How to Avoid Eroding the Return on Investment in Ground Lease
Rents – Unrelated Business Income Tax Issues for Real Estate
Leasing by 501(c)(3) and Other Tax-Exempt Organizations
and Real Estate Investment Trusts (REITs)
By Janet M. Johnson and Michael J. Huft1
It is not uncommon for tax-exempt organizations to want to lease real estate they own for
residential or commercial uses, whether the real estate consists of empty land or existing
buildings. The rental income they receive often provides a good source of revenue for the
organization, as well as a means of maintaining in use property that the organization may wish to
hold for long-term development for its own uses, but temporarily is not needed. In other cases,
the organization wishes to lease property that it will never use, but nonetheless believes that
leasing will provide an alternative investment to stocks and bonds, offering a greater and more
predictable stream of income over a longer period of time than would be available by selling the
property outright and reinvesting the proceeds in more traditional investment vehicles like stocks
and bonds. If the tax-exempt entity occupies adjacent property, entering into a long-term ground
lease rather than selling the property also provides a means of controlling the future uses of the
property as it is developed or redeveloped over long periods of time.
In this respect, tax-exempt organizations are no different from for-profit businesses that
need to find a use for property that may not be needed (temporarily or permanently) for the
organization’s own operations. There are major differences, however, in the tax consequences of
leased real estate between for-profit and not-for-profit organizations. Although tax-exempt
entities ordinarily do not pay tax on their income, the Internal Revenue Code of 1986, as
amended (“Code”) does tax the income of tax-exempt organizations derived from commercial
activities that are not related to their exempt purposes.2 Although an organization is permitted to
engage in some degree of commercial activity (and pay the tax on the income derived from such
activity), if the taxable income from activity constitutes too large a portion of the organization’s
overall income, it will jeopardize the organization’s status as an exempt organization.
This paper addresses the unique considerations for tax-exempt organizations seeking to
avoid tax on the income from leasing real property. It examines the special considerations that
tax-exempt organizations must address in leasing (including ground leasing) real estate to third
party lessees, including vacant land leased for development purposes in order to increase the
revenue it will generate for the organization. Finally, it examines the special cautions that must
be observed if the real estate is debt-financed.
1
© 2014 by Janet J. Johnson and Michael J. Huft. Janet M. Johnson is a partner in the Real Estate Group at Schiff
Hardin LLP, where she practices real estate law; Michael J. Huft is counsel at Schiff Hardin LLP, where he
concentrates his practice in the area of tax-exempt organizations.
2
The focus of this paper is the federal income tax issues associated with rents from real estate for tax-exempt
entities and REITs. Space does not permit the examination of the state income tax consequences to tax-exempt
entities deriving income from unrelated activities.
A real estate investment trust (“REIT”), as defined in Section 856 of the Code, is a
taxable organization that meets certain qualifications and makes an election to be treated as a
REIT. If the qualifications are met and the election is made, the REIT’s income becomes subject
to only one level of income tax at the shareholder level on distributions of the REIT’s income.
Unless the election is made, the organization is taxable as a corporation. Among the
qualifications that a REIT must meet is that at least 75% of its gross income must be derived
from rents from real property and certain other income derived from real property or interests in
real property. Code Section 856(c)(3).3
Because REITs are subject to some of the same rules that apply to tax-exempt
organizations, and the regulations applicable to tax-exempt entities refer in some cases to the
regulations that apply to REITs, this paper will also examine the applicability of such rules to
REITs. The tax consequences for a REIT if it fails to meet the requisite tests are different than
for a tax-exempt entity that simply has to pay UBIT on the portion of its income considered
UBTI. If a REIT fails certain of its required tests to remain a REIT, including the failure of the
requisite portion of its income to be from rents from real property (and other allowable sources
of income), as well as a failure to meet any of the other tests,4 it will have to pay a special tax
calculated as provided in Section 856 of the Code. If the failure to meet the requisite tests
continues without being rectified, eventually the REIT may lose its status as a REIT.
As noted in this paper, if the rent terms are properly structured, tax-exempt organizations
and REITs can avoid federal income tax on rents received from leasing or ground leasing their
real estate.5
3
In addition, at least 95% of its gross income must be derived from dividends, interest, rents from real property and
certain other sources. See Code Section 856(c)(2).
