Friday, April 26, 2024
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GiftLaw Note: When a charity or a charitable trust receives a property, it is important to examine the potential unrelated business income (UBI) upon sale of the property. If the maximization of return requires sale of the property in lots or parcels, then the question is whether or not this dividing and selling would cause the charity to be entering into the real estate business and generating UBI under Secs. 512 through 514 of the Code.

In this case, a charity received property and plans to sell parcels of that property to an independent developer who will then build homes, townhouses and other buildings on the property. The sale over a five- to 10-year period is permissible and will not cause UBI. The reason for avoidance of UBI is that the sale, even though over a period of five to 10 years, is not a "regularly engaged in activity," but rather is a one-time liquidation of an investment asset.

Thus, it is generally permissible for a charity or charitable trust to liquidate an asset in the manner that results in the best realization of income. It seems particularly important in this circumstance that the charity did not actually undertake the development, but rather merely sold the property to the outside developer. Furthermore, it was helpful in this case that a portion of the property is retained for the athletic fields and programs of the charitable organization, thus demonstrating a relationship of the property to the charitable purpose.
This is in response to L's request of October 23, 1995, in which L requested that we consider whether the proposed sale of undeveloped real estate will constitute unrelated business.

L is a private college located in M. L is exempt from tax under section 501(c)(3) of the Internal Revenue Code. L the tax imposed by section 51 1 (a)(1) on any unrelated business income L may have.

In 1988 L purchased real property (Parcel 1), consisting of 55 acres. L acquired Parcel I in order to relocate its athletic fields and from its main campus to accommodate future expansion of L's facilities on its main campus.

In 1962 L purchased property (Parcel 2), consisting of 58.53 acres. L has used part of Parcel 2 as open space for L's intramural athletic program.

L has determined to convert both parcels into more productive assets, since both are currently held as raw land and are not income producing. However, L will retain a portion of Parcel 1, which will house the athletic fields and stadium. Towards this end, L retained the services of N, an independent real estate consulting firm to develop a plan for the disposition of these parcels. N recommended that Parcel 1 be developed as a residential subdivision, and that Parcel 2 be developed as a combination of commercial uses, "garden apartments" and townhomes.

N prepared preliminary plans for the subdivision of Parcel 1 into 83 single family home sites, one parcel for the future development of 54 townhomes, and the retention of sufficient open space by L for future use as a football field. N then obtained the necessary preliminary subdivision approvals on L's behalf from the Borough of M to allow the subdivision of Parcel 1. N has since sought out and evaluated several potential purchasers to develop the site, ultimately settling on 0, a P corporation owned solely by Q, a party unrelated to L.

0 has formed a limited partnership called R, which will develop the property. L will convey the single family homesites to R in four phases over a 48 month period, and will be paid for each homesite from the gross receipts from their sales, as the improved homesites are sold by R. R has a right of first refusal to purchase the townhome parcel, and in the event that the townhome parcel is sold to a third party, L will reimburse R for a portion of the improvements common to both the single family and townhome parcels.

N has recommended that Parcel 2 be developed as a mixture of commercial and residential rental properties. At this point a preliminary plan has been prepared by N, for which subdivision approval is being obtained. The plan as developed by N will involve the subdivision of Parcel 2 into 11 parcels. At this point, N has not identified any purchasers/developers for Parcel 2. However, it is anticipated that N will locate the purchasers and arrange for the sales. It is envisioned that these sales will occur over a five to ten year period.

Section 501 (c)(3) of the Code provides, in part, for the exemption of organizations that are organized and operated exclusively for educational purposes, no part of the net earnings of which inures to the benefit of any private shareholder or individual.

Section 511 of the Code imposes a tax on the unrelated business taxable income of certain tax exempt organizations, including charitable and educational organizations described in section 501(c)(3) of the Code.

Section 512(a)(1) of the Code defines the term "unrelated business taxable income" with certain modifications, as the "gross income derived by any organization from any unrelated trade or business ..."

Section 513(a) of the Code provides that the term "unrelated trade or business" means, in the case of any organization subject to tax by section 511, any trade or business the conduct of which is not substantially related (aside from the need of the organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis of its exemption under section 501.

Section 512(b) of the Code provides for certain exclusions, specific deductions, and other special rules in computing unrelated business income, in part as follows:

"(5) There shall be excluded all gains or losses from the sale, exchange, or other disposition of property other than --
  1. stock in trade or other property of a kind which would properly be includible in inventory if on hand at the close of the taxable year, or
  2. property held primarily for sale to customers in the ordinary course of the trade or business ..."
In Rev. Rul. 55-449, 1955-2 C. B. 599, it was concluded that the construction and sale of 80 houses by an organization, otherwise exempt under section 501(c)(3) of the Code over a period of 18 months for the sole purpose of raising funds for the support of a church constituted an unrelated business within the meaning of section 513 notwithstanding the fact that the organization did not plan to engage in further similar activities.

