- 7.27.9 DebtFinanced Property
- 220.127.116.11 Overview
- 18.104.22.168 Debt-Financed Property Exceptions
- 22.214.171.124.1 Property Related to Certain Exempt Purposes
- 126.96.36.199.2 Property Used in an Unrelated Trade or Business
- 188.8.131.52.3 Property Related to Research Activities
- 184.108.40.206.4 Property Used in Thrift Shops, Etc.
- 220.127.116.11.5 Use by a Related Organization
- 18.104.22.168.6 Related Exempt Uses
- 22.214.171.124.6.1 Case Law
- 126.96.36.199 Special Rules
- 188.8.131.52.1 Medical Clinic
- 184.108.40.206.2 Life Income Contract
- 220.127.116.11.3 Basis of DebtFinanced Property Acquired in Corporate Liquidation
- 18.104.22.168.4 Allocation Rules
- 22.214.171.124 Neighborhood Land Rule
- 126.96.36.199 Digest of Published Rulings and Procedures
Part 7. Rulings and Agreements
Chapter 27. Exempt Organizations Tax Manual
Section 9. DebtFinanced Property
The term "debt-financed property," means any property (e.g. rental real estate, tangible personal property and corporate stock) held to produce income, and with respect to which there is an acquisition indebtedness at any time during the taxable year. (IRC 514(b)(1)). However, see exceptions below.
Thus, when an exempt organization purchases mineral production payments with borrowed funds the mineral production payments are debt-financed property. Rev. Rul. 76–354, 1976–2 C.B. 179.
A partnership interest may also be debt-financed property. Rev. Rul. 74–197, 1974–1 C.B. 143.
There are several exceptions to the debt-financed property rules, which includes property that is:
related to certain exempt purposes
used in an unrelated trade or business
related to research activities
used in thrift shops
used by a related organization
used for exempt purposes
IRC 514(b)(1)(A) provides that if substantially all the use of any property is substantially related to the exercise or performance of an organization’s exempt purpose, such property is not treated as "debt-financed property." The term "substantially all" is defined as 85%.
The extent to which property is used for a particular purpose is determined on the basis of all the facts and circumstances. Where appropriate, these may include:
A comparison of the portion of time such property is used for exempt purposes with the total time such property is used,
A comparison of the portion of such property that is used for exempt purposes with the portion of such property that is used for all purposes, or,
Both of the previous two comparisons.
Rev. Rul. 77–47, 1977–1 C.B. 156, provides that buildings, acquired through assumption of outstanding mortgages by an exempt organization that restores, preserves, and exhibits buildings of historical and/or architectural significance, constitute debt-financed property when they are leased at fair rental value for uses that neither bear any relationship to the buildings’ historical or architectural significance nor accommodate viewing by the general public.
If less than 85% of the use of any property is devoted to an organization’s exempt purposes, only that portion of the property which is used in furtherance of the organization’s exempt purposes is not treated as debt-financed property. Regs. 1.514(b)–1(b)(1).
X, an exempt college, owns a four story office building which has been purchased with borrowed funds. In 1971, the lower two stories of the building are used to house computers which are used by X for administrative purposes. The top two stories are rented to the public for purposes not described in IRC 514(b)(1)(A), (B), (C), or (D). The gross income derived by X from the building is $6,000, all of which is attributable to the rents paid by tenants. There are $2,000 of expenses, allocable equally to each use of the building. The average adjusted basis of the building for 1971 is $100,000, and the outstanding principal indebtedness throughout 1971 is $60,000. Thus, the average acquisition indebtedness for 1971 is $60,000. Since the two lower stories are used for exempt purposes, only the upper half of the building is debt-financed property. Consequently, only the rental income and the deductions directly connected with such income are to be taken into account in computing unrelated business taxable income. The portion of such amounts to be taken into account is determined by multiplying the $6,000 of rental income and $1,000 of deductions directly connected with such rental income by the debt/basis percentage. The debt/basis percentage is the ratio which the allocable part of the average acquisition indebtedness is of the allocable part of the average adjusted basis of the property, that is, the ratio which $30,000 (one-half of $60,000) bears to $50,000 (one-half of $100,000). Thus, the debt/basis percentage for 1971 is 60% (the ratio of $30,000 to $50,000). Under these circumstances, X shall include net rental income of $3,000 in its unrelated business taxable income for 1971, computed as follows:
Total rental income $6,000 Deductions directly connected with rental income $1,000 Debt/basis percentage ($30,000/$50,000) 60% Rental income treated as gross income from an unrelated trade or business (60% of $6,000) $3,600 Less the allowable portion of deductions directly connected with such income (60% of $1,000) 600 ______ Net rental income excluded by X in computing its unrelated business taxable income pursuant to section 514 3,000
Congress intended that income, under the general definition of unrelated trade or business, be taxable in its entirely. However, without a statutory exception, such income, if derived from debt-financed property, might be taxable only to the extent of the outstanding indebtedness on such property. Consequently, IRC 514(b)(1)(B) provides that property, to the extent it produces income which is unrelated business taxable income under the general definition, is not treated as "debt-financed property." However, any gain on the disposition of such property which is not included in income from an unrelated trade or business by reason of IRC 512(b)(5) is includible as gross income derived from, or on account of, debt-financed property.