4
The other tests an entity must meet to qualify as a REIT are set out in Code Section 856 and include management
tests, income tests and income distribution tests, as well as asset holding tests.
5
In order for “rents” to be exempt from UBIT, they must be from “real property.” This paper assumes that the
property leased by the tax-exempt entity or REIT is real property. “Real property” is defined in Treas. Reg. § 1.8563(d) to include “land or improvements thereon, such as buildings or other inherently permanent structures thereon
(including items which are structural components of such buildings or structures) . . . and interests in real property.”
Traditional real estate assets, such as office, industrial and retail buildings and multi-family apartment buildings,
would be considered real property without any question. However, in recent years a number of REITs or publicly
traded limited partnerships (or entities planning to become REITs or publicly traded limited partnerships) that
intended to acquire “non-traditional” types of assets have sought private letter rulings from the IRS dealing with the
question of whether the assets described by the REIT’s or the limited partnership’s representatives in the request are
“real property” for purposes of Code Section 856. The IRS has responded finding all of the following examples of
assets described in the requests to be real property: PLR 201250003 (September 6, 2012) (offshore oil drilling
platform and related machinery and equipment permanently attached to the seabed); PLR 201129007 (April 6, 2011)
(wireless and broadcast communication towers and related structures housing transmitting, receiving and switching
equipment and sometimes backup electricity generators, fencing and other buildings); PLR 201005018 (October 6,
2009) (facility consisting of hoses, pipes, manifolds, valves, and underground scales; insulated heat traced pipes
suspended above ground on a steel girder system; pumps, valves and vents affixed to the piping system; storage
tanks; boilers; blending devices; buildings; various interests in land, including easements; and various land
improvements, such as driveways, roadways, docks, rail spurs, dikes, containment areas and security fencing that
were all permanently affixed to the system or the ground); PLR 200937006 (March 3, 2009) (primarily buried
pipeline system consisting of structures, pipes, regulators and meters, monitoring and control devices, as well as
2
A.
Leasing Real Estate to Third Parties
Section 511(a) of the Code imposes a tax (referred to as the unrelated business income
tax, or “UBIT”), computed at the corporate income tax rate, on the unrelated business taxable
income (“UBTI”) of most exempt organizations, including universities, churches, public
hospitals, charities and foundations, social welfare organizations, certain cooperatives, business
leagues, and pension and other qualified plans.6 In general, the unrelated business income tax
applies to (i) organizations described in Code Sections 401(a) and 501(c); (ii) any college or
university that is an agency or instrumentality of any state government or subdivision thereof, or
that is owned or operated by any agency or instrumentality of any such government; (iii) any
corporation wholly owned by one or more such colleges or universities; and (iv) charitable trusts.
With certain exceptions not relevant here, the UBTI of an organization subject to UBIT is the
gross income derived by such organization from any unrelated trade or business regularly carried
on by it, less any allowed deductions that are directly connected with such trade or business, both
computed with certain modifications provided for in Code Section 512(b). An unrelated
business is any trade or business, the conduct of which is not substantially related to the
performance by such organization of the functions that constitute the basis of its exemption from
tax. Code Section 513(a).
Code Section 512(b) provides for the categorical exclusion from UBTI of income from
certain enumerated sources or arising from certain activities. Of particular relevance to this
paper, Code Section 512(b)(3) provides that all rents from real property are excluded from UBTI,
provided that the determination of the amount of such rent does not depend in whole or in part on
the net income or profits derived by any person from the property leased. In addition, if personal
pressure reducing stations and interconnection points to end-user buildings with meters monitoring usage, as well as
product holding structures permanently affixed to the ground and integrated into the pipeline system that are
hundreds of feet high and in diameter, all of which would be leased to an operator); and PLR 200725015 (March 13,
2007) (electricity transmission system to be leased to a third party). In all of these private letter rulings, the IRS
determined the facilities were real property because they consisted of physically connected and functionally
interdependent assets and the facilities were not operated by the owners in a manufacturing or other production
process, it was not feasible to move any substantial part of the facilities, the owner was not licensed to operate the
facilities, and the facilities were leased to third parties who were responsible for operating and maintaining them and
paying all expenses related to their operation and maintenance.
