Dividends, interest, rents, annuities and other investment income are generally excluded when calculating unrelated business income tax (UBIT). However, tax law provides two exceptions where such income will be deemed taxable. And, with IRS scrutiny of unrelated business income intensifying these days, not-for-profit organizations need to know about these potential pitfalls.

Debt-Financed Property

When a not-for-profit organization incurs debt to acquire an income-producing asset, the portion of the income or gain that's debt-financed is generally taxable as unrelated business income (UBI). Such assets are usually real estate — for example, an apartment building with income from rents not related to the organization's mission. However, 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 outstanding "acquisition indebtedness" — debt incurred before, during or shortly after the acquisition (or improvement) of property if the indebtedness would not have been incurred but for the acquisition.

Certain property, however, is exempt from this treatment:

Related to exempt purposes. If 85% or more of the use of the property is substantially related to a not-for-profit organization's exempt purposes, it is not excluded as debt-financed property. Related use cannot be solely to support the organization's need for income or its use of the profits.

Used in an unrelated trade or business. To the extent that income from a property is treated as income from an unrelated trade or business, the property is not considered debt-financed, as the income is already UBI.

Used in certain excluded activities. Debt-financed property does not include property used in a manner 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, is conducted for the convenience of members, or consists of selling donated merchandise.

Covered by the neighborhood land rule. If a not-for-profit organization 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 is in the neighborhood of other property the organization uses for exempt purposes. The latter exception applies only if the intent to demolish any existing structures and use the land for exempt purposes within 10 years is not abandoned.

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 not-for-profit organization. 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% of the "beneficial interest" — either stock in a for-profit or voting board positions in a not-for-profit. For example, if a for-profit leases space from an organization that owns more than 50% of its stock, the lease payments are valid deductions from taxable income. However, when these lease payments are received by the controlling not-for-profit organization, 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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.