Tax Management Portfolio, Real Estate Transactions by Tax-Exempt Entities, No. 480-2nd, analyzes the tax considerations pertinent to the investment by exempt entities, including pension trusts, in real estate. To view this Portfolio,
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Tax Management Portfolio, Real Estate Transactions by Tax-Exempt Entities, No. 480-2nd, analyzes the tax considerations pertinent to the investment by exempt entities, including pension trusts, in real estate.
Exempt organizations are taxed on their unrelated business taxable income (UBTI). A primary concern of exempt organizations that invest in real estate is UBTI. Generally, gross income of an exempt organization is UBTI if: (i) the income is derived from the conduct of a trade or business; (ii) the business activity is regularly carried on; and (iii) the conduct of the business activity is not substantially related to the organization's exempt function. Tax law excludes from UBTI certain types of income that would otherwise come within the definition of UBTI.
Of central importance to exempt organizations that invest in real estate is the exclusion from UBTI of rents from real property. To qualify for this exclusion, the rent must be from property that comes within the definition of real property. Another initial concern is whether a transaction is characterized as a lease, a loan, or a partnership. Rents from personal property are not subject to UBTI rental exclusion, although the law disregards incidental rents from personal property. Tax law includes in UBTI rents from real property that are dependent on the income or profits derived from the leased property. This Portfolio examines in detail various permissible and impermissible rental formulas.
Tax law also excludes interest from UBTI. Qualifying interest does not, however, include amounts determined with respect to income or profits. This Portfolio examines the circumstances in which debt may be recharacterized as equity, as well as the treatment of contingent interest.
Income and deductions that would otherwise be excluded from UBTI may nevertheless be subject to taxation if incurred with respect to debt-financed property. This Portfolio examines various real estate-related aspects of the debt-financed property rules.
Other topics addressed by the Portfolio include corporate ownership of investments rather than direct ownership by the exempt organization, joint venture participations by exempt organizations, limited liability companies as exempt organizations, investment through specially treated conduit organizations, state or municipal retirement plans, foreign government pension plans, ERISA and state law considerations, and prohibited sale-in, lease-out (SILO) and lease-in, lease-out (LILO) transactions.
This Portfolio may be cited as Borden, 480-2nd T.M., Real Estate Transactions by Tax-Exempt Entities.
Bradley T. Borden
Bradley T. Borden, B.B.A., M.B.A., Idaho State University; J.D. (Order of the Coif), LL.M. (Taxation), University of Florida Levin College of Law; Professor of Law, Brooklyn Law School (courses include Federal Income Taxation; Partnership Taxation; Taxation of Real Estate Transactions; admitted to practice, Texas, U.S. Tax Court; Certified Public Accountant; member, American Bar Association Section of Taxation (John S. Nolan Tax Law Fellow; Former Chair, Sales, Exchanges & Basis Committee); author, books (Tax-Free Like-Kind Exchanges (Civic Research Institute, 2d ed. forthcoming 2015); Taxation and Business Planning for Real Estate Transactions (LexisNexis 2011), Tax-Free Swaps: Using Section 1031 Like-Kind Exchanges to Preserve Investment Net Worth (DNA Press, 2007)); Limited Liability Entities: A State-by-State Guide to LLCs, LPs, and LLPs (Wolters Kluwer, updated annually) (with Robert J. Rhee) author, various articles in leading tax journals (including Journal of Taxation; Journal of Taxation of Investments, Real Estate Taxation; Tax Management Memorandum; Tax Management Real Estate Journal; Tax Notes; Taxes: The Tax Magazine) and several law reviews (including Baylor Law Review, University of Cincinnati Law Review, Florida Law Review, Florida Tax Review, Georgia Law Review, Houston Law Review, Iowa Law Review,Kansas Law Review, South Carolina Law Review, Virginia Tax Review); frequent speaker, tax law topics.