6
Although the UBIT Code provisions apply to pension and other types of qualified plans, these types of plans are
less likely to engage in unrelated business activities through direct ownership and investment in real estate, so they
are not covered in detail in this paper. However, the trustees of such plans do often seek to invest (along with other
tax-exempt or taxable entities) in real estate investment funds, which if not structured properly might result in the
pass through to the exempt organization of income that is UBTI. There also are other Code provisions prohibiting
pension funds and other qualified plan fiduciaries from engaging in prohibited transactions. The prohibited
transactions Code provisions are more problematic for such entities because the result of violating the prohibited
transactions is the obligation to pay excise taxes which can exceed the amount involved in the prohibited transaction
if it is not undone within the applicable tax period. See Code Section 503. The prohibited transactions rules and the
formation of real estate investment funds are beyond the scope of this paper. For an excellent article on the use of
private REITs as a way to structure an investment fund in which pensions, qualified plans and other tax-exempt
entities may invest without recognizing UBTI, see Mitchell R. Berg, Peter E. Fisch and Ian S. Tattenbaum, Using
Private REITs to Minimize UBTI in Real Estate Investment Funds, 18 The Real Est. Fin. J. 36 (2002).
3
property is leased with the real property and if the portion of the overall rent attributed to that
personal property exceeds ten percent, the excess will be considered UBTI.7
If more than fifty percent of the rental income is attributed to personal property, then the
entire amount of the rent will be included in UBTI. In the latter case, the portion of the rent
income attributed to real property may retain its tax-free character if a separate lease is executed
for the personal property.8 In a typical ground lease transaction, often only the land (whether
undeveloped or underlying a building) is leased, which avoids any issues associated with UBIT
on rents from leasing personal property. However, if a ground lease is terminated and both the
real property improvements constructed by the lessee on the real property and any associated
personal property installed within the improvements revert to the tax-exempt lessor, it would be
wise for the tax-exempt lessor to consult with its tax advisor before simply leasing the improved
real property and personal property to a new lessee. If the personal property is a significant part
of the value of the property to be leased, it may be wise from a UBIT perspective for the taxexempt entity to sell the personal property to the new lessee and lease only the improved real
property to the lessee, or to sell the personal property and improvements to the new lessee and
lease only the land as it did in the original transaction.
1.
What Constitutes Rent
Neither the Code Section 512 nor the regulations adopted under Code Section 512 with
respect to the exclusion from UBTI for rents from real property expressly define what constitutes
rent. Instead, Treas. Reg. § 1.512(b)-1(c)(5) describes what are not rents from real property as
follows:
For purposes of this paragraph, payments for the use or occupancy of rooms and
other space where services are also rendered to the occupant, such as for the use
or occupancy of rooms or other quarters in hotels, boarding houses, or apartment
houses furnishing hotel services, or in tourist camps or tourist homes, motor
courts, or motels, or for the use of [sic] occupancy of space in parking lots,
warehouses, or storage garages, does not constitute rent from real property.
Generally, services are considered rendered to the occupant if they are primarily
for his convenience and are other than those usually or customarily rendered in
connection with the rental of rooms or other space for occupancy only. The
supplying of maid service, for example, constitutes such service; whereas the
furnishing of heat and light, the cleaning of public entrances, exits, stairways, and
7
Code Section 512(b)(3) provides that rents attributable to personal property are excluded from UBTI only “if the
rents attributable to such personal property are an incidental amount of the total rents received or accrued under the
lease.” Section 1.512(b)-1(c)(2)(b) of the regulations provides a safe harbor of 10 percent or less of the total for
rents from personal property to be considered an “incidental” amount of the total rents. 26 C.F.R. 1.512(b)1(c)(2)(b).
8
However, if the real property and personal property leases have “an integrated use” (i.e., the personal property is
used on the leased real property), then the separate leases will be considered one lease. 26 C.F.R. 1.512(b)1(c)(iii)(b)(3). Thus, the rents from a separate lease of personal property would likely have to be with separate
entities or moved to a separate location to be excluded from UBTI if it is more than an incidental amount of the rents
from the real property.
4