)(3) (one as a charitable organization and the other as an educational organization—a university). These organizations own equal interests in a partnership, and they have boards of trustees that overlap by more than 50% of the voting positions. The partnership owns a building and land. The building was acquired using borrowed funds and thus was debt financed. It currently is leased 100% to the university, which uses the entire building in its research activities. Because the building is generating net income, is the net rental income unrelated business taxable income (UBTI) to both organizations, to only one organization, or to neither organization?

Exempt organizations can be subject to income tax if they have UBTI. Sec. 512 defines UBTI as gross income derived from any unrelated trade or business, regularly carried on, less deductions directly connected with the carrying on of such trade or business. Sec. 512(b) excludes certain types and classes of income from the definition of UBTI. Rent derived from real property is one of the excluded classes of income. Unfortunately, if the rent is from property that is debt financed, this exclusion does not apply, and UBTI is generated to the extent of a ratio of the debt to adjusted basis of the property (Sec. 512(b)(4)).

Under Sec. 512(b)(8), an exclusion also applies for colleges, universities, and hospitals for income derived from research performed for any person.  Based on this language, a college or university can exclude from UBTI debt-financed real estate rental net income derived from the use of real property in a bona fide research capacity.

Regs. Sec. 1.514(b)-1(b)(1)(i) indicates that debt-financed property used by an institution in furtherance of its exempt purpose is excluded from UBTI. The Service has stated this position in several published documents (see, e.g., Rev. Ruls. 58-547, 69-464, 77-47, 81-138, and IRM 7.27.9.2.1). Further exclusions from UBTI can be found under Regs. Sec. 1.514(b)-1(b)(4):

To the extent that the gross income from any property is derived from research activities excluded from the tax on unrelated business income by paragraph (7), (8), or (9) of section 512(b), such property shall not be treated as debt-financed property.

This sentence seems to extend the UBTI exclusion to income generated by property of other Sec. 501(c)(3) organizations (not just colleges, universities, and hospitals), as long as the property is involved in research activities. The income generated by the use of a building with special attributes (controlled environment, specialized facilities, security, etc.) necessary for research should qualify as income derived from research activities, just as laboratory equipment would qualify.

The “all income” component of this subsection provides further substantiation that debt-financed rental income of certain exempt organizations (i.e., a college, university, or hospital) is not UBTI because of a link to research activities. Key elements of this conclusion are the phrases “all income” and “derived from research for any person.”

Thus, one can conclude that neither exempt organization has unrelated business income because all of the income is the result of research activities. The debt-financed rental income received by the exempt organization actually performing research is not considered to be UBTI because it is excluded from the definition of debt-financed property under Sec. 514(b)(1)(A). Thus, an exempt organization does not create UBTI by intra-organization leasing of real estate, even when the real estate is debt financed.

Under Sec. 512(b)(8), the rental income received by the exempt organization not directly involved in the research activities also is excluded from the definition of UBTI because the income is associated with research activity involving a college, university, or hospital.

EditorsNotes

Joel E. Ackerman, CPA, MST is with Holtz Rubenstein Reminick LLP, DFK International/USA Melville, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

If you would like additional information about these items, contact Mr. Ackerman at (631) 752-7400 x262 or jackerman@hrrllp.com.