In recent years, the IRS has increased its scrutiny of not-for-profits’ unrelated business income (UBI). Dividends, interest, rents, annuities and other investment income generally are excluded when calculating unrelated business income tax (UBIT). However, there are two exceptions where such income is taxable.
- Debt-financed property
When your nonprofit incurs debt to acquire an income-producing asset, the portion of the income or gain that’s debt-financed is generally taxable UBI. Such assets are usually real estate, but 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 outstanding “acquisition indebtedness.”
But certain property isn’t considered debt-financed and therefore is exempt from this treatment. Examples include when:
- 85% or more of the property’s use is substantially related to your nonprofit’s exempt purpose,
- The property is used in a trade or business that’s excluded from the definition of “unrelated trade or business” either because it’s used in research activities or because the activity has a volunteer workforce, is conducted for the convenience of members, or consists of selling donated merchandise, or
- It’s covered by the neighborhood land rule.
What is the neighborhood land rule? If your nonprofit acquires real property intending to use it for exempt purposes within 10 years, the property won’t be treated as debt-financed property as long as it’s in the neighborhood of other property you use for exempt purposes.
- Income from controlled organizations
Interest, rents, annuities and other investment income aren’t excluded from UBI if they are received from a for-profit subsidiary or controlled nonprofit. Such payments are included in the parent organization’s taxable UBI to the extent that they reduce 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% of the “beneficial interest” (either stock in a for-profit or voting board positions in a nonprofit).
Proceed with caution
Failing to pay UBIT on debt-financed property or income from controlled organizations could have serious consequences, ranging from taxes, penalties and interest to the loss of your tax-exempt status. Contact us for more information on UBIT rules.