- 7.27.10 Acquisition Indebtedness
- 18.104.22.168 Overview
- 22.214.171.124.1 Case Law
- 126.96.36.199.2 Revenue Rulings
- 188.8.131.52.3 Reasonably Foreseeable
- 184.108.40.206.4 Examples
- 220.127.116.11.5 Converted Property
- 18.104.22.168.6 Failure to Retire Indebtedness
- 22.214.171.124 Property Acquired Subject to Lien
- 126.96.36.199 Extension of Obligations
- 188.8.131.52.1 Allocation
- 184.108.40.206 Other Types of Indebtedness
- 220.127.116.11.1 Indebtedness Incurred in Performing Exempt Purpose
- 18.104.22.168.2 Annuities
- 22.214.171.124.3 Certain Federal Financing
- 126.96.36.199.4 Lending of Securities
- 188.8.131.52.5 Acquisition Indebtedness of Certain Organizations
- 184.108.40.206 Digest of Published Rulings and Procedures
Part 7. Rulings and Agreements
Chapter 27. Exempt Organizations Tax Manual
Section 10. Acquisition Indebtedness
Income from investment property is subject to liability for tax under IRC 511 where there is "acquisition indebtedness" regarding such property.
"Acquisition indebtedness" means the outstanding amount of:
the principal indebtedness incurred in acquiring or improving the property,
the principal indebtedness incurred before the acquisition or improvement of the property if such indebtedness would not have been incurred but for such acquisition or improvement, and
the principal indebtedness incurred after the acquisition or improvement if such indebtedness would not have been incurred but for such acquisition or improvement and such indebtedness was reasonably foreseeable when the property was acquired or improved.
For there to be "acquisition indebtedness," there must be a debt. In general, debt is an obligation to pay a specific sum in the future. Usually, periodic payments are required so long as the debt exists; otherwise, debt is found only where there is a lien against particular property. However, loans against the cash value of an insurance policy create a debt even though there is no subsequent periodic payments or liens.
In Mose and Garrison Siskin Memorial Foundation, Inc. v. United States, 790 F.2d 480 (6th Cir. 1986), the court considered whether proceeds from withdrawals made against the accumulated cash value of life insurance policies was acquisition indebtedness. The organization, which is exempt under IRC 501(a) as an organization described in IRC 501(c)(3), receives life insurance policies from donors who continue to pay the annual premiums. The organization withdrew the accumulated cash value of the policies and reinvested the proceeds in marketable securities and other income-producing investments. The court held that the withdrawals against the cash value of the policies are indebtedness for purposes of IRC 514 and, therefore, income derived from the investments is unrelated business taxable income. The court noted that although a policy loan differs from an ordinary loan, such loans have been regarded as a form of indebtedness for federal income tax purposes.
Rev. Rul. 77–72, 1977–1 C.B. 157, provides that indebtedness owed to an exempt organization by its wholly-owned exempt subsidiary title holding company resulting from a loan to pay debts incurred to acquire two income producing office buildings is not "acquisition indebtedness" within the meaning of IRC 514(c).
Rev. Rul. 95–8, 1995–14 C.B. 107, provides that if an exempt organization sells publicly traded stock short through a broker, then neither the gain nor loss attributable to the change in value of the underlying stock nor the rebate fee is income or loss derived from debt-financed property.
According to Reg. 1.514(c)–1(a)(1), whether indebtedness is reasonably foreseeable depends upon the facts and circumstances of each situation. Although the need for the incurrence of an indebtedness may not have been actually foreseen by the organization, a subsequent incurrence of indebtedness may have been reasonably foreseeable.
Y, an exempt scientific organization, mortgages its laboratory to replace working capital used in remodeling an office building which Y rents to an insurance company for purposes not described in IRC 514(b)(1)(A), (B), (C), or (D). The indebtedness is "acquisition indebtedness" since such indebtedness, though incurred subsequent to the improvement of the office building, would not have been incurred but for such improvement, and the indebtedness was reasonably foreseeable when, to make such improvement, Y reduced its working capital below the amount necessary to continue current operations.
