Income from Exempt Organization's Inherited Rental Properties Won't Lead to UBTI

(Parker Tax Publishing August 2016)

The IRS, in a private letter ruling, determined that commercial real estate properties that a Code Sec. 501(c)(3) organization inherited from its sole financier would not cause it to incur unrelated business taxable income (UBTI). The IRS ruled that both rental income from the properties and any gain on potential sales of the properties would be excluded from UBTI under the real property exclusions in Code Sec. 512(b). PLR 201630009.

Background

Under the facts of PLR 201650009, a foundation was a Code Sec. 501(c)(3) tax-exempt organization classified as a private foundation under Code Sec. 509(a). The foundation's exempt purpose was to receive funds, administer investments, and distribute funds to other Code Sec. 501(c)(3) organizations. Historically, the foundation invested in cash and publicly traded bonds and securities.

The foundation's funding had come solely from an individual, who had recently died. The decedent left a will providing that the foundation would receive, among other things, commercial real estate properties that were primarily office rental properties. The decedent's executor intended to distribute these real estate properties to the foundation as single member limited liability companies, with any debt encumbering the properties to be paid in full by the estate prior to, or simultaneously with, the transfer of the properties.

The foundation intended to continue to hold the properties as part of a diversified investment portfolio that would also contain cash and publicly traded securities. The real estate properties were to be held as income producing properties and not as inventory used in a trade or business. The decision to sell or keep any one of the individual real estate properties was to be made on a property-by-property basis, taking into consideration the foundation's overall investment portfolio, investment strategy, and capital appreciation. The foundation anticipated that any sales of the real estate properties would be sporadic and occasional.

The foundation requested a private letter ruling from the IRS addressing whether the rental income received from the commercial real estate properties, or any income received as a result of the sale of the properties, would be excluded from unrelated business taxable income.

Analysis

Code Sec. 511(a) imposes a tax for each taxable year on the unrelated business taxable income (UBTI) of every organization described in Code Sec. 501(c). Code Sec. 512(a)(1) provides that the term "unrelated business taxable income" means the gross income derived by any organization from any unrelated trade or business regularly carried on by it.

Code Sec. 512(b)(3)(A) provides that, in computing UBTI, all rents from real property and all rents from personal property leased with such real property (if the rents attributable to such personal property are an incidental amount of the total rents received or accrued under the lease) are excluded. In addition, Code Sec. 512(b)(5) generally excludes from the computation of UBTI all gains or losses from the sale, exchange, or other disposition of property. This exclusion does not extend to stock in trade or other property of a kind which would properly be includible in inventory, or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business.

With regard to the rental income, the IRS noted that the foundation's commercial real estate properties were "real property," as defined in Reg. Sec. 1.512(b)-1(c)(3). The rental income, the IRS found, was from rents of the real property or from personal property leased with the real property that would be an incidental amount of the total rents received or accrued under the lease. The IRS noted that no part of the rent paid depended on the income or profits derived by any person from the property leased, and that the foundation would not provide services to the lessees. Thus, the IRS ruled, the income from the commercial real estate properties the foundation received by bequest consisted of rent that was excluded from UBTI by Code Sec. 512(b)(3).

With regard to the sale of the properties, the IRS noted that the foundation intended to hold the real estate properties as part of a diversified investment portfolio, at least in the near term, and that any sales of the real estate properties would be sporadic and occasional. The foundation had indicated that it might decide to make capital improvements to the real estate properties as needed, but that the real estate properties would not be held for the primary purpose of improving the properties for immediate resale. The IRS found that the real estate properties would be held as income producing properties and not as inventory used in a trade or business. Accordingly, the IRS ruled that any income from the sale, exchange, or other disposition of the commercial real estate would also be excluded from the computation of UBTI by Code Sec. 512(b)(5).

For a discussion of unrelated business taxable income, see Parker Tax ¶66,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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