Debt-financed income and UBTI.

• Author: Fetsch, H. Martin
• Position: Unrelated business taxable income

Two exempt organizations meet the requirements of Sec. 501 (c)(3) (one as a charitable organization and the other as an educational organization--a university). These organizations own equal interests in a partnership, and they have boards of trustees that overlap by more than 50% of the voting positions. The partnership owns a building and land. The building was acquired using borrowed funds and thus was debt financed. It currently is leased 100% to the university, which uses the entire building in its research activities. Because the building is generating net income, is the net rental income unrelated business taxable income (UBTI) to both organizations, to only one organization, or to neither organization?

Exempt organizations can be subject to income tax if they have UBTI. Sec. 512 defines UBTI as gross income derived from any unrelated trade or business, regularly carried on, less deductions directly connected with the carrying on of such trade or business. Sec. 512(b) excludes certain types and classes of income from the definition of UBTI. Rent derived from real property is one of the excluded classes of income. Unfortunately, if the rent is from property that is debt financed, this exclusion does not apply, and UBTI is generated to the extent of a ratio of the debt to adjusted basis of the property (Sec. 512(b) (4)).

Under Sec. 512(b)(8), an exclusion also applies for colleges, universities, and hospitals for income derived from research performed for any person. Based on this language, a college or university can exclude from UBTI debt-financed real estate rental net income derived from the use of real property in a bona fide research capacity.

Regs. Sec. 1.514(b)-1(b)(1)(i) indicates that debt-financed property used by an institution in furtherance of its exempt purpose is excluded from UBTI. The Service has stated this position in several published documents (see, e.g., Rev. Ruls. 58-547, 69-464, 77-47, 81-138, and IRM 7.27.9.2.1). Further exclusions from UBTI can be found under Regs. Sec. 1.514(b)-1(b)(4):

To the extent that the gross income from any property is derived from research activities excluded from the tax on...