U, an exempt private preparatory school, as its sole educational facility owns a classroom building which no longer meets the needs of U’s students. In 1971, U sells the building for $3 million to Y, a corporation which it does not control. U receives $1 million as a down payment from Y and takes back a purchase money mortgage of $2 million which bears interest at 10% per annum. At the time U became the mortgagee of the $2 million purchase money mortgage, U realized that it would have to construct a new classroom building and knew that it would have to incur an indebtedness in the construction of the new classroom building. In 1972, U builds a new classroom building for a cost of $4 million. In connection with the construction of this building, U borrows $2.5 million from X Bank pursuant to a deed of trust bearing interest at 6% per annum. Under these circumstances, $2 million of the $2.5 million borrowed to finance construction of the new classroom building would not have been borrowed but for the retention of the $2 million purchase money mortgage. Since such indebtedness was reasonably foreseeable, $2 million of the $2.5 million borrowed to finance the construction of the new classroom building is acquisition indebtedness with respect to the purchase money mortgage and the purchase money mortgage is debt-financed property.
In 1972, U (see above example) receives $200,000 in interest from Y (10% of $2 million) and makes a $150,000 interest payment to X (6% of $2.5 million). In addition, assume that for 1972 the debt/basis percentage is 100% ($2 million/$2 million). Accordingly, all the interest and all the deductions directly connected with such interest income are to be taken into account in computing unrelated business taxable income. Thus, $200,000 of interest income and $120,000 ($150,000 x $2 million/$2.5 million) of deductions directly connected with such interest income are taken into account. Under these circumstances, U must include net interest income of $80,000 ($200,000 of income less $120,000 of deductions directly connected with such income) in its unrelated business taxable income for 1972.
In 1972, X, an exempt organization, forms a partnership with A and B. The partnership agreement provides that all three partners will share equally in the profits of the partnership, will each invest $3 million, and that X will be a limited partner. X invests $1 million of its own funds in the partnership and $2 million of borrowed funds. The partnership purchases as its sole asset an office building which is leased to the general public for purposes other than those described in IRC 514(b)(1)(A), (B), (C), or (D). The office building cost the partnership $24 million of which $15 million is borrowed from Y bank. This loan is secured by a mortgage on the entire office building. By agreement with Y bank, X is held not to be personally liable for payment of such mortgage. By reason of IRC 702(b) the character of any item realized by the partnership and included in the partner’s distributive share shall be determined as if the partner realized such item directly from the source from which it was realized by the partnership and in the same manner. Therefore, a portion of X’s income from the building is debt-financed income. Under these circumstances, since both the $2 million indebtedness incurred by X in acquiring its partnership interest and $5 million, the allocable portion of the partnership’s indebtedness incurred with respect to acquiring the office building which is attributable to X in computing the debt/basis percentage (one-third of $15 million), were incurred in acquiring income-producing property, X has acquisition indebtedness of $7 million ($2 million plus $5 million). Similarly, the allocable portion of the partnership’s adjusted basis in the office building which is attributable to X in computing the debt/basis percentage is $8 million (one-third of $24 million). Assuming no payment with respect to either indebtedness and no adjustment to basis in 1972, X’s average acquisition indebtedness is $7 million and X’s average adjusted basis is $8 million for such year. Therefore, X’s debt/basis percentage with respect to its share of the partnership income for 1972 is 87.5% ($7 million/$8 million).
If property is converted to a use which results in treatment as debt-financed property, the outstanding principal indebtedness with respect to such property is thereafter treated as "acquisition indebtedness."
Assume that in 1971 a university borrows funds to acquire an apartment building as housing for married students. In 1974 the university rents the apartment building to the public for purposes not described in IRC 514(b)(1)(A), (B), (C), or (D). The outstanding principal indebtedness is "acquisition indebtedness" as of the time in 1974 when the building is first rented to the public. Reg. 1.514(c)–1(a)(3).
If an organization sells property it used for exempt purposes but with respect to which there was indebtedness (which would have been acquisition indebtedness if IRC 514(c) applied) and then acquires debt-financed property without retiring the indebtedness on the original property, the outstanding indebtedness on the original property is treated as "acquisition indebtedness" with respect to the acquired property even though the original property was not debt-financed property.
To house its administration offices, an exempt organization purchases a building with $600,000 of its own funds and $400,000 of borrowed funds secured by a pledge of its securities. It later sells the building for $1,000,000 without redeeming the pledge. It uses these proceeds to purchase an apartment building it rents to the general public for purposes not specified in IRC 514(b)(1)(A), (B), (C), or (D). The indebtedness of $400,000 is "acquisition indebtedness" with respect to the apartment building even though the office building was not debt-financed property.
