Donations and grants are typically the first things that come to mind when considering nonprofit funding sources. However, many organizations generate additional revenue through other means such as merchandise, advertisements, and even rentals. Whereas donations and grants are generally considered tax-exempt, the income generated from the additional revenue sources mentioned above may be subject to Unrelated Business Income Tax or UBIT for short. This article will specifically cover rental income and its classification.
UBIT ensures fairness by taxing income earned from regular business activities not directly related to a nonprofit’s core mission.
The underlying reason for taxing this income is to prevent nonprofits from competing unfairly with regular businesses while still allowing them to generate income through ventures like renting out unused space.
The Hot Dog Cart Example
Imagine you are running a nonprofit with the mission of providing programming and services to your local community members. Every day, in front of your building, you sell hot dogs out of a hot dog cart. The cart is owned by the nonprofit, and all of the proceeds generated from the hot dog sales are used to fund your programs and services. Is the hot dog income exempt or subject to UBIT?
Well, the first question you need to answer is: are hot dogs directly related to your programs or services, or is the hot dog cart operating as a trade or business? In this example, the hot dog cart and sales generated from the cart would be considered a trade or business. This cart is competing with other for-profit hot dog carts, and the act of selling hot dogs is not critical to the mission of your nonprofit. Therefore, the hot dog profits would be subject to UBIT. The IRS is not looking at how you are using the funds that are generated, rather they care about where the income is generated from and how it is earned.
Rental income can be complex.
Generally, rental income for nonprofits falls under an “inherently excluded source of revenue” category. This means it’s not subject to UBIT – which can serve as a big tax advantage! However, there are a few caveats to consider:
- Debt Financing: If your rental property has debt financing (a mortgage, for example), things get more complex. The presence of debt can potentially convert that excluded income into taxable UBIT.
- Rental Contracts: The terms of your rental contract can also impact UBIT. Supplying additional services alongside renting the space (for example, setting up furniture, catering events, or providing additional material rentals) can push the income into the taxable UBIT category.
- Real Property vs. Personal Property: Understanding the distinction between real property (land and buildings) and personal property (furniture, equipment) is crucial. Rental income from real property can be classified based on its nature as related, unrelated or excluded revenue, while rental income from personal property is generally considered UBIT.
Debt doesn’t always mean UBIT.
There’s some good news! Even with debt financing, your rental income might still be excluded. Here’s how:
- 85% Rule: If you use at least 85% of your building space for your exempt purpose (your core mission), the entire rental income remains excluded, regardless of debt.
- For example, imagine a five-story building: four and a half floors are dedicated to your core services/mission and one is rented out. This scenario would likely qualify for exclusion. (Before that was only 75% of the space) – this now ensures 90% of the space is mission-driven)
- Percentage Calculation: If less than 85% of the space is used for your mission, a calculation comes into play. This determines what portion of the rental income is taxable UBIT. The calculation considers the average debt on the property compared to its average value.
In most cases, it is best for organizations with debt-financed rental properties to prioritize paying down the debt. Here’s why: Once the debt is gone, the rental income automatically reverts back to being excluded, saving you on taxes.
Don’t be afraid of UBIT.
It is important to remember that UBIT is not inherently bad. Oftentimes, it is worth paying a 21% tax because these non-exempt activities are generating unrestricted funds for your organization. The IRS does not hold unrelated business income against your nonprofit unless it grows to a significant portion of your total revenue, typically around 20%. As long as your organization is primarily operating for its exempt purposes, it is not a cause for concern.
Consult your tax advisor.
The UBIT rules can get intricate, especially when multiple factors come into play. It is incredibly important to consult with a tax advisor specializing in nonprofits. Some rules impacting UBIT vary from state to state, and a professional can assess your specific situation and help you navigate the complexities of rental income taxation. Remember, a little planning goes a long way in ensuring your nonprofit maximizes its resources while staying compliant. For questions or further guidance regarding UBIT reach out to our 990 Tax Advisors. Click here to download our 990 FAQs and Preparation Checklist.