Table of Contents
Detailed Analysis I. Introduction A. General B. State Law Considerations II. Unrelated Business Income Tax A. Overview 1. Scope of Tax 2. Estimated Tax 3. Method of Accounting B. Definition of UBTI C. Exclusions from UBTI: Overview D. The Exclusion of Rents 1. Definition of Real Property 2. Characterization of a Transaction 3. Development and Management Activities 4. Rents from Personal Property a. In General b. “Incidental” Personal Property Rents c. Integration of Leases d. Nature of Leasehold Interest 5. Rents Dependent on Income or Profits a. In General b. Transactional Analysis of Typical Lease Transaction (1) Typical Leasing Arrangement (2) Permissible Rental Formulas (a) Applicability of REIT Regulations (b) Limiting the Effect of Disqualified Rents (c) Permissible Gross Receipts Formulas and Exclusions (i) Multiple Fixed Percentages of Tenant's Receipts as Additional Rent (ii) Shifting Percentages (iii) Quarterly Percentage Rents (iv) Combination Rental Formulas (v) Escalating Fixed Minimum Rent Plus Percentage Rent (vi) Inflation Increases (vii) Returns, Refunds, Exchanges, and Taxes (viii) Shopping Center Lease Exclusions (ix) Improvements and Alterations (x) Escalation Receipts (d) Conformity to Customary Business Practice (e) Participation in Refinancing and Sale Proceeds (f) Participation in Cash Flow (g) Purchase Price Based in Part on User's Earnings (3) Treatment of Payments for Services (a) Definition of Services (i) Hotels and Apartments (ii) Short-Term Lease of Recreational Lodge (iii) Sporting and Entertainment Facilities (iv) Services at Multiple Properties (v) Rental for Catering (vi) Health Club Facility versus Gymnasium (vii) Landlord's Teleconference Center Facilities (viii) Telecommunication “Smart” Buildings (ix) Rooftop Sites, Advertising Displays, and Telecommunication Towers (x) Leasing Space for Microwave and Other Communication Equipment (xi) Leasing Space for Organized Event (b) Providing Parking and Storage Facilities (c) Minimal Services May Disqualify Rents (d) Submetering Utilities Revenue (e) Telephone and Vending Machine Commissions (f) Construction and Professional Services Performed by a REIT (g) Cable Television Services Provided by REIT (h) Services in Developing of Income-Producing Property (i) Allocation of Payments Between Rent and Services (4) Subordination Fee as Rent (5) Allocation of Depreciation Between Taxable and Tax-Exempt Rent (6) Guaranteed Payment as Rent 6. Exempt Organization's Use of Taxable Subsidiary to Construct Improvements E. Exclusion of Interest 1. Legislative Treatment of Contingent Interest a. IRS View of Contingent Interest b. Contingent Interest as an Economic Necessity c. Distinguishing Debt from Equity 2. Current Practice and Relevant Tax Issues 3. Common Law Treatment of Contingent Interest 4. Guidelines in Structuring Contingent Interest Debt a. Definite Maturity Date and Cap on Interest Participation b. Convertibility c. Consultation and Approval Rights d. Interest Based on Gross Receipts 5. Loan or Joint Venture a. The Farley Realty Case b. Loan Treated as Partnership c. Purported Ownership Treated as 25% Joint Venture Interest d. Loans Treated as Equity e. Sale to Controlled Corporation Respected as a Sale f. Formula-Based Sale Respected as a Sale 6. Service and Commitment Fees and Lender's Legal Fees a. Loan Derived from a Business “Regularly Carried On” b. Points c. Origination Fees d. Commitment Fees e. Prepayment Penalties f. Service Fees g. Guaranteed Payments F. UBTI Exclusion — Nondealer Sales and Sale of Collapsible Corporation Stock 1. Definition of Dealer 2. Attribution of Activity Among Related Entities 3. IRS May Rule on Dealer Status Issue 4. Income from Sale of Acquired Distressed Property 5. Dealer Income May Be Attributed to Limited Partner 6. Partnership's Business Activities Attribution 7. Sale of Taxable Business 8. Substantially Related to Exempt Purposes G. Debt-Financed Income Is UBTI 1. Definition of Debt-Financed Income 2. Computation of Debt-Financed Income a. Deductions Allowed b. Net Operating Loss and Capital Loss Carryovers c. Debt-Financed Percentage — Gain on Sale of Property 3. Definition of Debt-Financed Property a. Subdivision of Land Not “Held to Produce Income” b. Continued Holding of Property After Intended Use Is Not Feasible c. Stock of a Leveraged Real Estate Corporation d. Exemption for Substantially Related Property e. Exemption for Neighborhood Land f. Sale of Partnership Interests 4. Definition of Acquisition Indebtedness a. Indebtedness Need Not Be Assumed b. Mortgage of Adjoining Property and Sale of Development Rights c. Refinancing Does Not Increase Acquisition Indebtedness d. Pledges of Property and Subordination of a Lease e. Wraparound Loan f. Subordination of Ground Rent Does Not Create Acquisition Indebtedness g. Loan to Second Tier Partnership h. Transitory Indebtedness Used for Ordinary and Routine Purposes 5. Real Estate Acquisitions Not Subject to §514(c) a. The Fractions Rule b. Chargebacks c. Common Trust Funds and §501(c)(2) Corporations 6. Methods of Avoiding Debt-Financed Income a. Transactions Between Exempt Organization and Controlled Corporation (1) Exempt Organization Loan to Affiliate (2) Loan to