In Kern County Electrical Pension Fund, v. Commissioner, 96 T.C. 845 (1991), the pension owned certificates of deposit at a savings and loan that could be withdrawn prior to maturity but only with a substantial reduction of the interest earned. At a time when interest rates were rising, the pension fund obtained a loan from the savings and loan using the certificates as collateral and invested the loan proceeds in new certificates at higher interest rates. The court held that the interest received on the new certificates was income from debt-financed property and was not excludable because it does not represent, in substance, additional interest on the old certificates.
Generally, whenever property is acquired by purchase, gift, devise, bequest, or any other means subject to a mortgage, the amount of outstanding principal indebtedness secured by such mortgage is treated as "acquisition indebtedness" even though the organization did not assume or agree to pay the indebtedness. However, Rev. Rul. 76–95, 1976–1 C.B. 172, provides that an organization, exempt under IRC 501(c)(3), that acquires an undivided interest in rental property subject to a mortgage and prepays its proportionate share of the mortgage indebtedness, receiving releases of liability from the mortgagee and co-owners, has no acquisition indebtedness even though the entire property remains encumbered by the mortgage.
Assume that an exempt organization pays $50,000 for real property valued at $150,000 and subject to a $100,000 mortgage. The $100,000 of outstanding principal indebtedness is "acquisition indebtedness" just as though the organization has borrowed $100,000 to buy the property.
Pursuant to Reg. 1.514(c)–1(b)(2), a lien is similar to and treated as a mortgage if title to property is encumbered by the lien for the benefit of a creditor.
IRC 514(c)(2)(C) provides that a lien for taxes or a lien for assessments made by a State or an instrumentality or a subdivision of a State will not be acquisition indebtedness until and to the extent that an amount secured by the lien becomes due and payable and the exempt organization has had an opportunity to pay the taxes or assessments in accordance with State law.
Hawaii law (sec. 67–23) provides that special assessments become due and payable at the end of a designated 30-day period. However, a failure to pay the assessment at the end of that period constitutes, under State law, an election to pay the assessment in installments. For purposes of this provision, the assessment lien becomes due and payable only at the time when the relevant installment is required to be paid. See 1976–3 C.B. Vol. 2 pp. 428–430.
Liens similar to mortgages include:
Deeds of trust,
Conditional sales contracts,
Security interests under the Uniform Commercial Code,
Agreements to hold title in escrow, and
Liens for taxes or assessments (other than those described above).
The outstanding principal indebtedness secured by a mortgage on property acquired by bequest or devise is not treated as "acquisition indebtedness" during the 10-year period following the date an organization receives the property.
If an organization acquires property by gift subject to a mortgage, the outstanding principal indebtedness secured by the mortgage is not treated as "acquisition indebtedness" during the 10-year period following the date the organization receives such gift, so long as:
The mortgage was placed on the property more than 5 years before the organization received the gift, and
The property was held by the donor for more than 5 years before the organization received the gift.
The exceptions for property acquired by gift, bequest, or devise do not apply if an organization assumes and agrees to pay all or part of the indebtedness secured by the mortgage or makes any payment for the equity in the property owned by the donor or decedent.
An extension, renewal, or refinancing of an obligation evidencing a pre-existing indebtedness is considered a continuation of the old indebtedness to the extent the outstanding principal amount of the pre-existing indebtedness is not increased. Where the modified obligation exceeds the pre-existing indebtedness, the excess is treated as a separate indebtedness for purposes of IRC 514 and the regulations thereunder. Reg. 1.514(c)–1(c)(1).
Generally, any modification or substitution of the terms of an obligation by an organization is considered an extension or renewal of the original obligation, rather than the creation of a new indebtedness to the extent that the outstanding indebtedness is not increased.
The following are examples of acts resulting in the extension or renewal of an obligation:
Substitution of lien to secure an obligation,
Substitution of obligee whether or not with the consent of the organization,
Renewal, extension or acceleration of the payment terms of obligation, and
Addition, deletion, or substitution of sureties or other primary or secondary obligors.
If the outstanding principal amount of a modified obligation exceeds that of the unmodified obligation and only a portion of the refinanced indebtedness is being treated as acquisition indebtedness, the payments on the refinanced indebtedness must be apportioned pro rata between the amount of the pre-existing indebtedness and the excess amount. Reg. 1.514(c)–1(c)(3).
