Rental Properties + Independent Schools: Understanding the Nuances and Optimal Structure

September 19, 2023

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Owning and operating rental properties can be an attractive income-generating activity for many independent schools. Whether it’s renting on-campus properties to local community groups or acting as a more traditional landlord, rental activities can produce valuable cash flow that schools can direct toward their mission. 

However, it’s important that the ownership and management of these rental properties is structured appropriately. Certain rental activities may be subject to Unrelated Business Income Tax (UBIT), plus state and local taxes, and it is vital schools factor this into their decision-making process. 

In addition to these tax considerations, it’s also important that independent schools structure their ownership of rental properties in a manner that provides tax and operational efficiencies. Creating a separate legal entity to manage rental property offers schools liability protection while also providing clarity in financial reporting. 

In this guide, we explore the various tax and operational nuances that schools should consider when evaluating rental activities. We will also outline the optimal entity structure schools should adopt and share how the experienced professionals at Smith + Howard assist schools in this domain. 

Rental Properties + Independent Schools: Common Scenarios

Typically, independent schools operate rentals in one of two ways. 

The first way tends to be the most straightforward from an operational and tax perspective. Many schools have large physical spaces that they rent out to private entities and community members. For example, a school might rent its gymnasium to a basketball camp, or its auditorium to a local church. Generally, the income from these activities is not considered taxable.

The second category of rental activity is much more complex, though it is also less frequent. As part of a long-term strategy, schools may seek to purchase real estate on land adjoining school 

property. These may be acquired as part of a multi-year expansion plan, as lodging for staff members, or as income-producing rental properties. Operating these types of properties as rental properties can have significant tax implications for schools.  

Tax Implications of Owning and Operating Rental Properties

Generally speaking, when a tax-exempt organization receives income from the rental of real property, the income is not considered taxable. However, there are several notable exceptions to this rule:

  • Rent of Personal Property: the rental of personal property (such as furniture) is considered taxable. However, schools typically rent this personal property in combination with real property (for example, furniture and an event space). Normally, the value of the real property far exceeds the value of the personal property, and the school is not required to pay taxes on the rent of the personal property under the de minimis rule. 
  • Provision of Services: if additional services are provided to the renter, income from these services may be characterized as UBI. This is rarely an issue for schools, as most services, such as janitorial services, are being performed for the school, rather than for the convenience of the tenant. 
  • Properties Financed by Debt: income from debt-financed property is considered taxable. However, if the school can demonstrate that at least 85% of the property’s use is for exempt purposes, they can avoid this income being taxed. 

Consider the example of the school’s gymnasium: even if the school rents this facility to a basketball camp, students use the gymnasium everyday year round, meaning it’s likely that 85% or more of the use of the gymnasium is related to the school’s mission. Income from off-campus properties, such as neighboring houses rented out by the school, is typically subject to UBIT when the property is financed by debt.

Income from properties that fall under one of the above exemptions may be considered Unrelated Business Income (UBI), and therefore liable for tax at the federal level. This isn’t necessarily a bad thing: if your school has a UBIT obligation, that simply means it’s generating additional income to invest in its mission. 

Some schools may be able to offset UBIT exposure of owning surrounding property by applying the ten-year rule. If the school can show that the property it has purchased is part of a ten-year expansion plan, it can potentially avoid UBIT. This must be routinely documented, updated, and approved by the board, and appropriate documentation must be maintained. 

In addition to UBIT at the federal level, there may also be state and local tax considerations. Some states have tax legislation similar to federal UBIT regulation, whereas others have none. Local property taxes often apply on rental properties, although some jurisdictions have exemptions for properties owned by tax-exempt organizations. 

How Should Independent Schools Structure Rental Property Ownership?

The optimal entity structure for a rental property owned by an independent school is relatively straightforward. Any rental properties should be owned by a separate LLC. This LLC is disregarded for tax purposes but creates a liability shield that provides the school with legal protection. 

There is no requirement to file a separate tax return for this LLC, but its existence must be acknowledged on the school’s annual Form 990 filing. Structuring the ownership of the rental property in this way eliminates the need for additional tax filings and also provides higher levels of operational clarity. 

In addition to the separate LLC, it’s also recommended that independent schools maintain separate bank accounts and financial records for rental properties. This helps schools better understand the cash flow of rental real estate activities. If the income is liable for UBIT, this separate record-keeping significantly streamlines the work involved in the reporting process. 

Schools should also ensure they have the appropriate resources to manage the operational demands of their rental properties. Often, an existing staff member is tasked with managing rental activities in addition to their existing responsibilities. Schools should build infrastructure to support the rental process. This can include legal documentation, such as rental agreements and applications, as well as support with routine maintenance tasks.  

Take a Proactive, Tax-Efficient Approach with Smith + Howard: Experienced Advisors to Independent Schools

Operating rental properties can be an extremely beneficial activity for many independent schools. Not only can these properties produce sizable cash flow when correctly managed, but they also serve as long-term investment assets. In many instances, schools may use these rental properties strategically, whether that’s to house staff members or to support an expansion of school facilities. 

If your school is considering investing in rental properties, it’s important to proactively consider the implications of any investments. There should be many people involved in the decision-making process, from board committees to financial and operational leaders. To navigate the nuances of rental properties, schools should also seek qualified professional guidance. 

At Smith + Howard, our CPAs serve as trusted advisors to a wide range of independent schools, including many that own rental properties. Our experienced professionals work with finance leaders to structure rental property ownership in a tax-efficient manner, providing CFOs and board members with the information required to make well-informed decisions. 

Our team is also equipped to handle ongoing reporting requirements, from preparing Form 990 filings to pursuing UBIT exemptions under the 10-year rule. We serve as trusted advisors, helping independent schools understand the tax and financial implications of major strategic decisions. 
To learn more about Smith + Howard’s support for independent schools, contact an advisor today.

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If you have any questions and would like to connect with a team member please call 404-874-6244 or contact an advisor below.