Many arts and culture nonprofits operate some form of rental property. Whether it’s renting out concession space to a restaurant or store, or even investing the organization’s endowment in real estate funds, rental activities can be a profitable activity for many organizations.
Managed well, these activities can generate additional revenues that nonprofit organizations can use to advance their mission. However, leaders must consider the tax implications of these activities, ideally before their organization starts engaging in them.
Income from rental property often meets the criteria to be considered unrelated business income and is therefore subject to Unrelated Business Income Tax (UBIT). Understanding these tax implications is important in helping nonprofits determine the true income potential of rental activities.
Read on as we outline some common scenarios where arts and culture nonprofits might find themselves managing rental activities. We explore the tax implications of these activities and demonstrate the value nonprofits can realize by taking a proactive approach to tax planning.
Many arts and culture organizations engage in some form of rental activity. Popular examples include renting out event spaces in your venue for business meetings, weddings, and other celebrations. Another common scenario is the rental of a restaurant space inside your venue for a vendor to open a cafe for patrons and employees of your institution. Depending on the circumstances, these are activities that could trigger UBIT liabilities.
In other instances, a nonprofit organization’s ownership of rental properties might be more indirect. Many arts and culture organizations manage significant endowments, investing these in a variety of traditional and alternative assets. Investments in real estate funds that operate rental properties could create additional unrelated business income that may be liable for tax.
Every situation is unique, and nonprofit leaders should work closely with their tax advisors to clarify the potential tax implications of various activities and investments.
In general, the income a tax-exempt organization receives from the rental of real property is not subject to UBIT. However, there are several exceptions to this general rule that could cause certain income to be considered taxable in the eyes of the IRS.
Nonprofits should evaluate their rental agreements and other related contracts with their tax advisor to better define potential tax liabilities. By weighing the tax considerations outlined below, nonprofits can build a more comprehensive understanding of the potential returns of investing in rental properties and activities.
One of the primary considerations an arts and culture nonprofit must make is whether the rental property is debt-financed. Income from debt-financed rental properties is considered unrelated business income, unless 85% or more of the use of the property is sufficiently related to an organization’s exempt purpose.
Any debt-financed improvements to real property can also cause income to be characterized as unrelated business income.
On occasion, rental properties may be mixed-use. If a museum were to rent an event space to a local business to hold an event featuring a blend of educational content about the museum’s mission and unrelated topics, the museum would have to whether the event is related to unrelated to the museum’s exempt purpose.
In most instances, rental spaces are used for related activities as well as unrelated. It may be an administrative burden for arts and culture nonprofits to determine what percentage of the rental space’s usages is related, and what percentage is unrelated, particularly when considering expense apportionment.
Another consideration is whether the rental activity covers real property, personal property, or a mixture of both. Examples of personal property may include furniture and equipment, such as fridges, stoves, tables, and chairs in a restaurant located inside a tax-exempt theater. Parking lots are also considered personal property.
Rental income derived from personal property is taxable, but when rented in combination with real property, organizations can typically exclude the entirety of the income if the rental income from personal property is less than 10% of the total rents.
If services are provided to renters, such as the support of event planning staff or even janitorial services, income from these services may be considered taxable. When services are provided, the nonprofit’s participation in the business or trade is no longer considered passive, causing the income to be subject to UBIT. In some instances, services such as janitorial services are considered typical maintenance of the real property, rather than services rendered to the renter, and therefore this income is typically not taxable.
The employees tasked with managing rental activities often have additional responsibilities related to the nonprofit’s exempt purpose. Defining how these employees allocate their time between rental activities and exempt activities is an important determination in allocating expenses.
Employees tasked with managing endowments should proactively consider the tax implications of any investment they choose to make, not just investments in real estate funds that operate rental properties. Income from certain investments may be liable for UBIT. The structure of the fund may also give nonprofit organizations nexus in new states, creating additional reporting requirements.
It’s unlikely these tax implications will sway the decision to invest or not in a particular fund, but qualifying potential tax exposure before investing can help nonprofits better plan for an efficient tax strategy.
Often, investments in real estate funds can produce significant losses in the early years of the holding period due to depreciation and other starting costs. Managed right, nonprofits may be able to use these losses to offset unrelated business income from other investments, assuming these investments are in the same silo on Form 990-T.
It’s valuable to involve your organization’s tax advisor in this process. They may accompany you to meetings with fund managers, help you develop a questionnaire your organization can send to funds to better understand tax implications before investing, and help you tax plan for the life of the investment.
Owning rental property, whether directly or indirectly, can generate significant income for nonprofits to invest in furthering their mission. However, depending on the circumstances, this income may be subject to unrelated business income tax.
If your nonprofit organization has a UBIT liability, it’s important to remember that this is not necessarily a bad thing – it simply means your organization generated additional income which can be invested to further its mission. However, it is important to proactively consider the tax implications of new activities, particularly the ownership and operation of rental properties, and to perform a comprehensive cost-benefit analysis of these activities.
Partnering with an accounting firm with significant experience advising nonprofit organizations in the arts and culture space ensures your organization takes an efficient approach.
At Smith + Howard, our nonprofit tax and accounting professionals provide sophisticated support to a wide range of arts and culture institutions across the United States. Our team takes a proactive approach, built on the principles of technical excellence and an unwavering commitment to client service.
To learn more about how Smith + Howard can support the tax and accounting needs of your arts and culture nonprofit, contact an advisor today.
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