Assume that an organization has an outstanding principal indebtedness of $500,000 which is treated as an acquisition indebtedness of $500,000 and then borrows another $100,000, which is not acquisition indebtedness, from the same lender executing a $600,000 note for the total obligation. A payment of $60,000 on the total obligation would reduce the acquisition indebtedness by $50,000 and the excess indebtedness by $10,000.
There are other types of indebtedness which are generally not subject to "acquisition indebtedness" that include —
Indebtedness incurred in performing an exempt function
Certain federal financing
An indebtedness incurred in performing exempt functions is not "acquisition indebtedness." Therefore, "acquisition indebtedness" does not include the indebtedness incurred by an exempt credit union in accepting deposits from its members.
In Alabama Central Credit Union v. United States, 646 F. Supp. 1199 (N.D. Ala. 1986), the court held that purchasing securities on margin and with borrowed funds is not inherent in the performance or exercise of a credit union’s exempt purpose or function.
In Southwest Texas Electrical Cooperative, Inc. v. Commissioner, 67 F.3d 87 (5th Cir. 1995), aff’g 1994–363 T.C.M. (1994), a nonprofit rural electric cooperative borrowed funds to replace its own funds it had spent in its exempt activities. Immediately after receiving the borrowed funds, it invested them in U.S. Treasury Notes. The Fifth Circuit held that the interest income from the Treasury Notes was unrelated debt-financed income.
The obligation to make payment of an annuity is not "acquisition indebtedness" if the annuity meets the following requirements:
It must be the sole consideration issued in exchange for the property acquired,
At the time of the exchange, the present value of the annuity must be less than 90% of the value of the prior owner’s equity in the property received,
The annuity must be payable over the lives of either one or two individuals in being when issued, and
The annuity must be payable under a contract which does not guarantee a minimum nor specify a maximum number of payments, and provide for any adjustment of the amount of the annuity payments by reference to the income received from the transferred property or other property.
Pursuant to Reg. 1.514(c)–1(e), the value of an annuity at the time of exchange is computed in accordance with IRC 1011(b), Reg. 1.1011–2(e)(1)(iii)(b)(2), and section 3 of Rev. Rul. 62–216, 1962–2, C.B. 30.
Under IRC 514(c)(6), "acquisition indebtedness" does not include an obligation to finance the purchase, rehabilitation, or construction of housing for low and moderate income persons to the extent that it is insured by the Federal Housing Administration.
To the extent that an obligation is insured by the Federal Housing Administration under section 221(d)(3) (12 U.S.C. 1715(d)(3)) or section 236 (12 U.S.C. 1715z–1) of Title II of the National Housing Act, as amended, the obligation is not "acquisition indebtedness." See Reg. 1.514(c)–1(f).
It is common practice for an owner of securities to lend the securities to a broker who uses them to make timely deliveries of securities to purchasers. In the usual transaction, the broker is required to return identical securities to the lender, and the loan of securities is fully collateralized by cash or marketable securities having a fair market value of not less than the fair market value of the securities loaned. The lender receives from the borrower amounts equal to the dividends paid on the stock during the period of the loan and additional compensation for the stock. Under IRC 512(a)(5), if an exempt organization enters into a securities loan, there is no adverse consequence under IRC 514. An obligation to return collateral is not treated as acquisition indebtedness. All payments because of the securities are deemed to be from the securities loaned and not from the collateral security or the investment of collateral security from such loans. Any deductions that are directly connected with the collateral security for the loan or with the investment of the collateral security are deemed to be deductions directly connected with the securities loaned. See IRC 514(c)(8). If an exempt organization incurred indebtedness to purchase loaned securities, any income from such securities, including any income from the loan of the securities, would be treated as debt-financed income and would be subject to tax to the extent provided in IRC 512(b)(4) and IRC 514.
Kern County Electrical Pension Fund v. Commissioner, 96 T.C.845 (1991), the pension owned certificates of deposit at a savings and loan that could be withdrawn prior to maturity but only with a substantial reduction of the interest earned. At a time when interest rates were rising, the pension fund obtained a loan from the savings and loan using the certificates as collateral and invested the loan proceeds in new certificates at higher interest rates. The court held that the interest received on the new certificates was income from debt-financed property and was not excludable because it does not represent, in substance, additional interest on the old certificates.
