Debt-Financed Income (Section 514) (Portfolio 465)

Tax Management Portfolio, Debt-Financed Income (Section 514), No. 465-2nd, describes and analyzes the tax treatment of income and deductions attributable to debt-financed assets owned by exempt organizations. 

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Tax Management Portfolio, Debt-Financed Income (Section 514), No. 465-2nd, 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, 465-2nd T.M., Debt-Financed Income (Section 514).


Carla Neeley Freitag, B.A., Duke University (magna cum laude 1974); J.D., University of Florida College of Law (with high honors 1976); LL.M. (Taxation), University of Miami School of Law (1988); admitted to practice in Florida, Texas, and Georgia; member, American Bar Association; author, The Funding of Living Trusts (ABA Section of Real Property, Probate and Trust Law, 2004); contributor to Tax Practice Series; author of 462 T.M., Unrelated Business Income Tax, 539 T.M., Net Operating Losses — Concepts and Computations, 607 T.M., Farm and Ranch Expenses and Credits, 744 T.M., Taxation of Cooperatives and Their Patrons, and 517 T.M., Educational Expenses and Credits; co-author of 521 T.M./863 T.M., Charitable Contributions: Income Tax Aspects; Tax Management Distinguished Author.


Detailed Analysis

I. Introduction

A. Background of § 514

B. Summary of § 514

C. Organizations Subject to § 514

D. Limitation of Discussion

II. Debt-Financed Property

Introductory Material

A. General Definition

1. Property Held to Produce Income

2. Property with Acquisition Indebtedness

B. Exceptions

1. Property with a Substantially Related Use

a. Two Alternative Applications

b. Substantially Related Use

(1) In General

(2) Mortgaged Realty

(3) Purchase of Securities on Margin

(4) Property Leased to Medical Clinics

c. Extent of Substantially Related Use

(1) Comparison of Substantially Related Use and Nonexempt Use

(2) Related Organizations

(a) Related Organization Defined

(b) Use by Related Organizations

(c) Related Exempt Uses

2. Property Used in an Unrelated Trade or Business

a. In General

b. Amounts Specifically Taxable Under § 512

(1) Personal Property Rentals

(2) Certain Amounts Received from Controlled Organizations

c. Gain on the Sale of Property Used in an Unrelated Trade or Business

3. Property Used to Derive Research Income

4. Property Used in Certain Excepted Trades or Businesses

5. Qualifying Brownfield Property

6. Real Property Acquired for Prospective Exempt Use

a. Neighborhood Land Rule

(1) General Rule

(2) Neighborhood Land

(3) Time Restrictions

b. Effect of Conversion to Actual Exempt Use

c. Limitations Pertaining to Existing or Subsequently Constructed Structures

d. Limitation for Property Subject to a Business Lease

e. Special Rules for Churches

7. Life Income Contracts

III. Acquisition Indebtedness

Introductory Material

A. General Definition

1. Statutory Requirements

a. Definition

b. Indebtedness Incurred Before or During Property Acquisition

c. Indebtedness Incurred After Property Acquisition

d. Indebtedness Unrelated to Property Acquisition

2. Indebtedness Defined

a. In General

b. Interorganizational Indebtedness

B. Special Rules

1. Changes in the Use of Property

2. Continued Indebtedness

3. Property Acquired Subject to Mortgage or Similar Lien

a. Mortgages

b. Liens Similar to Mortgages

4. Extension of Obligations

5. Property Held by Partnerships

C. Exceptions

1. Mortgaged Property Acquired by Gift, Bequest, or Devise

a. Testamentary Bequests and Devises

b. Inter Vivos Gifts

c. Exception Not Applicable

2. Indebtedness Inherent in Performing Exempt Purpose

a. In General

b. Indebtedness Incurred to Acquire Investment Assets

c. Relationship Between Inherent Indebtedness Exception Under § 514(c)(4) and Substantially Related Use Exception Under § 514(b)(1)(A)