Rev. Rul. 59-91, 1959-1 C.B. 215, describes a corporation that sold a portion of its property which had been held as an investment. The property that was sold was subdivided into residential lots, graded, the streets surfaced, and the required drainage installed. In holding that the gains realized from the sales of the lots constituted ordinary income, the ruling implies that the sizeable improvements made in order to facilitate the sales led to the conclusion that the property was held primarily for sale to customers.

In the case of Brown v. Commissioner, 143 F.2d 468 (5th Cir. 1944), the taxpayer owned 500 acres of unimproved land used for grazing purposes. He decided to sell the land and subdivided it into lots, cut in streets, installed sewers, constructed gas and electric lines and engaged in other activities of the kind usually carried out by a real estate developer. Each year 20 to 30 properties were sold. The court held that the taxpayer was holding lots for sale to customers in the regular course of business.

In Farley v. Commissioner, 7 T.C. 198 (1946), the taxpayer sold 25 lots out of a tract of land previously used in his nursery business but now more desirable as residential property. Since the taxpayer made no active efforts to sell and did not develop the property, the court described the sale as "in the nature of the gradual and passive liquidation of an asset." Therefore, the income derived from the sales represented capital gains income, rather than ordinary income from the regular course of business as in the Brown case.

In Adam v. Commissioner, 60 T.C. 996, (1973), acq. 1974-1 C.B. 1, the Tax Court analyzed the following factors in determining whether the taxpayer was engaged in the operation of a trade or business:
  1. the purpose for which the asset was acquired,
  2. the frequency, continuity. and size of the sales,
  3. the activities of the seller in the improvement and disposition of the property,
  4. the extent of improvements made to the property,
  5. the proximity of sale to purchase, and
  6. the purpose for which the property was held during the taxable year.
In Adam and subsequent cases, the Tax Court found that no one of these factors is controlling but all are relevant facts to consider in determining whether the sale of property occurred in the regular course of the taxpayer's business. See Houston Endowment, Inc. v. United States, 606 F.2d 77 (5th Cir. 1979) Biedenharn Realty Co. v. United States, 526 F.2d 409 (5th Cir. 1976); and Buono v. Commissioner, 74 T.C. 187 (1980).

In Malat v. Riddell, 383 U.S. 569 (1966), the Supreme Court interpreted the meaning of the phrase "held primarily for sale to customers in the ordinary course of the trade or business" under section 1221 (1). The Service has often applied the principles derived under section 1221 to rulings interpreting the language of section 512(b)(5). The Court interpreted the word "primarily" to mean "of first importance" or .'principally." By this standard, ordinary income would not result unless a sales purpose is dominant.

Further, the courts have often held that a taxpayer may make "reasonable expenditures and efforts" (such as subdividing land, construction of streets, the provision of drainage, and furnishing of access to such a necessity as water as part of the "liquidation" of an investment asset without being treated as engaged in a trade or business for purposes of Section 1221 (1). See Barrios Estate v. Commissioner, 265 F.2d 517 (2d Cir. 1957) and Buono v. Commissioner, 74 T.C. 187 (1980).

L did not acquire the property for sale to individuals, but rather acquired the parcels for use in its exempt purposes. L acquired Parcel 1 in 1988 and Parcel 2 in 1962. This is completely contrary to the short turn around period between purchase and sale which an organization engaged in the "business" of selling real property would ordinarily experience. L has represented that L has previously used Parcel 2 in furtherance of L's exempt purposes and intends to use a portion of Parcel 1 for such purposes in the future. L will retain a portion of Parcel 1 for use as an athletic field and stadium.

L is maintaining control over the development process to ensure that a compatible environment for L's continuing use of adjoining areas. None of the development activity has been undertaken directly by L. L will not perform any functions relating to the advertising or marketing of the parcels to the general public. Although the sale transactions may take a significant period of time to accomplish, it is still a one time transaction. It is clear that L has not approached the sale of these parcels in a manner typical of real estate sales, but rather as the liquidation of an investment held for exempt purposes.

Therefore, it is our conclusion that the property has not been held for sale in the ordinary course of business. Rather, this is a one-time liquidation of an investment asset. We further conclude that, consistent with the primary purpose test and facts and circumstances set out in Malat v. Riddell, these transactions do not involve the sale of property in the ordinary course of business but rather represent the liquidation of investment assets.

The income from these transactions is excluded by virtue of the exclusion contained in section 512(b)(5), since the sale of investment property is involved rather than property held in inventory or for the sale to customers in the ordinary course of a trade or business.

Accordingly, we conclude the real estate is not held in the ordinary course of any trade or business. and income derived from the sale of parcels described above will not be subject to tax as unrelated business income within the meaning of sections 511 through 514 of the Code, by virtue of the exception of section 512(b)(5).

This letter is directed only to the organization which requested it. Section 6110(j)(3) of the Code provides that it may not be used of cited as precedent.

We are providing you key District Director with a copy of this ruling. You should keep a copy for your permanent records.

Sincerely yours,
____
Edward K. Karcher
Chief, Exempt Organizations
Technical Branch

Related Topics On Real Estate Subdivision, Sale of Lots and UBI

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