Many churches have realized a gain from the sale of property. In some cases, the church is selling property that it purchased in the past. In other cases the church is selling property that it received as a gift. Are these gains taxable to the church? That was the issue addressed by the IRS in a recent private letter ruling.
An owner of timberland proposed to donate portions of the property to a charity over a number of years. The charity's board of directors wanted to sell the timberland upon receipt in order to satisfy its fiduciary duty under state law to avoid speculative and nonproductive investments.
The board planned to use real estate brokers to sell the donated land in parcels at a price sufficient to satisfy the board's fiduciary duty. The board was concerned that gains realized from the sale of donated timberland would be taxable to the charity. As a result, the board asked the IRS if the gains would be taxable.
The IRS ruled (Letter Ruling9412039) that any gain realized by the charity from the sale of donated timberland would not be taxable. The IRS noted that federal law imposes a tax on the "unrelated business income" of tax-exempt organizations (including churches). However, "all gains or losses from the sale, exchange, or other disposition of property" are excluded from this tax, other than gains from the sale of property "held primarily for sale to customers in the ordinary course of the trade or business."
The IRS referred to a Supreme Court ruling addressing the standard to be applied in determining whether property is held "primarily" for sale to customers in the ordinary course of business. The Court interpreted the word "primarily" to mean "of first importance" or "principally." The IRS concluded that "by this standard, ordinary income would not result unless a sales purpose is dominant." The IRS concluded:
[Y]ou have determined that it is in your best interest to sell the land …. You will engage an independent broker to liquidate the assets of timberlands. You will retain oversight control; however, you will not perform any activities relating to the advertising or liquidation of the tracts. Neither you nor the timber management company will perform any development activity. Based on the fair market value estimate, the broker will set a minimum price and will request bids for all tracts in a single transaction.
Although a sale of the parcels in a single transaction is not assured, you will instruct the broker to sell the timberlands in as few parcels as possible at a price consistent with the prudence standards of [your] state law. You believe that the compensation arrangement with the broker will provide an incentive to the broker to sell the timberlands in a few large transactions rather than many small transactions.
These facts distinguish the proposed transaction from the sale of property held primarily for sale to customers in the ordinary course of business. Utilizing the services of a real estate broker in the manner described is not a determinative factor …. [W]e have concluded that this transaction does not involve property held primarily for sale to customers in the ordinary course of business. Therefore, income from the sale of this property is excluded from the computation of unrelated business taxable income ….
Relevance to church leaders
Church treasurers often wonder if gains realized from the sale of church property are taxable. This ruling illustrates an important point—any gain realized by a tax-exempt organization from the sale of property is not taxable as unrelated business income unless the gain is from the sale of property "held primarily for sale to customers in the ordinary course of the trade or business."
Churches that realize gain from an occasional sale of donated property, or from the sale of current property as part of a relocation, ordinarily will not be subject to the tax on unrelated business income since the property in such cases is not "held primarily for sale to customers in the ordinary course of the trade or business."
There are situations in which a church could be subject to the tax on unrelated business income as a result of gains realized from the sale of property. For example, assume that a church receives a large tract of donated property and subdivides it into individual lots that it attempts to market as a revenue-making project. It is likely that any gains realized from the sale of the lots would be taxable since the property in such a case could be viewed as "held primarily for sale to customers in the ordinary course of the [church's] trade or business."
Recommendation. If you have any questions regarding the application of the unrelated business income tax to a particular transaction, consult with a tax attorney or CPA.