Partnership in Which Corporation Is a General Partner b. Prepayment of Share of Debt by Tenant in Common c. Refinancing of Nonqualified Debt d. Sale of Stock of a §501(c)(2) Corporation H. Overriding Royalty Income III. Corporate Ownership of the Investment Rather Than Direct Ownership A. Foreign State Jurisdiction 1. Alter-Ego Theory of Jurisdiction 2. Acts of the Exempt Organization in a Foreign State B. Tax Results of Different Types of Corporate Ownership 1. Section 501(c)(2) Exempt Title-Holding Corporations a. UBTI Taxed at Corporate Rates b. Limitations on Title-Holding Corporation's Activities and Taxable Income (1) In General (2) Section 501(c)(2) Corporation — Permissible Income (3) Permissible Activities (4) Section 501(c)(2) Status of Corporate Limited Partner c. Exempt Organization's Receipts from Controlled Corporation (1) Avoiding Controlled Corporation Status (2) Exempt Organization Lease Partnership with a Controlled Corporation (3) Ordering of Pass-Through Rules and Debt-Financed Income Rules (4) Pass-Through Does Not Apply to Dividends d. Use of a Group Trust e. Taxable Corporation Converted to a §501(c)(2) f. Unavoidability of General Utilities Repeal g. Leverage Exemption Not Available to §501(c)(2) Corporation 2. Section 501(c)(25) Leveraged Real Property Title-Holding Corporation a. In General b. Temporary Investment of Cash c. Nonstock Corporations d. Qualified Subsidiary Exception to the 35-Shareholder Rule e. Disqualified Shareholders f. Other Requirements — Shareholder Termination Rights 3. Sections 502 and 512(b)(13) Feeder Corporations a. Debt Capitalization to Reduce Taxable Income b. Technical Disqualification: Special Class of Stock and Debt c. Technical Disqualification: Taxable Subsidiary's Ownership of Feeder's Shares d. Lease to Controlled Corporation to Reduce Taxable Income (1) Avoiding Pass-Through (2) Non-Arm's-Length Rents 4. Property Held for Sale or Rental 5. Consolidated Filing and UBTI 6. Gain on Liquidation of Controlled Corporation 7. Transfers to Exempt Organizations and Conversions to Exempt Status 8. Separateness of a Controlled Taxable Corporation 9. Feeder Corporation's Net Operating Loss 10. Single-Member Limited Liability Company Owned by Exempt Entities IV. Joint Venture Participation Introductory Material A. Exempt Organization May Prefer Direct Participation 1. Negotiate a Better Economic Return 2. Tax Advantages 3. Purchase of Interest in Existing Partnership B. Avoiding Partnership Classification 1. Tests Used to Determine Whether an Arrangement Is a Tax Partnership a. The Substantive-Law Test b. The State-Law Test c. The Joint-Profit Test d. The Expense-Sharing Test e. The Degree-of-Activity Test f. The Type-of-Activity Test g. The Source-of-Activity Test h. The Business-Purpose Test i. The Estoppel Test j. The Fact-Question Test 2. IRS Allows Flexibility Concerning Supervisory Role 3. Partnership Not a Lease C. Allocation of Tax Items 1. Marketability of Exempt Organization's Position 2. Use of Participating Loan or Ground Lease to Sidestep §168(h)(6) 3. “At Risk” Rules 4. Tax Planning Where a Partnership Generates UBTI a. Special Allocations on Pay Down of Pension Trust Share of Debt b. Sections 754 and 732(d) Elections c. Straight-Line Depreciation Requirement D. Tax-Exempt Use Property E. Anti-SILO/LILO Provisions V. Limited Liability Companies as Exempt Organizations Introductory Material A. Disregarded Limited Liability Companies B. Conditions for Limited Liability Company §501(c)(3) Exemption C. Contributions to Disregarded Entities VI. Investment Through Specially Treated Conduit Organizations A. Common Trust Funds B. Investment Through a REIT C. Government Pension Funds as REIT Investors D. Insurance Company Separate Accounts E. Investment Through a Group Trust VII. Retirement Plans A. Qualified Pension Plans B. State Retirement Plans C. Political Subdivision of State D. Government Employee Retirement Plans E. A Court Mandated Fund F. An Entity Carrying on a Governmental Function G. ERISA Considerations 1. Background 2. Plan Assets Regulations VIII. Foreign Government Pension Plans
Table of Worksheets Worksheet 1 Former Internal Revenue Manual, Exhibit 7.20.4-12 (12-05-06), “Limited Liability Company Reference Guide” and “Instructions for Limited Liability Company Reference Guide” Worksheet 2 Preamble to PS-56-90, 1993-1 C.B. 911, Debt-Financed Real Property Held Through Partnerships Worksheet 3 Staff of J. Comm. on Tax'n, 91st Cong., General Explanation of the Tax Reform Act of 1969, 62-71 (J. Comm. Print 1970) Worksheet 4 S. Rep. No. 96-1036, at 28–31 (1980) (Conf. Rep.) Worksheet 5 H.R. Rep. No. 98-861, at 1096–1098 (1984) (Conf. Rep.) Worksheet 6 Staff of J. Comm. on Tax'n, 98th Cong., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 1150–1153 (J. Comm. Print 1984) Worksheet 7 H.R. Rep. No. 100-495, at 953–957 (1987) (Conf. Rep.) Worksheet 8 S. Rep. No. 100-445, at 426–429 (1988) (Conf. Rep.) Worksheet 9 H.R. Rep. No. 103-213, at 547–549 (1993) (Conf. Rep.) Worksheet 10 H.R. Rep. No. 105-220, at 561–562 (1997) (Conf. Rep.) Worksheet 11 Sample Application for Exemption Under §501(c)(2) with Filled-In Form 8718, Form 1024, and Form 2848
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