Do Nonprofits Pay Capital Gains Tax?

Nonprofit organizations are generally tax-exempt from federal income tax on revenue supporting their charitable, educational, or religious missions. However, capital gains tax applies under specific conditions. Understanding when and how capital gains are taxed is important for compliance.

Understanding Capital Gains and Nonprofit Exemptions

Capital gains arise from the sale of a capital asset, which includes property, investments like stocks and bonds, or certain intangible assets, when the sale price exceeds the asset’s original cost. For an organization, this can mean profits from selling real estate, divesting from an investment portfolio, or disposing of equipment. The gain is the difference between the selling price and the adjusted cost basis of the asset.

Nonprofit organizations are exempt from federal income tax on income from activities related to their exempt purpose. This exemption extends to capital gains. If a nonprofit sells an asset and uses the gain to further its mission, the gain is not subject to taxation.

For instance, if a nonprofit sells shares from its investment portfolio to fund programmatic activities, the capital gain is generally exempt. Similarly, if an organization sells a building used for its exempt purpose, like a school or community center, and uses the proceeds for a new facility or operations, the gain is exempt. The direct link between the asset and the exempt purpose, and the use of proceeds for that purpose, determines tax exemption.

Taxable Capital Gains and Unrelated Business Income

While many capital gains for nonprofits are exempt, there are specific situations where these gains can become taxable. The primary reason for taxing capital gains in a nonprofit context is when they are classified as Unrelated Business Taxable Income (UBTI). UBTI refers to income derived from a trade or business regularly carried on by the organization that is not substantially related to the exercise or performance of its exempt purpose.

Capital gains can fall under UBTI in several scenarios. One such instance is when an organization engages in active trading of securities, rather than passive investment, where the trading activity constitutes a regular trade or business. While passive investment gains are generally exempt, the line can be crossed if the organization’s involvement becomes extensive and frequent, resembling a commercial enterprise. The Internal Revenue Service (IRS) scrutinizes the nature and extent of the trading activity to determine if it constitutes an unrelated business.

Another common scenario involves the sale of property that was not used for the organization’s exempt purpose. For example, if a nonprofit owns a commercial building and rents out space to for-profit businesses, and then sells that building, any gain attributable to the unrelated rental activity could be considered UBTI. The gain from the sale of such property is taxable if the property was held primarily for the production of income from an unrelated trade or business.

Gains from debt-financed property can also lead to UBTI. If a nonprofit acquires property with borrowed funds and that property is used to generate unrelated business income, a portion of any gain realized from its sale may be taxable. The taxable portion is generally proportionate to the debt on the property.

Reporting Capital Gains

Nonprofit organizations must accurately report their financial activities to the Internal Revenue Service (IRS), including any capital gains, regardless of whether they are taxable or exempt. The specific forms used for reporting depend on the nature of the gain and the organization’s overall financial picture. This reporting ensures transparency and compliance with tax regulations.

For capital gains that are exempt from taxation because they are directly related to the organization’s exempt purpose, these are typically reported on the organization’s annual information return, Form 990. Specifically, exempt capital gains are often reported on Schedule D (Capital Gains and Losses) of Form 990. This schedule requires details such as a description of the property, the date it was acquired, the date it was sold, the sales price, and the cost or other basis, along with the amount of gain or loss.

When capital gains are considered Unrelated Business Taxable Income (UBTI), they must be reported on a separate tax form, Form 990-T, Exempt Organization Business Income Tax Return. This form is specifically designed for reporting and paying tax on income from unrelated business activities. The information required on Form 990-T for capital gains includes similar details to Schedule D of Form 990, such as the asset description, acquisition and sale dates, sales price, and adjusted basis, but it specifically identifies these gains as taxable UBTI.

The organization then calculates any tax due on the UBTI, which is generally taxed at corporate income tax rates for most tax-exempt corporations, or at trust rates if the organization is organized as a trust. Filing both Form 990 and Form 990-T, when applicable, ensures that the IRS has a complete picture of the nonprofit’s financial operations and its adherence to tax-exempt requirements. Accurate record-keeping of all asset transactions, including acquisition costs and sales proceeds, is important for proper reporting.