For nonprofits, investment income from sources like dividends, interest, rents, and annuities is typically excluded from the calculation of unrelated business income tax (UBIT). However, when this income is derived from debt-financed property, it often becomes taxable. To avoid triggering unwanted IRS scrutiny, it’s crucial to segregate income from such properties and include it in your UBIT calculations.
What Qualifies as Unrelated Business Income?
Income generated from debt-financed property is generally considered taxable unrelated business income (UBI) in proportion to the amount of debt on the property relative to its full acquisition cost. For instance, if 75% of a property’s purchase price is financed with a loan, then 75% of the income or gain from that property is typically subject to UBI.
The most common type of debt-financed property for nonprofits is real estate, such as an office building that generates rental income unrelated to your organization’s mission. However, debt-financed property can also include stocks or other investments purchased with borrowed funds.
For UBIT purposes, income-generating property is considered debt-financed if it has outstanding “acquisition indebtedness” at any point during the tax year. If your nonprofit incurred debt before, during, or shortly after acquiring or improving the property (and would not have otherwise incurred the debt), the property may be classified as acquisition indebted.
What Doesn’t Count as UBI?
Not all debt-financed property is subject to UBIT. Certain types of properties and activities are excluded:
- Property Related to Your Exempt Purpose: If 85% or more of the property’s use is substantially related to your nonprofit’s exempt purposes, it is not considered debt-financed property, and the income generated from it will not be taxable. However, simply using the income to support your programs does not qualify the property as related to your exempt purpose; the property itself must be used in providing program services.
- Property Used in Certain Excluded Activities: This includes 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, has a volunteer workforce, is conducted for the convenience of members, or operates to sell donated merchandise.
- Real Property Covered by the Neighborhood Land Rule: If your nonprofit acquires real estate with the intention of using it for exempt purposes within 10 years, and the property is typically connected to other property used for exempt purposes, it may not be subject to UBIT. However, if you abandon your intention to use the property for exempt purposes, this favorable treatment no longer applies.
When to Seek Professional Help
There are additional circumstances in which investment income, such as dividends, interest, rents, and annuities, may be taxable — for instance, if the income is paid directly from a subsidiary that your nonprofit controls. Navigating the complexities of UBIT can be challenging.
At Accavallo & Company LLC, we encourage you to reach out to us for guidance and assistance. Our experts can be reached at [email protected] or call 203-925-9600 for immediate assistance.
