Many churches rent a portion of their property to outside groups. Is rental income generated by such arrangements subject to the unrelated business income tax (UBIT)? We have addressed this question in a number of articles in this newsletter. In general, rental income received by a church is not subject to UBIT so long as the property that is rented is not subject to any indebtedness. A recent IRS ruling addresses a unique question—what if a charity rents property that it owns debt-free to another organization that incurs debt in developing the property? Does the debt incurred by the lessee affect the charity's exemption from UBIT?
Facts of the case
A charity acquired property consisting of land and a building, and later acquired additional land adjacent to the building. All the property was acquired for cash and none of the property was ever subject to debt. The charity decided to "develop" the property through a lease arrangement to protect its investment, maximize its rate of return, and ensure that office space on the property would be up to market standards. In 1996, it entered into negotiations with another organization for a 97-year lease that would allow the lessee to develop the property, constructing a multi-story office tower and cinema. The charity and lessee proposed to sign a lease agreement calling for the lessee to pay the charity "base monthly rent" plus "additional" rent payments based on the greater of a fixed amount or a percentage of gross receipts received by the lessee.
The charity owns the property, and the property is not currently subject to debt. Further, the charity has no plans to incur indebtedness in connection with the construction of the improvements by the lessee. On the contrary, all financing for the project will be secured by the building to be constructed by the lessee. In the event that the lessee defaults on the construction or permanent loan, the lease provides that the charity has certain rights and remedies to preserve its interest in the land, and that among these rights is the right to be indemnified against loss of the land through foreclosure.
The charity asked the IRS if rental income generated by the lease would generate taxable unrelated business income.
What the IRS said
The IRS began its ruling by noting that the tax code excludes "rents" from the definition of unrelated business taxable income. This exemption does not apply, however, "if the determination of the amount of rent depends in whole or in part on the income or profits derived by any person from the property leased (other than an amount based on a fixed percentage or percentages of receipts or sales)." Further, the exemption of rental income for the definition of unrelated business taxable income does not apply to rental income derived from debt-financed property.
The IRS noted that rental income payable under the lease in question are fixed amounts "and will not be related to income or profits derived from the property." All of the payments "will be therefore classified as rents from real property within the meaning of the regulations." The IRS continued:
Because none of the property was subject to debt, and because [the charity] has taken all steps to ensure that it is not obligated in any manner on the debt incurred by [the lessee], the subsequent financing by [the lessee] of improvements to the property do not cause property owned by [the charity] to be debt-financed …."
Relevance to church treasurers
This ruling illustrates a number of important points:
- General rule. Rental income received by a church is exempt from the tax on unrelated business income.
- Rents based on lessee's profits. The tax code specifies that the exemption of rental income from the unrelated business income tax does not apply if the rental income is determined in whole or in part based upon the income or profits derived by the lessee from the leased property—other than an amount based upon a fixed percentage of the gross receipts or sales. If you rent property, and rental income is based on the lessee's income or profits, have your lease agreement reviewed by a tax attorney or CPA to be sure that you do not inadvertently trigger the unrelated business income tax.
- Debt-financed property. The exemption of rental income from the definition of unrelated business taxable income does not apply to the extent that the leased property is subject to an "acquisition indebtedness." However, this ruling illustrates that a church that rents debt-free property to another organization will not lose the exemption of rental income from UBIT because the lessee incurs debt in developing the property. However, the IRS stressed that the charity took steps, in the lease agreement, "to ensure that it is not obligated in any manner on the debt incurred by [the lessee]." This is an important point. If your church leases property to another organization that will develop the property, and it will incur debt doing so, then you should have a tax attorney draft your lease to be sure that you will not be obligated in any way for the lessee's debts. IRS Letter Ruling 9845020.
Tip. Even if the property your church rents is debt-financed, the rental income may be exempt from UBIT on the basis of other exceptions.