Debt-Financed Income (Section 514) (Portfolio 465)
This Portfolio describes and analyzes the tax treatment of income and deductions attributable to debt-financed assets owned by exempt organizations.
Tax Portfolio, Debt-Financed Income (Section 514), No. 465, describes and analyzes the tax treatment of income and deductions attributable to debt-financed assets owned by exempt organizations. Notwithstanding their general exemption from income taxation, exempt organizations are nevertheless subject to the unrelated business income tax, which taxes income from a regularly conducted trade or business that is unrelated to an organization’s exempt purpose or function. Most passive investment income, such as dividends, interest, and rents, is excepted from the scope of the unrelated business income tax. If, however, investment income is derived from debt-financed property, all or part of the income and deductions with respect to the property must be included in computing unrelated business taxable income. The purpose of the debt-financed property rules is to prevent exempt organizations from unfairly competing with their taxable counterparts in the acquisition of businesses and other investment assets that are debt-financed.
Debt-financed property is property held to produce income with respect to which there is acquisition indebtedness at any time during the taxable year. Debt-financed property can be real property or tangible or intangible personal property. Property is excepted from treatment as debt-financed property to the extent that it is used by an exempt organization in a manner that is substantially related to its exempt purpose or function. Other exceptions apply to: property used in an unrelated trade or business; property used to derive research income; property used in certain excepted trades or businesses; certain brownfield property, life income contracts; and real property acquired for prospective exempt use.
Acquisition indebtedness is indebtedness incurred in connection with the acquisition or improvement of property, whether the debt is incurred before, after, or at the time of acquisition. Under several important exceptions, however, income that would otherwise be considered debt-financed income may escape taxation. Exceptions relate to: mortgaged property acquired by gift, bequest, or devise; indebtedness inherent in the performance of an organization’s exempt purpose; obligations incurred in connection with gift annuities; property subject to certain federal financing; and securities lending transactions. In addition, an exception applies to real property acquired, directly or through partnerships, by educational organizations, qualified plans, multiple-parent title holding organizations, and church retirement income accounts.
The amount of income and deductions from debt-financed property included in unrelated business taxable income depends on the amount of the indebtedness and the adjusted basis of the debt-financed asset. There is included as gross income from an unrelated trade or business an amount which is the same percentage of the income from the debt-financed property as the average acquisition indebtedness for the taxable year is of the average amount of the adjusted basis of the property during the period it is held by the organization during the taxable year. The ratio of average acquisition indebtedness over average adjusted basis is referred to as the debt/basis percentage. The debt/basis percentage is also applied to determine the amount of deductions from the debt-financed property that are taken into account.
This Portfolio may be cited as Freitag, 465 T.M., Debt-Financed Income (Section 514).
Table of Contents
II. Debt-Financed Property
III. Acquisition Indebtedness
IV. Determination of Income and Deductions from Debt-Financed Property
Tax Management Portfolio Authors