If your nonprofit provides facility usage to another organization, could its property consequently lose tax-exempt qualification? That question often becomes extremely important to many organizations as they consider potential opportunities for revenue generation, wise stewardship of their resources, and issues involving current guest users who may or may not imperil this coveted tax-exempt status. This question becomes even more acute when a nonprofit organization seeks to submit a tax exemption application for property with third-party usage, or when potential tax liability for losing exemption is not presently known or otherwise factored into facility usage fees that are charged to third parties. It thus warrants careful attention and the legally correct answer!
This article is second in a series on third-party facility usage, following our law firm’s first article that focused on the importance of a facility usage policy. The following sections address key foundational considerations, the three primary types of property tax exemption (charitable, educational, and religious), and how nonprofits can qualify for such exempt status even if they charge third-party usage fees (known as “rent” in commercial, non-qualified contexts). These legal principles track with Illinois law but apply generally as well for property in other states, which often require similar exemption standards.
Initial Considerations for Exempt Qualification
As a starting point, all real estate is subject to taxation and with taxes owed to local government authorities as a matter of state law. Generally speaking, many exemptions and tax reduction options exist based on the taxpayer and property usage – e.g., senior citizen exemptions, significantly lower taxes for farmland, and reduced taxes based on vacancy. With respect to nonprofit organizations, entire exemptions from all property tax liability may be available if a property is both owned by an appropriate organization (typically one organized and operated in accordance with the federal Internal Revenue Code Section 501(c)(3)) and used by that organization for specific tax-exempt purposes and activities.
The most common nonprofit exemption categories are charitable, educational, and religious. Significantly, having Section 501(c)(3) tax-exempt status is not enough for state property tax exemption qualification. Nonprofit owners face a steeper proverbial hill to climb, as follows.
Key Foundational Principles – No Commercial Usage
The tax-exempt usage requirement, as noted above, applies both to the property owner itself and any occupant allowed on its property. More specifically, neither the owner nor any occupant may operate their activities “with a view to profit.” Such usage is commercial and therefore antithetical to property tax exemption. Consequently, to the extent the nonprofit owner or a guest operates like a commercial venture – charging fees, rejecting wholesale those who cannot afford the fees, using collection agencies, competing with the commercial sector in offering similar services, or simply being a for-profit business, the nonprofit owner will risk losing its property tax exemption for its real estate.
Likewise, a nonprofit that allows a business to occupy its property will lose tax-exempt qualification – at least for that portion of the third-party usage. By definition, a business operates “with a view to profit.”
Nonprofit’s Hefty Burden to Demonstrate Exemption Qualification
Whether a nonprofit is filing a new exemption application or seeking to defend its property’s tax-exempt status (in the rare but not unheard situation when a government agency challenges tax-exempt status), the evidentiary burden of proof always rests on the nonprofit – as the taxpayer applicant – to demonstrate exemption qualification. Notably, governing Illinois agencies tend to view property tax exemption quite skeptically, both at the initial county application level and at the final approval level with the Illinois Department of Revenue.
What is the nonprofit taxpayer’s burden? The applicable legal standard for exemption qualification is by “clear and convincing evidence,” with “all debatable facts resolved against exemption.” These requirements are quite hefty, and with a binary “yes” or “no” result for tax exemption. Smart nonprofit applicants thus will carefully and diligently prepare exemption applications reflecting strong legal qualification for exemption, with persuasive facts and complete information addressing all exemption aspects. And for nonprofits that have already garnered property tax exemption, they will strive to protect it well through clearly qualified property usage – including usage by third parties.
As a key example of these qualification hurdles, it is vitally important that nonprofit property owners not use any commercial terms in third-party occupancy arrangement, such as “lease,” “landlord,” “tenant,” and “rent.” They connote commercial activity, not qualified exempt usage. Rather, non-commercial terminology like “space sharing agreement,” “owner,” “guest,” and “contributions” (or perhaps simply “fees”) are more appropriate.
These terms are not just words. The language should reflect a non-commercial arrangement whereby both the property owner’s and the guest’s tax-exempt missions are advanced through the shared property usage, not for any prohibited view to profit. Such collaborative or shared goals should be expressly stated in a written facility usage agreement. Correspondingly, the agreement should reflect that any financial contributions or fees are paid solely to cover anticipated costs of shared space usage (both short-term and long-term).
Third-Party Guest’s Qualified Nonprofit Status
With the above foundational principles in mind, and to the extent that a nonprofit property owner wants to establish or maintain property tax exemption, the organization should seek out prospective guests that satisfy the following elements:
- they are likewise Section 501(c)(3) nonprofits;
- they have some apparent or other potential mission alignment;
- they will use the subject real estate for qualified tax-exempt purposes as defined under state law; and
- they will not collect usage fees with any “view to profit.”
