When Investment Income Counts as UBI

Dividends, interest, rents, annuities and other investment income are generally excluded when calculating unrelated business income tax (“UBIT”). But, tax law provides two exceptions where such income will indeed be deemed taxable. With Internal Revenue Service (“IRS”) scrutiny of unrelated business income intensifying these days, nonprofits need to know about these potential pitfalls.

  1. Debt-financed Property

When a nonprofit incurs debt to acquire or to improve an income-producing asset, the portion of the income or gain that’s debt-financed is generally taxable unrelated business income (“UBI”). Such assets are usually real estate — for example, an apartment building with income from rents not related to the nonprofit’s mission. But, the assets could also be stocks, tangible personal property, or other investments purchased with borrowed funds.

Income-producing property is debt-financed if, at any time during the tax year, it had “acquisition indebtedness,” which is defined as the outstanding amount of an indebtedness incurred, during or shortly after the acquisition, or improvement of property.  “Acquisition indebtedness” exists only if the indebtedness would not have been incurred, but for such acquisition or improvement.

Certain property is exempt from this treatment:

Related to exempt purposes. If 85 percent or more of the use of the property is substantially related to a not-for-profit’s exempt purposes and cannot be solely to support the organization’s need for income, or its use of the profits, the property is not treated as “debt-financed property.”

Used in an unrelated trade or business. To the extent that property produces income under the general definition of unrelated trade or business, the property is not treated as debt-financed, as the income is already UBI.

Used in certain excluded activities, including research. “Debt-financed property” does not include property used in a trade or business that is excluded from the definition of “unrelated trade or business” either because it is used in research activities, or because the activity has a volunteer workforce and is conducted for the convenience of members, or because the business consists of selling donated merchandise.

Covered by the neighborhood land rule. If a not-for-profit acquires real property intending to use it for exempt purposes within 10 years, the property will not be treated as debt-financed property, as long as it’s in the neighborhood of other property the organization uses for exempt purposes. The latter exception applies only so long as the intent to demolish any existing structures and use the land for furtherance of its exempt purposes, within 10 years, is not abandoned.

  1. Income from Controlled Organizations

Interest, rents, annuities and other investment income are not excluded from UBI if they are received from a for-profit subsidiary or controlled nonprofit. The payment is included in the parent organization’s taxable UBI to the extent it reduces the subsidiary organization’s net taxable income or UBI.

The IRS generally considers a corporation to be “controlled” if the other organization owns more than 50 percent of the “beneficial interest” — either stock in a for-profit, or voting board positions in a nonprofit. For example, if a for-profit leases space from an organization that owns more than 50 percent of its stock, the lease payments are valid deductions from taxable income. But when these lease payments are received by the controlling nonprofit, they are not excluded from UBI.

 

Proceed with Caution

Failing to pay UBIT on debt-financed property or income from controlled organizations, could have negative consequences ranging from taxes, penalties and interest, to, in extreme cases, the loss of tax-exempt status. Your CPA can help you stay on the right side of the UBIT law.

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