Friday April 19, 2024

7.1.4 Debt-Financed Income

Debt-Financed Income

Related and Dual Use Exceptions:  If a charity owns debt-financed property but (1) "substantially all" (85% or more) of the use of the property is (2) substantially related to the charity's charitable purpose, then no part of the property is treated as debt-financed.

The Neighborhood Land Rule:  A charitable organization may purchase land with a loan if the land will be used for the extension of the charity's exempt purpose within ten years from the date of acquisition.

The Ten Year Gift Rule:  If a person donates debt-encumbered property to a charity, the charity may accept the gift.

Gift Exceptions and the "Five and Five Rule":  If a charity receives debt-encumbered property through a bequest or devise (testamentary gift made by a donor at death), the property will not be treated as debt-financed for the following 10 years.

Qualified Research Income:  Income derived from research may be excluded from the UBIT rules.
If a charity has income that is generated by "debt-financed property," a percentage of that income is subject to unrelated business income taxation (UBIT). Sec. 514. This is true even if the income is passive or would not otherwise be subject to UBIT. The percentage is determined by dividing the amount of the debt by the charity's basis in the property. Sec. 514(a).

Debt-financed property is any property that is (1) held to produce income and (2) subject to acquisition indebtedness at any time during the year. "Acquisition indebtedness" includes any debt incurred in connection with the acquisition or improvement of the property. Sec. 514(c)

Related and Dual Use Exceptions
If a charity owns debt-financed property but (1) "substantially all" (85% or more) of the use of the property is (2) substantially related to the charity's charitable purpose, then no part of the property is treated as debt-financed. Sec. 514(b)

If debt-financed property is used both for charitable and noncharitable activities (with charitable activities amounting to less than 85% of use), the property is treated as debt-financed only in proportion to its noncharitable activities.

The Neighborhood Land Rule
A charitable organization may purchase land with a loan if the land will be used for the extension of the charity's exempt purpose within ten years from the date of acquisition. The land must also be in the immediate neighborhood of the charity (no more than one mile from the charity's primary location). The charity must demonstrate with reasonable certainty that the land will be used for the organization's exempt purpose within ten years. Sec. 514(b)(3)(c)(i).

The Ten Year Gift Rule
If a person donates debt-encumbered property to a charity, the charity may accept the gift. However, if a charity does accept a property subject to debt, the charity must sell or otherwise dispose of the property with ten years from the gift date. If a charity remains in title to the property for more than ten years, the property will be considered debt-financed and the charity will be required to pay UBIT. In the case of a church, the rule is extended to 15 years.

Gift Exceptions and the "Five and Five Rule"
If a charity receives debt-encumbered property through a bequest or devise (testamentary gift made by a donor at death), the property will not be treated as debt-financed for the subsequent 10 years.

If a charity receives debt-encumbered property during the donor's life, the property will not be treated as debt financed for the subsequent 10 years only if 1) the charity does not assume the mortgage, 2) the debt was placed on the property more than five years before the date of the gift and 3) the property was owned by the donor for more than five years before the gift was made.

Qualified Research Income
Income derived from research may be excluded from the UBIT rules. Research performed by the government, or any agency there of, is excluded from UBIT. Sec. 512(b)(7). Research performed by a college, university or hospital is also excluded from UBIT. Sec. 512(b)(8). Finally, income related to research conducted by an organization operated primarily for the purpose of conducting fundamental research is excluded from UBIT if the research is made available to the general public. Sec. 512(b)(9).

Private Letter Rulings

PLR 200352019 Indirect Interest in Endowment Won't Generate UBTI:   University is trustee of certain charitable remainder and charitable lead trusts (the "Trusts"). University is also the sole charitable beneficiary of each of the Trusts. Apart from the Trusts, University maintains an endowment, which it invests in a widely diverse manner. The endowment invests in stocks, bonds and real estate and holds certain partnership interests that produce some debt-financed income. The endowment has historically earned an excellent return on its investments.

PLR 200821036 Land Purchased by Church Meets Neighborhood Land Rule:   Church acquired land through debt-financing with the intent to develop the land for a related use. Church paid off the debt by Date 1. Though Church obtained approved building plans for the property and held fundraisers for the proposed development, fundraising fell short.

PLR 201246040 Church's Property Is Exempt From Debt-Financed Property Provision:   Church was incorporated in a particular state on Date 1. Church purchased three parcels of land. Parcel One was purchased on Date 2, Parcel Two on Date 3 and Parcel Three on Date 4.

Related Topics on Debt-Financed Income

Bartels Trust:    A supporting organization for the University of New Haven called the Bartles Trust was established in 1988. During the years 1991, 1992 and 1993, the Bartles Trust invested in securities on margin. The trust paid unrelated business income tax (UBIT) on the income from the margin investments and later sought a refund.

Siskin:    The Mose and Garrison Siskin Memorial Foundation, Inc. ("Foundation") is a tax-exempt organization under Sec. 501(c)(3). It borrowed money from 800 insurance policies that had been donated over a period of years. The interest cost on the insurance policy loans was approximately 5.5%. The borrowed funds were then invested at 10%, producing a profit of approximately 4.5%.

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