If your nonprofit provides facility usage to another organization, could any fees charged then result in tax liability? This question of federal unrelated business income tax often becomes relevant to many nonprofit property owners, as they consider potential opportunities for revenue generation, wise stewardship of their resources, and property tax exemption too. This article is third in a series on third-party facility usage, building on the importance of a facility usage policy and making sure the organization’s real estate continues to qualify for property tax exemption.[1]
Legal Background
Section 501(c) of the Internal Revenue Code provides an exemption from federal income taxes for Section 501(c)(3) public charities such as the Church, which is automatically a Section 501(c)(3) public charity, per Section 508 of the Tax Code. Sections 511 through 514 of the Tax Code carve out an exception to the exemption from income tax when an exempt organization engages in certain commercial business activities. Specifically, IRC Section 512(a) provides that the unrelated business income tax (“UBIT”) will be imposed on any activity of an exempt organization that is: (1) a trade or business; (2) regularly carried on; and (3) not substantially related to the organization’s tax-exempt purposes. The UBIT is designed to level the playing field by requiring nonprofits to pay comparable income taxes when they engage in business activities similar to their commercial counterparts.[2]
Several modifications in the Tax Code specifically exclude certain types of business activities from UBIT liability. One of these modifications is Section 512(b)(3), which excludes income derived from the rental of real property. The term “real property” is defined broadly and covers tangible real property, such as buildings, structural components, and intangible real property interests, such as right-of-way interests, easements, and the right to install, service, operate, repair, and remove wireless telecommunications equipment and services on real property.[3] This exception is not available, however, to the extent the property is debt-financed.
Please note further that under Section 514(b)(1)(i) of the Tax Code, the income derived from the lease of debt-financed real property will not be subject to UBIT if substantially all of the real property is used by the tax-exempt organization to exercise or perform its exempt purposes. The term “substantially” is defined as 85% or more of the property and may be calculated under a comparison of total time used, the square footage, or a combination of both. See IRC Section 514(b)(1)(ii). This exception is known as the “85% rule.”
Application to Facility Usage
Based on the above legal considerations, some of a nonprofit property owner’s facility usage may be subject to UBIT and some may not, as follows.
To the extent the organization receives income from charging fees for related tax-exempt purposes, no UBIT liability should result. Using a church or other house of worship as an example, such fee-based uses may include permissible rentals to other houses of worship for their related religious activities, to the organization’s members or others connected to the ministry for weddings or funerals, to youth-based ministry programs, and to educational programs with a strong ministry element.
To the extent that a nonprofit property owner rents out its facilities for unrelated purposes, UBIT liability will likely result. Such uses may include commercial rentals to businesses, community sports programs, and other non-exempt purposes. Such activities may be unrelated to a nonprofit’s mission, depending on its specific corporate documents and programs.
Please note further the following important three caveats. First, third-party facility usage fees will generally be exempt from UBIT under the passive income UBIT exception for properties that are not debt-financed, but for other properties, the debt financing aspect will render such exception inapplicable. Second, such fees may nevertheless be exempt from UBIT under the above-noted “85% rule,” depending on how much of the facility is actually under a related agreement. Third, even if the revenues are subject to UBIT, any resulting tax will be owed only on net revenues from such activity. For example, if the property owner receives $100,000 in 2022 from its third-party facility usage activities and its related expenses attributable to such activities are $99,000 (i.e., proportionate amount of mortgage, facility upkeep, etc.), then it would owe taxes on the net $1,000 in profit (at the regular business corporate tax rate). Note too that the property owner must report UBIT through an IRS Form 990-T tax return.
Consider Management Services
Note further that the UBIT exception for real estate facility usage income is premised on such income being “passive” income. “Renting” space alone (unless the property is debt-financed) will not result in UBIT, but actively conducting certain tangential activities, such as actively managing and marketing the property for third-party facility usage space for purposes unrelated to the nonprofit owner’s tax-exempt purpose or providing other services to prospective occupants beyond the provision of space (e.g., providing janitorial services to a long-term occupant), may result in UBIT. If a nonprofit’s leaders decide to pursue commercial rent relationships, rather than limiting facility usage to programs with specific missional alignment, leadership may want to consider using a separate legal entity to manage the property or may choose to pay outside property management and/or a realtor for advertising the property and finding potential tenants.
Consider Advertising Too
A nonprofit’s leaders should also consider how they will advertise spaces in connection with the property tax exemption considerations above. For example, advertising on the organization’s website could be limited to indicating that spaces are available for other organizations with missional alignment that do not charge fees or can demonstrate generous fee waivers and reductions. (Such advertising would not cause any UBIT issues, as it would be for “related” rather than “unrelated” purposes and activities.)
Stewardship
These questions all arise out of stewardship: that is, whether it is a good idea overall to allow others into the nonprofit’s space. If so, then a follow-up question is warranted – what should you include in a third-party usage agreement, particularly in regard to fee amounts, allocation of the parties’ respective responsibilities, specific usage designations, and attentiveness to risk management aspects? Accordingly, we look forward to addressing these important elements of third-party facility usage in our next “Making Room” blog series article.
[1] Our law firm’s prior “Making Room” blog series articles can be found on our website here: Third-Party Facility Usage Policy and Property Tax Exemption and Third-Party Facility Usage.
[2] For more information on UBIT, see our law firm’s blog article, When are Nonprofit Revenues Taxable? UBIT Basics.
[3] See Priv. Lt. Ruls. 9816027; 20041024; 200148074; and 200147058.
