Insight

When your nonprofit’s debt-financed income is subject to tax

|November 5, 2024

If your nonprofit has investment income, dividends, interest, rents and annuities, they’re generally excluded when calculating unrelated business income tax (UBIT). However, income from debt-financed property typically is taxable. So it’s important to segregate income from such property and include it in UBIT calculations to help ensure you don’t trigger unwanted IRS attention.

What counts as UBI?

Income produced from debt-financed property generally is taxable unrelated business income (UBI) in the same percentage as the debt is to the full acquisition cost. This means that 75% of any income or gain from a property with a loan for 75% of its cost will usually be taxable UBI.

The most common type of income-producing debt-financed property for nonprofits is probably real estate — for example, an office building with income from rents unrelated to your nonprofit’s mission. But such property might also include stocks or other investments purchased with borrowed funds.

Income-producing property generally is treated as debt-financed for UBIT purposes if, at any time during the tax year, it had outstanding “acquisition indebtedness.” So if your nonprofit incurred debt before, during or shortly after it acquired or improved property (but wouldn’t otherwise have incurred debt), the property may be considered acquisition indebted.

What doesn’t count?

Some types of debt-financed property aren’t considered when calculating UBIT:

Property related to your exempt purpose. If 85% or more of the use of the property is substantially related to your nonprofit’s exempt purposes, it won’t be considered debt-financed property. Therefore, income from the property won’t be taxable. Simply using the income to support your programs doesn’t make the property related to your organization’s exempt purpose. The property must be used in providing program services.

Property used in certain excluded activities. This is property used in a trade or business that’s excluded from the definition of “unrelated trade or business.” That’s either because it’s used in research activities or because the activity has a volunteer workforce, is conducted for the convenience of members, or operates to sell donated merchandise.

Real property covered by the neighborhood land rule. Your nonprofit must acquire the real estate intending to use it for exempt purposes within 10 years. Also, the property usually must be connected to other property your organization uses for exempt purposes. Favorable treatment will no longer apply if you abandon your intention to use the land for exempt purposes.

Who should you ask?

There are other circumstances when dividends, interest, rents, annuities and other investment income may be taxable — for example, if it’s paid directly from a subsidiary your nonprofit controls. Determining if and when income is subject to UBIT can be difficult. We encourage you to contact us for information and help.