Tax Brief: Tax Impacts from Debt Financed Rental Property

Tax-exempt organizations engaging in business that is unrelated to its primary exempt purpose may generate income that subject to the unrelated business income tax (UBIT). One common type of income that may be subject to UBIT is income derived from rental of debt-financed property. Debt-financed property is any property that is held to produce income and was subject to acquisition indebtedness at any time during the organization’s tax year, even if such property was disposed of or the debt was paid off during the tax year. Commonly, this type of income is referred to as unrelated debt-financed income (UDFI). 

If substantially all of the property’s use is directly related to carrying out the exempt purpose of the organization, it is not considered to be a debt-financed rental and any income is not taxable. In this case, “substantially all” can be defined as 85% or more of the use of the property is related to an exempt purpose in terms of total time the property is used, total portion of the property used, or a combination of both. If less than 85% of the use of the property is devoted to the organization’s exempt purpose, only the portion of the property that is not used to further the organization’s exempt purpose is subject to the debt-financed property rules and considered UDFI.

The UDFI may also be excludable even if the property is used in an unrelated trade or business activity. Unrelated activities that qualify for the income to be considered non-taxable include any activity that is: carried out by unpaid volunteers; performed for the convenience of members, students, patients, officers or employees of a IRC Section 501(c)(3) entity or public college/university; or involved in the selling of merchandise when substantially all of which has been donated. Rental income produced by leasing space to other organizations who perform any of the aforementioned activities may also be excluded from UDFI.

Any rental income produced by the debt-financed property that does not qualify for an exception should be treated as UDFI and reported on Form 990-T. Deductions are allowed to be taken to the extent they are applicable directly to the rented portion of the property subject to tax (depreciation, interest, utilities, etc.). A formula using average acquisition debt outstanding and average adjusted basis of the property during the tax year is then applied to the total rental revenue and expenses to determine the amount to be reported as UDFI. Tax owed by the organization is then calculated using the net income and the applicable corporate tax rate.

Knowing the tax implications ahead of time will help ensure organizations make an informed decision when considering renting debt-financed property to third-parties.

The purpose of this article is to summarize the key components and reporting requirements of debt-financed income and is not intended to be all encompassing or serve as replacement for the IRS regulations or Forms 990/990-T instructions.

This article is meant to be a resource and provide tools to assist your organization. Please consult your tax advisor regarding your specific tax situation.