3. Annuities

4. Certain Federal Financing

a. Indebtedness Incurred on or Before Oct. 22, 2004

b. Indebtedness Incurred After Oct. 22, 2004

5. Securities Lending Transactions

a. Definition

b. Excepted Items

6. Real Property Acquired by Educational Organizations, Qualified Plans, Multiple-Parent Title-Holding Organizations, and Church Retirement Income Accounts

a. Qualified Organizations

(1) Educational Organizations

(2) Affiliated Support Organizations of Educational Organizations

(3) Qualified Plans

(4) Multiple-Parent Title-Holding Organizations

(5) Retirement Income Accounts Provided by Churches

b. Limitations

(1) Acquisition or Improvement Price Not Fixed

(a) General Rule

(b) Qualifying Sales by Financial Institutions

(2) Amount of Indebtedness Dependent on Future Income

(a) General Rule

(b) Qualifying Sales by Financial Institutions

(3) Sale-Leaseback Transactions with Seller or Related Parties

(a) General Rule

(b) Small Leases on Commercially Reasonable Terms

(4) Qualified Trust Purchases from or Leases to Related Party

(a) General Rule

(b) Small Leases on Commercially Reasonable Terms

(5) Financing Provided by Related Party

c. Application to Partnerships

(1) General Rule

(2) All Partners Are Qualified Organizations

(3) All Allocations to Qualified Organizations Are Qualified Allocations

(a) In General

(b) Qualified Allocation Defined

(c) Allocations of Gain from Contributed Property

(d) Treatment of Guaranteed Payments

(4) Section 514(c)(9)(E)

(a) In General

(b) Applicable Authorities and Effective Dates

(c) Fractions Rule

(i) Basic Requirements

(ii) Application of Fractions Rule

(A) In General

(B) Effect of Subsequent Changes

(iii) Certain Allocations Disregarded

(A) Guaranteed Payments

(B) Preferred Returns

(C) Chargebacks and Offsets

(D) Partner-Specific Items of Deduction or Loss

(E) Unlikely Losses and Deductions

(F) Provisions Preventing Deficit Capital Account Balances

(G) Partner Nonrecourse Deductions

(H) De Minimis Allocations

(iv) Tiered Partnerships

(d) Substantial Economic Effect Requirement

(e) De Minimis Interest Rule

d. Special Rule for Disqualified Holders of Interests in Multiple-Parent Title-Holding Organizations

IV. Determination of Income and Deductions from Debt-Financed Property

A. Unrelated Debt-Financed Income and Deductions in General

B. Debt/Basis Percentage

1. Average Acquisition Indebtedness

a. General Rule

b. Special Rule for Determining Gain or Loss

2. Average Adjusted Basis

a. General Rule

b. Basis of Property Acquired in Corporate Liquidation

3. Indeterminate Price

C. Application of Debt/Basis Percentage

1. Application to Income

2. Application to Deductions

a. Deductions Allowable

b. Percentage of Deductions Taken into Account

c. Treatment of Net Operating Losses

d. Treatment of Capital Losses

D. Allocation Rules for Partially Debt-Financed Property


Working Papers

Table of Worksheets

Worksheet 1 Section 514(f)-(h), as in Effect Prior to the Tax Reform Act of 1976 (Business Lease Provisions)

Worksheet 2 General Explanation of the Tax Reform Act of 1969 Joint Committee on Internal Revenue Taxation, 62-71

Worksheet 3 S. Rep. No. 1036, 96th Cong., 2d Sess. 28-31 (Nov. 25, 1980)

Worksheet 4 H.R. Rep. No. 861, 98th Cong., 2d Sess. 1096-98 (1984) (Conference Report)

Worksheet 5 General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 Joint Committee on Taxation, 1150-53

Worksheet 6 Omnibus Budget Reconciliation Act of 1987, H.R. Rep. 100-495, 100th Cong. 1st Sess. 953-957 (Conference Report)

Worksheet 7 Internal Revenue Manual Excerpts: 7.27.8, Unrelated Debt-Financed Income; 7.27.9, Debt-Financed Property; 7.27.10, Acquisition Indebtedness

Worksheet 8 Preamble to PS-56-90, 57 Fed. Reg. 62266 (12/30/92) Proposed Regulations on Debt-Financed Real Property Held Through Partnerships (finalized by T.D. 8539, 59 Fed. Reg. 24924 (5/13/94)

Worksheet 9 Debt-Financed Property: Guide to Exceptions





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