IRC 514 does not apply to amounts which are otherwise included in the computation of unrelated business taxable income, such as rents from personal property included under IRC 512(b)(3), or rents and interest from controlled organizations includible under IRC 512(b)(13). See Example (3) of Regs. 1.514(b)–1(b)(3).
IRC 514(b)(1)(C) provides that property, to the extent it produces gross income derived from research activities otherwise excluded from the unrelated trade or business tax by IRC 512 (b)(7), (8), or (9), is not treated as "debt-financed property."
Under IRC 514(b)(1)(D), debt-financed property does not include any property to the extent it produces income from a trade or business which is excepted from the definition of an "unrelated trade or business" by IRC 513 (a)(1), (2), or (3). Thus, property used in connection with the donated merchandise, volunteer labor, or convenience exceptions does not constitute debt-financed property. Regs. 1.514(b)–1(b)(5).
Under IRC 514(b)(2), use of property by a "related organization" is taken into account in determining the extent to which such property is used for a purpose described in IRC 514(b)(1)(A), (C), or (D).
An exempt organization is related to another exempt organization only if:
one organization is an exempt title holding company described in IRC 501(c)(2) and the other receives profits derived from such exempt title holding company,
one organization has control of the other within the meaning of Regs. 1.512(b)–1(1)(4),
more than 50% of the members of one organization are members of the other, or
each organization is a local organization directly affiliated with a common state, national, or international organization which is also exempt.
Property owned by an exempt organization and used by a related exempt organization or by an exempt organization related to such related exempt organization is not treated as "debt-financed property" to the extent such property is used by either of such related exempt organizations in furtherance of their exempt purposes. Furthermore, property is not treated as debt-financed property to the extent such property is used by a related exempt organization for a purpose described in IRC 514(b)(1)(C) or (D). Regs. 1.514(b)–1(c)(2)(i).
M, an exempt trade association described in IRC 501(c)(6), leases 70% of the space of an office building for furtherance of its exempt purpose. The title to such building is held by N, an exempt title holding company described in IRC 501(c)(2), which acquired title to the building with borrowed funds. The other 30% of the space of this office building is leased to L, a nonstock exempt trade association described in IRC 501(c)(6). L uses such office space in furtherance of its exempt purpose. The members of L’s Board of Trustees serve for fixed terms and M’s Board of Directors has the power to select all such members. N pays over to M all the profits it derives from the leasing of space in this building to M and L. Accordingly, M is "related" to N and L is "related" to M Under these circumstances, since all the available space in the building is leased to either an exempt organization related to the exempt organization holding title to the building or an exempt organization related to such related exempt organization, no portion of the building is treated as debt-financed property.
An organization exempt under IRC 501(c)(6) subjected a shell building it owned to a mortgage so that it could finance its completion to suit the needs of its tenant. Notwithstanding that the organization had to borrow money and mortgage its property to finance the alterations, the building was not debt-financed under IRC 514, because the organization was furthering its stated purpose of promoting the commercial development of its metropolitan area by encouraging new industries to move to the area. Therefore, the leasing activity was substantially related within the meaning of IRC 514(b)(1)(A)(i) to the organization’s accomplishment of its exempt purpose. Rev. Rul. 81–138, 1981–1 C.B. 358.
In Elliot Knitwear Profit Sharing, Etc. v. Commissioner of Internal Revenue, 614 F.2d 347 (3rd Cir, 1980) an employee profit-sharing plan that was exempt from tax under IRC 501(a) because it qualified under IRC 401(a) purchased securities on margin. The court held that the securities purchased on margin constituted debt-financed property and that the profits derived from their sale are taxable as unrelated business income since the purchase of securities on margin is not inherent to the purpose of a tax-exempt profit-sharing plan and that such purchases are not substantially related to the purpose of such an organization so as to be excepted from the definition of debt-financed property.
