- 7.27.8 Unrelated Debt-Financed Income
- 220.127.116.11 Overview
- 18.104.22.168 Background
- 22.214.171.124 Computation of Debt-Financed Income
- 126.96.36.199.1 Formula
- 188.8.131.52 Gain From Sale or Other Disposition of Property
- 184.108.40.206 Average Acquisition Indebtedness
- 220.127.116.11.1 Indeterminate Price
- 18.104.22.168 Average Adjusted Basis
- 22.214.171.124 Deductions
- 126.96.36.199 Losses
- 188.8.131.52.1 Net Operating Loss
- 184.108.40.206 Digest of Published Rulings
Part 7. Rulings and Agreements
Chapter 27. Exempt Organizations Tax Manual
Section 8. Unrelated Debt-Financed Income
IRC 514 expands "unrelated business income" to include "unrelated debt-finance income" from investment property. The investment income included is proportionate to the debt on the property. Various types of passive income are subject to this tax but only if the income arises from property acquired or improved with borrowed funds, and the production of income is unrelated to the purpose constituting the basis of the organization’s tax exemption.
Related chapters under this handbook are found in:
Acquisition indebtedness — IRM 7.27.10
Average acquisition indebtedness — IRM 220.127.116.11
Average adjusted basis — IRM 18.104.22.168
Debt-financed property — IRM 7.27.9
Rents from real property have been traditionally excluded from the statutory definition of unrelated business taxable income. In order to avoid an abuse of this exclusion, the Revenue Act of 1950 included "business lease" provisions which provided, in general, that long-term rentals from real property would be taxed to the extent of the indebtedness on the property. This provision applied only to those exempt organizations that were subject to unrelated business income tax, and there was an exception for rents from real property subject to a business lease of five years or less.
In an attempt to convert ordinary income into capital gain, some business owners arranged for exempt organizations to acquire their businesses entirely out of the earnings of those businesses. This type of situation was highlighted in Clay B. Brown and Dorothy E. Brown v. Commissioner, 325 F. 2d 313 (1963), aff’d, 380 U.S. 563 (1965). Typically, a charity buys an incorporated business making a small (or no) down payment to the owners and agrees to pay the balance of the purchase price only out of profits to be derived from the property. The charity immediately liquidates the corporation and then leases the business assets to a new corporation formed to operate the business. The stockholders of the original business manage the business for the new corporation and frequently hold a substantial minority interest in the new corporation. The new corporation pays 80% of its business profits as "rent" to the charity which then passes 90% of those receipts on to the original owners until the original purchase price is paid in full. The charity has no obligation to pay the original owners out of any funds other than the "rent" paid to it by the new corporation.
In Clay Brown, the owners of the business were able to realize increased, after-tax income and the exempt organization was able to acquire the ownership of a business valued at $1.3 million without the investment of its own funds. In 1965, the Supreme Court held that the owners were entitled to treat as capital gains (reported on the installment basis) the money they received from the foundation. In University Hill Foundation, 51 T.C. 548 (1969), the Tax Court held that an organization, engaged in essentially the Clay Brown type of operation on a large scale, did not lose its tax exemption, nor did it have unrelated business income.
The Ninth circuit Court of Appeals eventually reversed the decision of the Tax Court in the University Hill Foundation case finding that the Foundation was engaged in a commercial business for profit and was therefore not operated exclusively for exempt purposes. University Hill Foundation v. Commissioner, 446 F. 2d 701, rev’g. 51 T.C. 548 (1969), cert. denied, 405 U.S. 965 (1972). In the interim, Congress remedied this situation by including in the Tax Reform Act of 1969 a provision which imposes the unrelated business income tax on all types of passive unrelated income from income-producing property. This contrasts to the "business lease" provisions that only taxed "rentals from real property." To further strengthen this measure, Congress expanded the categories of exempt organizations subject to unrelated business income tax to include all organizations exempt under IRC 501(a) other than organizations described in IRC 501(c)(1).
IRC 512(b)(4) provides that an organization subject to IRC 511 must include in gross income from an unrelated trade or business an unrelated debt-financed income.
For each debt-financed property, the "unrelated debt-financed income" is that amount which is the same percentage (not over 100%) of the total gross income derived during a taxable year from such property as the average acquisition indebtedness regarding the property is of the average adjusted basis of the property. This percentage is referred to in Reg. 1.514(a)–1(a)(1)(iii) as the "debt/basis percentage."
The formula for deriving "unrelated debt-financed income" is:
Average acquisition indebtedness X Gross income from debt−finance property = Unrelated debt financed income Average adjusted basis
Under this formula, the percentage of income treated as income from an unrelated trade or business decreases as the indebtedness on the debt-financed property decreases.
X, an exempt trade association, owns an office building which is debt-financed property. The building in 1971 produces $10,000 of gross rental income. The average adjusted basis of the building for 1971 is $100,000, and the average acquisition indebtedness with respect to the building in 1971 is $50,000. Accordingly, the debt/basis percentage for 1971 is 50% (the ratio of $50,000 to $100,000). Therefore, the unrelated debt-financed income with respect to the building for 1971 is $5,000 (50% of $10,000).
If an organization sells or otherwise disposes of debt-financed property, it must include in computing unrelated business taxable income an amount with respect to any gain (or loss) which is the same percentage (not over 100%) of the total gain (or loss) derived from the sale as:
The highest acquisition indebtedness regarding the property during the 12-month period preceding the date of disposition is of
The average adjusted basis of such property.
