Is Rental Income Taxable?

Not if rented property is owned debt-free, IRS rules.

IRS Letter Ruling 199940034

Background. Many churches rent a portion of their property to outside groups. Examples include rental of church facilities to another congregation, or to outside organizations that operate a preschool or conduct exercise classes. Some churches rent their sanctuary for weddings. Is rental income generated by such arrangements subject to the federal unrelated business income tax (UBIT)? The IRS addressed this issue in a recent ruling.

Facts of the case. A charity purchased land in 1997 to build a facility to carry out its charitable and educational functions. It planned on renting some of the building to the public for wedding receptions and other functions. The charity represented that all rent and fees would be at fair rental value for the property, as recommended by an independent expert in the real estate appraisal business. Services provided in connection with the rental of facilities would be only the usual and customary services including janitorial services. The rent and fees are expected to exceed the operating expenses of the facility. The excess revenue will be used by the charity to support its charitable activities.

The IRS ruling. The IRS noted that the tax code imposes a tax on the "unrelated business taxable income" of tax-exempt organizations. The code defines the term "unrelated business taxable income" to mean the gross income derived by any organization from any unrelated trade or business that is regularly carried on by it, less allowable deductions. An "unrelated trade or business" is defined as any trade or business that is not "substantially related" to the exercise or performance of a charity's exempt purposes.

The IRS acknowledged that the tax code excludes rents from real estate from the unrelated business income tax. But this exception does not apply if the rented property is "debt-financed." The code defines the term "debt-financed property" to mean any property "which is held to produce income and with respect to which there is an acquisition indebtedness at any time during the taxable year." An "acquisition indebtedness" means the unpaid amount of the indebtedness incurred by the organization in acquiring or improving the rented property.

The IRS noted that the charity in this case purchased the land, and planned on constructing its building, without having to incur any debt. As a result, it concluded that "the rental income … is excludable from the unrelated business tax."

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