In Alabama Central Credit Union v. United States, 646 F. Supp. 1199 (N.D. Ala. 1986), the court considered whether income from securities purchased on margin or with borrowed funds was income from debt-financed property. There, a credit union exempt under IRC 501(a) as an organization described in IRC 501(c)(14) received income from the sale of Government of Israel bonds and construction loan certificates guaranteed by the Government National Mortgage Association. The court held that the securities are debt-financed property, and that purchasing securities on margin and with borrowed funds is not inherent in the performance or exercise of a credit union’s purpose or function.
In Ocean Cove Corporation Retirement Plan and Trust v. United States, 657 F. Supp. 776 (S.D. Fla. 1987), a pension trust fund exempt under IRC 501(a) because it qualified under IRC 401(a) opened a margin account at a securities brokerage firm. The court held that securities purchased on margin constituted debt-financed property, such that any profits traceable to the margined securities are taxable as unrelated business income. The court also stated that a margin account is not substantially related to the pension plan’s exempt purposes.
In Marprowear Profit Sharing Trust v. Commissioner, 74 T.C. No. 80 (1980), a profit sharing trust that qualified under IRC 401(a),and was therefore exempt under IRC 501(a), received funds from the corporation that established it which it applied toward the purchase of a shopping center. The court concluded that such funds were a loan from the corporation rather than an advance contribution; that the loan was acquisition indebtedness within the meaning of IRC 514(c) because the shopping center was acquired for the purpose of producing income, which use was not substantially related to the organization’s exempt function, and; that the shopping center was therefore debt-financed property within the meaning of IRC 514(b)(1). Although the subject organization was not described in IRC 501(c), the court’s reasoning would apply to any exempt organization. It should be noted that certain organizations may qualify for the exception under IRC 514(c)(9) with regard to investments in real property.
Special rules are provided relating to the debt- financed property provisions concerning:
Life income contract
Property acquired in a corporate liquidation
Real property is not debt-financed property if it is leased to a medical clinic, and the lease is entered into primarily for the exempt purposes of the lessor. IRC 514(b)(1).
Assume that an exempt hospital leases all of its clinic space to an unincorporated association of physicians and surgeons who, by the provisions of the lease, agree to provide all of the hospital’s out-patient medical and surgical services and to train all of the hospital’s residents and interns. In this situation, the rents received are not unrelated debt-financed income.
If an individual transfers property to a trust or a fund subject to a contract providing that the income is to be paid to him/her or to the other individuals or both for a period of time not to exceed the life of such individual or individuals in a transaction in which the payments to the individual do not constitute the proceeds of a sale or exchange of the property so transferred and if the remainder interest is payable to an exempt organization described in IRC 501(c)(3), the property is not treated as "debt-financed property" by reason of the life income contract. Regs. 1.514(b)–1(c)(3).
On January 1, 1967, A transfers property to X, an exempt organization described in IRC 501(c)(3), which immediately places the property in a fund. On January 1, 1971, A transfers additional property to X, which property is also placed in the fund. In exchange for each transfer, A receives income participation fund certificates which entitle him/her to a proportionate part of the fund’s income for his/her life and for the life of another individual. None of the payments made by X is treated by the recipients as the proceeds of a sale or exchange of the property transferred. In this situation, none of the property received by X is treated as debt-financed property.
Under IRC 514(d), if debt-financed property is acquired by an exempt organization in a complete or partial liquidation of a corporation in exchange for its stock, the organization’s basis in such property is the same as it would be in the hands of the transferor corporation, increased by the amount of gain recognized to the transferor corporation upon such distribution and by the amount of any gain which is includible, on account of such distribution, in the gross income of the organization as unrelated debt-financed income.
IRC 514(e) provides that where only a portion of property is debt-financed property, proper allocation of the basis, indebtedness, income, and deductions with respect to such property must be made to determine the amount of income or gain derived from such property which is to be treated as unrelated debt-financed income.
If an organization acquires real property and intends to use it for exempt purposes (within 10 years), it will not be treated as debt-financed property if it is in the neighborhood of other property used by the organization for exempt purposes and the intent to use the property for exempt purposes (within 10 years) is not abandoned. This provision is referred to as the "neighborhood land rule." IRC 514(b)(3)(A).
Property is considered in the "neighborhood" of property owned and used by an organization for its exempt purposes if the acquired property is contiguous with the exempt purpose property. If the acquired property is not contiguous with the exempt purpose property, it may still be in the “neighborhood” of such property if it is within 1 mile of such property and the facts and circumstances of the particular situation make the acquisition of contiguous property unreasonable. Regs. 1.514(b)–1(d)(1)(ii).