Reg. 1.514(a)–1(a)(1)(v)(b) provides that the tax on this amount is determined in accordance with the rules regarding capital gains and losses. (Subchapter P, chapter 1 of the Code)
However, Rev. Rul. 77–71, 1977–1 C.B. 155, provides that the transfer, subject to an existing mortgage, of an appreciated building by a tax-exempt organization to its wholly-owned taxable subsidiary does not result in a gain with respect to which that exempt organization will be taxed under IRC 511.
The term "average acquisition indebtedness" means the amount of outstanding principal indebtedness during that portion of the taxable year the property is held by an organization.
Average acquisition indebtedness is computed by determining principal indebtedness on the first day in each calendar month during the taxable year, adding them together, then dividing the sum by the total number of months during the year the organization held the property. A fractional part of a month is treated as a full month in computing average acquisition indebtedness. Reg. 1.514(a)–1(a)(3)(ii).
In Marprowear Profit-Sharing Trust v. Commissioner, 74 T.C. 1086 (1980), a qualified trust under IRC 401(a) negotiated a reduction in the purchase price of a shopping center, which was debt-financed property, two years after the trust purchased the property. Since this reduced the amount owing on the property, the trust argued that it should be allowed to retroactively reduce the acquisition indebtedness on the property back to the time of the purchase. The Tax Court disagreed. The Court noted that to hold otherwise would mean that a property’s acquisition indebtedness could never be fixed because any mortgage payments, prepayments, or negotiated reductions of any sort in any following taxable year would reduce the property’s acquisition indebtedness.
In the event an organization purchases property in a transaction where neither the price no debt is clearly stated, the unadjusted basis of property acquired (or improved) is the fair market value of the property (or improvement) on the date of acquisition (or completion of improvement). The initial acquisition indebtedness is the fair market value of the property (or improvement) on the date of acquisition (or completion of improvement) less any down payment or other initial payment applied to the principal indebtedness. Reg. 1.514(a)–1(a)(4)(ii).
The average acquisition indebtedness of such property is computed in the usual manner as set forth above. Reg. 1.514(a)–1(a)(4)(iii).
The "average adjusted basis" of debt-financed property is the average amount of the adjusted basis of such property during that portion of the taxable year it is held by an organization. It is computed by averaging the adjusted basis as of the first day and as of the last day during the taxable year that the organization holds the property. (See IRC 1011 and the Regulations thereunder for determination of the adjusted basis of property.)
The average adjusted basis of debt-financed property is not affected by the fact that an organization was exempt from tax for prior taxable years. Adjustment must be made under IRC 1011 for the entire period since the acquisition of the property.
For example, adjustment must be made for depreciation for all prior taxable years whether or not the organization was exempt from tax. The fact that only a portion of the depreciation allowance may be taken into account in computing the percentage of deductions allowable under IRC 514(a)(2) does not affect the amount of the adjustment for depreciation which is used in determining average adjusted basis.
Under IRC 514(a)(2), the deductions allowed with respect to each debt-financed property are determined by applying the debt/basis percentage to the sum of the deductions allowable.
The deductions allowable are those items allowed as deductions by chapter 1 of the Code which are directly connected with the debt-financed property or income therefrom (including the dividends received deductions allowed by IRC 243, 244, and 245) except that:
The allowable deductions are subject to the modifications provided by IRC 512(b) on computation of the unrelated business taxable income, and
The depreciation deduction under IRC 167 is computed only by use of the straight-line method. Reg. 1.514(a)–1(b)(2).
To be "directly connected with" debt-financed property or the income therefrom, an item of deduction must have proximate or primary relationship to such property or income. Expenses, depreciation, and similar items attributable solely to such property qualify for deduction, to the extent they meet the above requirements.
If the straight-line depreciation allowance for an office building is $10,000 a year, an organization would be allowed a deduction for depreciation of $10,000 if the entire building were debt-financed property. However, if only half of the building were treated as debt-financed property, the depreciation allowed as a deduction would be $5,000.
If the sale or exchange of debt-financed property results in a capital loss, the amount of such loss taken into account in the taxable year in which the loss arises is computed in determining the gain (or loss) from the sale or other disposition of the property. If any part of a loss may be carried back, or forward to another taxable year, it is taken as a deduction for that year without further application of the debt/basis percentage for such year.
If, after applying the debt/basis percentage to the income and deductions from debt-financed property, the deductions exceed such income, an organization has a net operating loss for the taxable year. This amount may be carried back or forward to other taxable years in accordance with IRC 512(b)(6). However, the debt/basis percentage is not applied in such other taxable years to determine the amounts that may be taken as deductions in those years. Reg. 1.514(a)–1(b)(5).
A property is debt-financed property. During 1974, Y, an exempt organization, receives $20,000 of rent from a building which it owns. Y has no other unrelated business taxable income for 1974. For 1974 the deductions directly connected with this building are property taxes of $5,000, interest of $5,000 on the acquisition indebtedness, and salary of $15,000 to the manager of the building. The debt/basis percentage of 1974 with respect to the building is 50%. Under these circumstances, Y must take into account in computing its unrelated business taxable income for 1974, $10,000 of income (50% of $20,000) and $12,5000 (50% of $25,000) of the deductions directly connected with such income. Thus, for 1974, Y has sustained a net operating loss of $2,500 ($10,000 of income less $12,500 of deductions) which may be carried back or carried over to other taxable years without further application of the debt/basis percentage.
Transfer to wholly-owned subsidiary. The transfer, subject to an existing mortgage, of an appreciated apartment complex by a tax-exempt hospital to its wholly-owned taxable subsidiary does not result in a gain with respect to which the hospital will be taxed under IRC 511. Rev. Rul. 77–71, 1977–1 C. B. 155.