Why is there a tax on unrelated business income for exempt entities?
Congress does not want a tax-exempt entity to use its tax exemption to put for-profit companies out of business. If a tax-exempt entity is doing something that a for-profit company does and competing with for-profit companies, it should not get the benefit of its tax exemption to compete with the for-profit companies. For example, if a charity provides food and housing for a reduced fee to low-income families, the provision of those services and the collection of donations to fund those services to the low-income families should be tax exempt. However, if the charity runs a restaurant for paying customers, the activities related to paying customers will likely be subject to tax.
What is an unrelated trade or business?
Under Internal Revenue Code (“IRC”) Section 513, an unrelated trade or business is any trade or business which is regularly carried on and is not substantially related to the exempt purpose of the entity. However, fundraising activities that are used to finance the exempt purpose of the entity are not “unrelated.”
What type of exempt entity should be concerned with unrelated business taxable income (“UBTI”)?
Most types of exempt entities are subject to UBTI:
Can UBTI apply when an exempt entity invests in a real estate investment partnership?
Yes. An investment in a real estate partnership is at risk of being subject to UBTI because real estate investments are usually debt financed.
Are there exceptions from the UBTI under IRC Section 512 that would apply to real estate investment partnerships?
Yes. There are several exceptions for UBTI that may be earned by real estate investment partnerships.
However, the following specified gains and losses are included in UBTI: gains or losses from the sale, exchange or other disposition of stock in trade, inventory, or property held primarily for sale to customers in the ordinary course of the trade or business.
Will those exceptions protect tax-exempt investors from the UBTI in a real estate partnership?
Unfortunately, if the assets of a real estate partnership include debt-financed property, IRC Section 514 will bring you into the scope of UBTI, notwithstanding any of the exceptions above. In other words, even if the above exceptions on rent and gains exclude the income from UBTI, if the assets of the partnership are debt-financed then the income of the partnership will probably create UBTI for the tax-exempt partners.
Debt-financed property is property that is held to produce income and that has acquisition indebtedness. Under IRC Section 514(c), “acquisition indebtedness” is basically any debt that is incurred before, during or after the acquisition or improvement of property, if the debt would not have been incurred but for such acquisition or improvement. Where property is acquired subject to a mortgage, that is also considered debt-financed property, even if the organization did not assume or agree to pay such indebtedness.
The UBTI calculation for debt-financed property is made by taking a percentage of the total gross income derived from the property. The percentage is meant to represent the proportion of the property that is debt financed. It is calculated using a fraction with the average acquisition indebtedness over the average amount of the adjusted basis of such property over the year. Related deductions are also allowed by using the same percentage.
Would the “fractions rule” help a tax-exempt partner avoid UBTI on debt-financed property?
The fractions rule is part of one of the paths to avoid UBTI in a labyrinth of requirements under IRC 514(c)(9). Unfortunately, it is a long and difficult road to go through the rules and conclude that an exempt investor would be able to avoid UBTI in a real estate partnership that invests in debt-financed property.
The general rule under IRC 514(c)(9) states that acquisition indebtedness does not include debt incurred by a “qualified organization.” So far, so good. Unfortunately, there are significant restrictions to this general rule.
First, to avoid UBTI on debt financed property, the taxpayer must be a “qualified organization” and a “qualified organization” is a limited definition, which includes only:
Second, even if the tax-exempt entity is a qualified organization, under IRC Section 514(c)(9)(B) there are numerous exceptions to the general rule of exclusion for debt incurred by a qualified organization. For instance, debt-financed property would be included in UBTI calculation of a qualified organization if the price for the acquisition is not a fixed amount determined as of the date of the acquisition or the completion of the improvement. It would also be included in UBTI if the real property is leased to person who sold the property to the organization or an entity related to the organization. A real estate partnership would have to make sure it does not fall into any of these of these exceptions.
Third, in addition to avoiding the exceptions in the previous paragraph, if the property is held by a partnership, then the partnership must meet one of the following requirements in order to exclude the income from UBTI.
This fractions rule is further elaborated in the regulations.
What can be done to avoid UBTI from investments in real estate partnerships?
The only option may be to avoid investments in real estate partnerships altogether. Alternatively, the partnership could avoid financing its property with debt or possibly use a blocker corporation. Otherwise, if the entity is a qualified organization, it could engage the services of a tax expert who could very carefully draft the partnership documents to try to avoid UBTI by going through the maze of exceptions available in the Code. However, the other partners may not be inclined to agree to the strict restrictions required.
If you have inquiries about this article, please contact any member of the tax team at FGMK:
Adam S. Handler
Christie R. Galinski
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