Some criteria to consider in determining whether noncontiguous property is still in the "neighborhood" of exempt purpose property include the availability of land and the intended future use of the land. For example, a university attempts to purchase land contiguous to its present campus but cannot do so because the owners either refuse to sell or ask unreasonable prices. The nearest land of sufficient size and utility is a block away from the campus. The university purchases such land. Under these circumstances, the contiguity requirement is unreasonable and the land purchased would be considered "neighborhood land."
The neighborhood land rule does not apply to property 10 years after it is purchased. Further, the rule applies after the first five years only if the organization satisfies the Service that future use of the land for exempt purposes, before the expiration of the 10-year period, is reasonably certain. The organization need not show binding contracts in satisfying this requirement but must have a definite plan detailing a specific improvement and a completion date, and show some affirmative action toward the fulfillment of such plan. At least 90 days prior to the end of the fifth year the organization must forward the necessary information to the Service. Regs. 1.514(b)–1(d)(1)(iii).
If the neighborhood land rule is inapplicable because the acquired land is not in the neighborhood of other land used for exempt purposes or because the organization fails to establish after the first five years that the property will be used for exempt purposes, but the land is eventually used for exempt purposes within the 10-year period, such property is not treated as debt-financed property for any period prior to such conversion. Regs. 1.514(b)–1(d)(2).
The neighborhood land rule applies with respect to any structure on the land when acquired, or to the land occupied by the structure, only so long as the intended future use of the land requires that the structure be demolished or removed in order to use the land for exempt purposes. Thus, during the first five years after acquisition (and for subsequent years if there is a favorable ruling in accordance with IRC 514(b)(3)) improved property is not debt-financed so long as the organization does not abandon its intent to demolish the existing structures and use the land in furtherance of its exempt purpose. Regs. 1.514(b)–1(d)(3)(i) provide that if there is an actual demolition of such structures, the use made of the land need not be the one originally intended as long as it is any use which furthers the exempt purposes of the organization.
In addition to the above limitation, the neighborhood land rule and exceptions thereto do not apply to structures erected on the land after its acquisition nor to property subject to a business lease (as defined in IRC 514(f) immediately before the enactment of the Tax Reform Act of 1976) whether the organization acquired the property subject to the lease or whether it executed the lease subsequent to acquisition.
Where the neighborhood land rule is initially inapplicable but the land is eventually used for exempt purposes, a refund of taxes shall be allowed in accordance with IRC 514(b)(3)(D) and Regs. 1.514(b)–1(d)(4).
The neighborhood land rule also applies to churches or a convention or association of churches but with two differences. First, instead of the 10-year period during which an organization must demonstrate the intent to use acquired property for exempt purposes, a 15-year period applies. Second, there is no requirement that the acquired land be in the neighborhood of other property used by the organization for exempt purposes. Regs. 1.514(b)–1(e).
Debt-financed investment by employees’ trust — The investment by an exempt employees’ trust in a partnership that was organized to invest in securities and borrow 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. 74–197, 1974–1 C.B. 143. Distinguished by Rev. Rul. 79–122, 1979–1 C.B. 204.
Mineral production payments — Income derived by an exempt organization from mineral production payments purchased with borrowed funds constitutes unrelated business taxable income to the extent specified in IRC 514 of the Code. Rev. Rul. 76–354, 1976–2 C.B. 179.
Leases of historically or architecturally significant buildings — Buildings, acquired through assumption of outstanding mortgages by an exempt organization that restores, preserves, and exhibits buildings of historical and/or architectural significance, constitute debt-financed property within the meaning of IRC 514(b)(1) of the Code when they are leased at fair rental value for uses that neither bear any relationship to the buildings’ historical or architectural significance nor accommodate viewing by the general public. Rev. Rul. 77–47, 1977–1 C.B. 156.
Income from lending securities — Income derived by an exempt organization from the temporary transfer of securities to a brokerage house to cover short sales of the brokerage house in exchange for collateral of equal value, which is held by the organization pursuant to a contract requiring the brokerage house to pay the organization an amount equivalent to the dividend or interest income that would have been earned by the securities plus either a premium based on a percentage of the value of the securities or income earned from investing the collateral, is not unrelated debt-financed income under IRC 514. Rev. Rul. 78–88, 1978–1 C.B. 163. See IRC 514(c)(8).
Rental income related to exempt purpose — An exempt organization that was created by a chamber of commerce to encourage business development in a particular area, obtained a mortgage to help finance the construction of a building that is leased to an industrial tenant at less than the fair rental value. The leasing of the property is substantially related to the organization’s exempt purpose, and the property is not debt-financed property. Rev. Rul. 81–38, 1980–1 C.B. 358, amplifying Rev. Rul. 70-81, 1970–1 C.B. 131.