IRC 514(c)(9) provides that, with certain exceptions, the term "acquisition indebtedness" does not include indebtedness incurred by a qualified organization in acquiring or improving any real property.
For purposes of IRC 514(c)(9), a qualified organization includes:
A qualified trust under IRC 401;
An educational organization described in IRC 170(b)(1)(A)(ii) and its supporting organizations described in IRC 509(a)(3); and,
An organization as described in IRC 501(c)(25). However, a shareholder of an IRC 501(c)(25) organization may be taxable on its pro rata share of income received from debt-financed property held by the IRC 501(c)(25) organization if the shareholder itself is not a "qualified organization."
The exception to "acquisition indebtedness" under IRC 514(c)(9) does not apply to cases where:
The price for the acquisition or improvement is not a fixed amount;
The amount of any indebtedness or the time for making any improvement is dependent, in whole or in part, upon any revenue, income or profits derived from the real property;
After the acquisition the real property is leased to the seller or to a related party described in IRC 267(b) or 707(b);
In the case of a qualified trust the real property is acquired from or leased to certain disqualified persons under IRC 4975(e)(2);
Any person described in (c) or (d) provides the qualified organization with financing in connection with the acquisition or improvement; or
The real property is held by a partnership, unless the partnership meets the requirements of (a) through (e), and unless (i) all of the partners of the partnership are qualified organizations, (ii) each allocation to a partner of the partnership which is a qualifying organization is a qualified allocation under IRC 168(h)(6) or, (iii) the partnership meets the "disproportionate allocation rule."
In order for a partnership to meet the "disproportionate allocation rule," the following requirements must be met:
The allocation of items to a partner that is a qualified organization cannot result in that partner having a percentage share of overall partnership income for any partnership taxable year greater than such partner’s "fractions rule percentage."
Each partnership allocation must have "substantial economic effect." Allocations that cannot have economic effect must be deemed to be in accordance with the partners’ interests in the partnership. See Reg. 1.514(c)–2 for examples of how these rules operate.
Overall partnership income is the amount by which the aggregate items of partnership income and gain for the taxable year exceed the aggregate items of partnership loss and deduction for the year.
Overall partnership loss is the amount by which the aggregate items of partnership loss and deduction for the taxable year exceed the aggregate items of partnership income and gain for the year.
Generally, the partnership items that are included in computing overall partnership income or loss are those items of income, gain, loss, and deduction that increase or decrease the partners’ capital accounts.
Generally, a guaranteed payment to a qualified organization is not treated as an item of partnership loss or deduction in computing overall partnership income or loss.
Income that a qualified organization may receive or accrue with respect to a guaranteed payment is treated as an allocable share of overall partnership income or loss for purposes of the fractions rule.
A qualified organization’s fractions rule percentage is that partner’s percentage share of overall partnership loss for the partnership taxable year for which that partner’s percentage share of overall partnership loss will be the smallest.
A partnership must satisfy the fractions rule both on a prospective basis and on an actual basis for each partnership taxable year, beginning with the first partnership taxable year in which the partnership holds debt-financed real property and has a qualified organization as a partner.
Generally, a partnership does not qualify for the unrelated business income tax exception for any taxable year of its existence unless it satisfies the fractions rule for every year the fractions rule applies.
A subsequent change to a partnership agreement that causes the partnership to violate the fractions rule ordinarily causes the partnership’s income to fail the unrelated business income tax exception only for the taxable year of the change and subsequent taxable years.
Co-owner indebtedness — An organization, exempt under IRC 501(c)(3), that acquires an undivided interest in rental property subject to a mortgage and prepays its proportionate share of the mortgage indebtedness, receiving releases of liability from the mortgagee and co-owners, has no acquisition indebtedness within the meaning of IRC 514(c)(1) even though the entire property remains encumbered by the mortgage. Rev. Rul. 76–95, 1976–1 C.B. 172.
Subsidiary of labor union — Indebtedness owed to a labor union by its wholly-owned tax-exempt subsidiary title holding company resulting from a loan to pay debts incurred to acquire two income-producing office buildings is not "acquisition indebtedness" within the meaning of IRC 514(c). Rev. Rul. 77–72, 1977–1 C.B. 157.
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.
If an exempt organization sells publicly traded stock short through a broker, then neither the gain nor loss attributable to the change in value of the underlying stock nor the rebate fee is income or loss derived from debt-financed property. Rev. Rul. 95–8, 1995–14 C.B. 107.