Saturday, August 6, 2011

Be careful with rental income and the UBIT rules

Saturday, August 6, 2011
What’s the problem? We all know that certain types of income are statutorily excluded from being treated as unrelated business income (UBI). These include interest, dividends, royalties, as well as “rent” from real property. So again, why all the hub-bub? Blog over, let’s move on.

Whoa, not so fast. Let me take a few minutes and share with you some of the hub-bub. Just as we know that certain forms of income are excluded from UBI, we also know that, for every tax rule, there are exceptions, buts and howevers as far as the eye can see. And, the rule that rental income is excluded from UBI is no exception to that exception. There are specific situations and fact patterns that will result in an organization’s rental income being taxed as UBI. Some fairly common, some not so common.

The most common situation that will convert normally tax free rental income into UBI is when the property being rented has debt related to it such as a mortgage. If there is acquisition indebtedness on a property that is being rented by a tax-exempt organization, the income will be treated as UBI under the debt-financed income rules. So if you have this situation, get ready to prepare a Form 990-T. Also, the calculation of the amount taxable is not as straight forward as it may sound. The organization needs to calculate, on the Form 990-T, how much of the income and directly related expenses should be taken into account in arriving at the amount taxable as UBI. The calculation involves comparing the average basis of the property to the average debt on the property and applying that fraction to the income and expenses. Enough about that.

Another common situation triggering taxable rental income is when services are provided to the lessee as part of the rental arrangement. This requires close scrutiny of the lease to make sure that the organization is not running afoul of this rule. The services that will trigger this exception are services that are more for the convenience of the tenant, rather than services that are normally part of a lease arrangement, such as furnishing of heat and light. For example, providing personnel to help the lessee with a rental by setting up the room or providing kitchen services will cause the rental income to be treated as UBI.

What if personal property is rented along with the real property that is being rented? Any problem? Maybe. Let’s start out again with a general rule. Income from the rental of personal property is taxable as UBI. However, if the personal property is leased in conjunction with real property, and the rental amount allocable to the personal property is incidental (10% or less) compared to the amount allocable to the real property, all the rental income can be excluded from UBI. Not bad, huh? Well as we know, Congress giveth and Congress taketh away. On the flip side, if more than 50% of the rental income is attributable to personal property, then all the rental income is taxable as UBI, even the amount allocable to the real property. Damn them! If the amount allocable to personal property is between 10% and 50%, an allocation of the rental income between taxable and non-taxable can be made.

Another common situation that creates taxable rental income is when the rental income is based in whole or in part on the “net income” of the tenant. Other situations resulting in taxable UBI are if the rental income is received from a controlled corporation or in a situation where the owner-lessor is a social club, a VEBA, or supplemental unemployment benefit trust.

So what are the take-away’s? One, as always, if you see a general tax rule, always look for the exceptions. Going back to the days when our research was paper documents, the rule was “always turn the page”. I guess now it would be keep scrolling down. The second, and just as important take-away is, if you have an exempt organization that has rental income, look into the circumstances surrounding the lease. Is it debt-financed? Who is the lessee? Is the lease for real and/or personal property? Is the organization providing any services as part of the lease? You will be glad you did a little digging. You want to find any issues before the IRS does.

Well, I think that is enough “hub-bub” for now. I’ll be back in a few weeks with more fun stuff.


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