Linda J. Kramer, CPA, MBA
Accounting & Auditing Director
Accounting & Auditing Director
If your nonprofit has investment income, dividends, interest, rents and annuities, they’re generally excluded when calculating income subject to unrelated business income tax (UBIT). However, income from debt-financed property may be taxable. So it’s important to segregate income from such property and include it in UBIT calculations to help ensure you don’t trigger unwanted IRS attention.
What counts as debt-financed Unrelated Business Income (UBI)?
Income produced from debt-financed property generally is taxable as unrelated business income (UBI) in the same percentage as the debt is to the full acquisition cost. This means that 75% of any income or gain from a property with a loan for 75% of its cost will usually be taxable UBI.
The most common type of income-producing debt-financed property for nonprofits is probably real estate — for example, an office building with income from rents unrelated to your nonprofit’s mission. Other debt-financed property might include stocks or other investments purchased with borrowed funds.
Income-producing property generally is treated as debt-financed for UBIT purposes if, at any time during the tax year, it had outstanding “acquisition indebtedness.” If your nonprofit incurred debt before, during or shortly after it acquired or improved the property (but wouldn’t otherwise have incurred debt), the property may be considered acquisition indebted.
What doesn’t count?
Some types of debt-financed property aren’t considered when calculating UBIT:
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- Property related to your exempt purpose. If 85% or more of the use of the property is substantially related to your nonprofit’s exempt purposes, it won’t be considered debt-financed property. Therefore, income from the property won’t be taxable. Simply using the income to support your programs doesn’t make the property related to your organization’s exempt purpose. The property must be used in providing program services.
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- Property used in certain excluded activities. This is property used in a trade or business that’s excluded from the definition of “unrelated trade or business.” That’s either because it’s used in research activities or because the activity has a volunteer workforce, is conducted for the convenience of members, or operates to sell donated merchandise.
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- Real property covered by the neighborhood land rule. Your nonprofit must acquire the real estate intending to use it for exempt purposes within 10 years. Also, the property usually must be connected to other property your organization uses for exempt purposes. Favorable treatment will no longer apply if you abandon your intention to use the land for exempt purposes.
Bottom line
IRS code section 514 on Unrelated Debt-Financed Income contains a more detailed analysis with definitions, explanations and exceptions.
Understanding the tax implications in advance will help nonprofits make informed decisions before making any debt-financed purchases or accepting any debt-financed gifts. Documentation for all debt-financed property and the related income is essential to be able to comply with the IRS reporting requirements. This includes properly identifying any expenses that may be used to offset income subject to tax. Also, documentation as to why the income may be excluded in any year is important should the IRS come knocking.
Contact your GT Reilly advisor with any questions you may have about UBI.
