Can a Nonprofit Own Rental Property?

A nonprofit organization can own rental property, but this ownership introduces complex considerations that can affect its tax-exempt status. The tax implications are primarily determined by how the property is used and whether it was acquired with debt. Navigating federal income tax rules and local property tax laws requires careful planning so a nonprofit can successfully manage rental properties as a revenue source without jeopardizing its core mission.

Mission-Related vs. Investment Rental Activities

The first step in analyzing a nonprofit’s rental property is to determine if the activity is “substantially related” to its exempt purpose. When a rental activity directly furthers the organization’s mission, the income generated is not subject to federal income tax. For example, a nonprofit dedicated to providing affordable housing that rents units to low-income families at below-market rates is conducting a mission-related activity.

Similarly, a historical society that rents a historic home for public tours or an arts organization leasing studio space to artists at subsidized rates are also using property to advance their purpose. In contrast, if a nonprofit owns an office building and rents space to an unrelated for-profit business at market rates, this is viewed as an investment activity. The purpose of this rental is to generate income, not to directly carry out the nonprofit’s exempt function, which changes the tax analysis.

Understanding Unrelated Business Income Tax (UBIT)

When a nonprofit generates income from an activity not substantially related to its mission, it may be subject to Unrelated Business Income Tax (UBIT). UBIT is a federal tax imposed at the 21% corporate rate on net income from these activities to prevent an unfair competitive advantage over for-profit businesses.

For income to be classified as Unrelated Business Income (UBI), it must meet three IRS criteria: the activity is a trade or business, is regularly carried on, and is not substantially related to the organization’s exempt purpose. An activity is a “trade or business” if its primary purpose is to produce income, and “regularly carried on” means it shows a frequency comparable to commercial endeavors. However, the Internal Revenue Code excludes “passive” income from UBIT, which includes most rents from real property, though this exclusion has important exceptions.

Common Triggers for UBIT on Rental Income

Two common triggers can override the general exclusion for rental income and subject it to UBIT. The first is income from “debt-financed property,” which is real estate a nonprofit acquired or improved using debt, such as a mortgage, that is still outstanding. If a property is debt-financed, a portion of the rental income becomes subject to UBIT.

The taxable portion is calculated using the “debt/basis percentage,” which is the ratio of the average acquisition indebtedness to the property’s average adjusted basis. For instance, if a property is 60% financed by debt, then 60% of the net rental income is treated as taxable UBI. This rule does not apply if at least 85% of the property’s use is directly related to the nonprofit’s exempt mission.

Another trigger involves the lease agreement’s structure. If the rent amount is based in whole or in part on the tenant’s net income or profits, the rental income is subject to UBIT. This arrangement is viewed by the IRS as a joint business venture rather than a passive rental relationship. To avoid this, rental agreements should be based on a fixed amount or a percentage of the tenant’s gross receipts or sales.

State and Local Property Tax Exemptions

Beyond federal income tax, nonprofits owning property must navigate state and local property tax laws. Obtaining an exemption from property taxes is a separate process from securing federal 501(c)(3) status and is not automatic. Property tax exemptions are governed by state and local statutes, which require that the property be used exclusively for the organization’s exempt purposes.

This “exclusive use” requirement can be a challenge for rental activities. If a nonprofit rents a portion of its property to a for-profit commercial entity, that part of the property may lose its tax-exempt status. For example, if a church rents out its basement to a commercial daycare, the portion of the property used by the daycare could become subject to property taxes. Some jurisdictions may allow for a partial exemption, where only the mission-related portions of the property remain exempt.

The rules and application processes for property tax exemptions vary widely between jurisdictions. Organizations must file for an exemption with the local assessor’s office and often must submit annual renewals. Failure to comply or a change in property use can lead to the loss of the exemption and potentially the assessment of back taxes.