When Nonprofits Must Pay Tax on Debt-Financed Income

For most nonprofits, income from investments like dividends, interest, rents, and annuities is generally exempt from unrelated business income tax (UBIT). However, income derived from debt-financed property is typically taxable. To avoid potential IRS scrutiny, it’s crucial to separate income from such properties and include it in your UBIT calculations.

What Is Considered Unrelated Business Income (UBI)?

Income generated by debt-financed property is generally considered taxable UBI, proportional to the debt ratio. For example, if a property is 75% financed by debt, then 75% of the income or gains from that property will likely be taxable as UBI.

The most common debt-financed property for nonprofits is real estate, such as an office building generating rental income not related to the nonprofit’s mission. Stocks or other investments purchased with borrowed funds may also qualify as debt-financed property.

For UBIT purposes, a property is considered debt-financed if it has outstanding "acquisition indebtedness" during the tax year. If your nonprofit took on debt before, during, or shortly after acquiring or improving a property, it may be classified as debt-financed.

What Property Is Exempt?

Certain types of debt-financed property are excluded from UBIT calculations:

- Property Related to Your Exempt Purpose: If at least 85% of the property’s use is tied to your nonprofit’s mission, it’s not considered debt-financed, and income from it isn’t taxable. Merely using the income for your programs doesn’t qualify — the property must directly support your mission.

- Property Used in Certain Excluded Activities: This includes property used in activities like research, those run by volunteers, or businesses conducted for the convenience of members or selling donated goods.

- Real Property Covered by the Neighborhood Land Rule: If your nonprofit buys real estate intending to use it for exempt purposes within 10 years, and the property is connected to other mission-related property, it may be exempt from UBIT. However, this favorable treatment ends if your organization abandons its plans to use the land for exempt purposes.

When to Seek Professional Guidance

There are additional scenarios where investment income, like dividends or rents, may be subject to UBIT — for example, if it's paid by a subsidiary your nonprofit controls. Determining when income is taxable can be complex, so it's important to consult with a tax advisor. Contact us for guidance on navigating UBIT and debt-financed income.