Based on these qualifying elements, the property owner should not hesitate to ask prospective guest occupants for their corporate articles of incorporation, bylaws, IRS determination letter, and even their recent financials. Such documentation should help show whether a prospective occupant meets the initial requirements for being a tax-exempt organization within the parameters for property tax exemption. For example, other types of Section 501(c) organizations will not qualify for property tax exemption, such a Section 501(c)(7) club or a Section 501(c)(6) trade association. Note further that a church or other house of worship will not necessarily have an IRS determination letter, since they are automatically tax-exempt under Section 508 of the Internal Revenue Code. Financial statements may be critical too, in terms of whether fees are charged as part of the organization’s exempt activities or on a commercial basis. Typically, provision of fee waivers, fee reductions, scholarships, and other financial aid will be telling, and such information will become vitally important particularly for charitable qualification as next addressed.
Third-Party Qualified Usage
A prospective guest occupant’s nonprofit tax-exempt status is critical, but it’s not enough. (Keep climbing the hill.). The guest’s proposed space usage must also qualify for property tax exemption. In Illinois and most states, such exemption should fall into one of the following primary exempt categories - religious, educational, or charitable.
For Illinois property tax exemption purposes, these words are legal terms of art. “Religious” means use by a church, another house of worship, or a religious organization essentially operating as an extension of the church with primarily religious activities. “Educational” means a nonprofit school that reduces government burdens, such as a grammar school or college offering courses like a public institution. “Charitable” is a broader catch-all category that requires a more detailed analysis and is based on the following legal foundations.
More than one hundred fifty years ago, the Illinois Supreme Court defined the term “charity” as follows:
A charity, in a legal sense, may be more fully defined as a gift, to be applied consistently with existing laws, for the benefit of an indefinite number of persons, either by bringing their hearts under the influence of education or religion, by relieving their bodies from disease, suffering or constraint, by assisting them to establish themselves for life, or by erecting or maintaining public buildings or works, or otherwise lessening the burdens of government.
Consistent with its scrutiny of hospitals and other large nonprofit entities, the Illinois Department of Revenue has defined the term “charity” more narrowly, thereby raising significant policy concerns as to what really constitutes “charity.” The DOR has also been suspicious of potential charitable abuses and more critical of many charitable operations, particularly those with some apparent commercial viability.
In 1968, the Illinois Supreme Court established a six-factor test for charitable tax exemptions, which is still applied according to each case’s particular facts and circumstances. Specifically, charitable exemption qualification depends on the following factors:
- the benefits derived are for an indefinite number of persons;
- the organization has no capital, capital stock or shareholders, and earns no profits or dividends;
- the organization derives its funds mainly from public and private charity and holds them in trust for the objects;
- the organization dispenses charity to all who need and apply for it;
- the organization does not appear to place obstacles of any character in the way of those who need and would avail themselves of the charitable benefits it dispenses; and
- the organization actually and exclusively uses any subject real estate for charitable purposes.
In applying these factors on a case-by-case basis, hearing officers and courts have discretion regarding the weight to accord each factor. No one factor is determinative. Furthermore, under Illinois constitutional and statutory tax principles, these factors are to be construed strictly against exemption.
How About Switching to Taxable Usage, or a Partial Exemption?
At some point, a nonprofit property owner may decide that it is financially and otherwise worthwhile, on balance, to provide space on a commercial basis – such as to a business or other organization for which a “view to profit” undeniably exists. More specifically, if the potential revenue is sufficiently high that the organization is willing to pay the resulting property tax bill, then such arrangement may be quite attractive. Note though that the nonprofit will lose its property tax exemption. In Illinois, the property owner should report this change in property exemption status to the County Assessor’s office. The owner will need to affirmatively reapply for exemption after such non-exempt use ceases and the property again is used actively for tax-exempt purposes.
Note too that a portion of a nonprofit’s real estate may be treated as tax-exempt, while other portions are taxable. For example, the organization may wish to rent out half of a building or a portion of its parking lot for a non-exempt purpose. In that event, the nonprofit owner should report the taxable usage and then can expect to receive tax bills based on the proportionally rented portions. In that situation, the owner should be extremely careful to allow such non-exempt usage only in the designated areas for the non-exempt tenant. If the commercial tenant is allowed to occupy some of the exempt areas (e.g., regular use of a gym, access to the entire parking lot), then property tax exemption for those areas may be unintentionally lost.
What’s Next? Income Tax Implications and Facility Usage Agreements
Maintaining property tax exemption can be complicated, especially as more parties become involved in use of the property. As an additional wrinkle, are the revenues from third-party usage taxable? The answer is many cases is “no,” based on their passive nature. Another question is how should nonprofits best memorialize their non-commercial third-party usage? Briefly, nonprofit organizations should carefully develop facility usage agreements and forms in a way that shows the tax-exempt nature of the facility usage and absence of any prohibited view to profit. When drafted appropriately, these documents can help demonstrate the “clear and convincing evidence” of how the facility use arrangement qualifies for property tax exemption as non-commercial activity and notwithstanding any fees charged. We will address both income tax implications of usage fees and facility usage agreements in our law firm’s forthcoming articles in this facility usage series.