IRC Section 514 expands unrelated business income to include unrelated debt-financed income from investment property in proportion to the debt acquired in purchasing it. Property purchased with borrowed money (acquisition indebtedness) and held to produce investment income is referred to as debt-financed property.
IRC Section and Treas. Regulation
IRC Section 514(a) Generally includes as gross income from unrelated trade or business certain amounts with respect to debt-financed property.
IRC Section 514(b) Defines debt-financed property
IRC Section 514(c) Defines the term acquisition indebtedness.
Treas. Reg. Section 1.514(b)-1 Definition of debt-financed property
Treas. Reg. Section 1.514(c)-1 Definition of acquisition indebtedness
Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)
Southwest Tex. Elec. Coop., Inc. v. Commissioner, 67 F.3d 87 (5th Cir. 1995) The organization drew on low-interest federal loans available for, but not used, for the purpose of exempt-function construction related activities. The 5th Circuit affirmed the Tax Court’s holding that the interest income from the treasury notes purchased with the loan funds was debt-financed property within the meaning of section 514(b), and therefore unrelated business income to the organization.
Rev. Rul. 74-197 The investment by an exempt employees' trust in a partnership that was organized to invest in securities and borrows funds for that purpose may result in unrelated business taxable income to the extent its share of partnership income is derived from or on account of the debt-financed securities.
Rev. Rul. 76-354 An organization carried out its charitable purpose by making grants to other charitable organizations. To obtain income for its charitable program it incurred indebtedness to purchase mineral production payments Therefore, the indebtedness constituted an acquisition indebtedness within the meaning of IRC Section 514(c). Accordingly, the mineral production payments are debt-financed property within the meaning of section 514(b) and the income derived therefrom is unrelated business taxable income to the extent specified in IRC Section 514(a).
Rev. Rul. 81-138 Primary activity of an organization exempt from federal income tax under section 501(c)(6) of the Code was the carrying on of a program of encouraging new industries to move to the area. Property leased to an industrial tenant by the organization at less than fair market value in order attract industry to the community did not constitute debt-financed property within the meaning of section 514(b)(1). The activity contributed importantly to the purpose of the organization's exempt status.
Rev. Rul. 95-8 Income from a short sale of publicly traded stock is not income attributable to debt-finance property within the meaning of section 514. Although a short sale created an obligation, it did not create indebtedness. Deputy v. du Pont, 308 U.S. 488, 497-98 (1940).
Debt-financed property is any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness. IRC Section 514(b); Rev. Rul. 81-138. Debt-financed property includes rental real estate, tangible personal property, and corporate stock held to produce income such as interest, dividends, royalties, rents, capital gains, etc. Debt financed property has been held to include mineral production payments purchased with borrowed funds (Rev. Rul. 76-354) and a partnership interest (Rev. Rul. 74-197).
IRC Section 514(c) defines acquisition indebtedness as the outstanding amount of an indebtedness incurred before, during or after that acquisition or improvement. In the case of indebtedness incurred before or after, acquisition indebtedness exists only if the indebtedness would not have been incurred but for such acquisition or improvement. IRC Section 514(c)(1)(B), (C).
There are also several factors that need to be considered before determining the amount of debt-financed income, including the income from the property, the cost of the property, and the amount of the liability.
The amount of income subject to unrelated business income tax is derived from calculating the “average acquisition indebtedness,” the “average adjusted basis” and the net income from the debt-financed property. See IRC Section 514(a)(1).
Income from property acquired subject to a liability is generally considered debt-financed, and therefore usually included in unrelated business taxable income; however, there are several specific exceptions:
- If substantially all of a property’s use is related to exempt purposes.
- Income that is otherwise taxable under IRC Sections 511-513 unless included in income under IRC Section 512(b)(5).
- Income from property producing research income described in IRC Section 512(b)(7), (8), or (9).
- Income from any activity excepted from the definition of unrelated trade or business by IRC Section 513(a)(1) [volunteer exception], (2) [501(c)(3) and college exception], or (3) [thrift shop exception].
- Income from property owned by exempt organization and used by a related organization to the extent used for purpose in IRC Section 514(b)(1)(A), (C), (D) .
- Medical Clinic Exception (related use).
- Life Income Contract Exception: Income received from a remainder interest where the income is paid to the donor, other individuals, or both during the lifetime of such individuals.
- Neighborhood land rule: Income from neighborhood property intended to be used for exempt purposes in the next 5 [or 10] years
Issue Indicators or Audit Tips
The audit techniques involved in examining debt-financed income are primarily financial in nature. Basic financial auditing techniques should be employed.
- Examine the financial statements, particularly the balance sheet accounts, for income producing assets and long-term liabilities. The income statement should be examined for passive forms of income that is generally produced by debt-financed property. The assets should be closely examined even though the liability accounts do not show any encumbrances that could be attached to assets.
- Does the 990, 990-EZ, or 990-PF show any rental income? If so, is debt on the balance sheet that might be associated with that income.
- Tour the facilities. Inquire during the tour about whether any part is rented out.
- The purchase of common stocks or bonds with borrowed funds (stocks purchased on margin) gives rise to debt-financed property. An examination of the brokerage statements for the year(s) of examination should help to turn-up any margin accounts or pledges of securities. Expense analysis should disclose any interest payments. The Board of Directors Finance Committee (or a similar type committee) minutes should disclose the investments and any encumbrances.
- Investments in partnerships as either a limited or general partner can create debt-financed income. Anytime there is an investment in a partnership, the partnership return (Form 1065) must be secured to determine if there is any debt-financed income. Also inspect the K-1 received by the organization from the partnership.
- Most loans on property require insurance, so you should review the insurance policies of the organization to see who the "loss payees" are.
- Public property records will contain information on lien holders and mortgagors. These should be reviewable on-line.