Do Nonprofits Pay Capital Gains Tax on Real Estate?

An organization recognized under Internal Revenue Code Section 501(c)(3) is generally exempt from federal income tax. However, this exemption has limits, especially for capital gains from selling real estate. The regulations discussed here apply primarily to public charities. Private foundations have a different structure and are subject to a 1.39% excise tax on their net investment income. For public charities, the circumstances surrounding a property’s acquisition and use determine if the profits are taxable.

The General Exemption for Mission-Related Property

The foundational principle for nonprofits selling real estate is that gains are not taxed if the property was substantially related to the organization’s exempt purpose. This means the property must have been actively used to carry out the charitable activities central to the nonprofit’s existence. This rule ensures that organizations can reallocate assets to better serve their mission without being penalized by taxes.

For instance, a university that sells a dormitory to finance a new student housing facility would not pay capital gains tax on the sale, as the original property was integral to its educational mission. Similarly, a church selling its current building to relocate to a larger one would find the gain exempt, as the property was used for religious services.

Another example involves a food bank selling its warehouse to acquire a larger distribution center to expand its operations. In these cases, the real estate was not a passive investment but an active tool in fulfilling the nonprofit’s core objectives. The sale is viewed as a continuation of its exempt activities.

Unrelated Business Income Tax on Real Estate Sales

The primary exception to the tax exemption for nonprofits is the Unrelated Business Income Tax (UBIT). This tax is levied on income from activities not substantially related to the organization’s charitable mission and is calculated at the 21% corporate tax rate. The IRS applies a three-part test to determine if income is subject to UBIT.

First, the activity must be a trade or business carried on to produce income. Second, the business must be “regularly carried on,” which considers the frequency and continuity of the activity. An infrequent sale is less likely to meet this standard than a pattern of consistent transactions.

The third criterion is that the activity is not “substantially related” to the nonprofit’s exempt purpose, meaning it must contribute to the mission beyond just providing funds. For a real estate sale, if a nonprofit buys and sells properties as a recurring strategy for revenue, it may be conducting an unrelated trade or business. For example, a charity that starts flipping houses would likely have its profits subjected to UBIT.

This framework distinguishes between disposing of a mission-related asset and engaging in a commercial real estate enterprise. A single sale of an investment property is treated differently than a continuous cycle of buying and selling land for profit.

Statutory Exclusions for Real Estate Gains

Even when a real estate sale might appear to generate unrelated business income, the Internal Revenue Code provides specific statutory exclusions that can shield the gains from taxation. These prevent UBIT from applying to certain common, non-commercial real estate transactions.

One exclusion applies to gains from selling donated property. If a charity sells a donated parcel of land, the gain is not taxable as long as the nonprofit sells the property in largely the same condition it was received, without substantial development or improvements.

Another exclusion covers property previously used for exempt purposes but no longer needed. For example, if a hospital closes a satellite clinic and sells the building, the gain can be excluded from UBIT. This exclusion applies if the property was used for mission-related activities for more than 50% of the time in the five-year period before the sale.

Gains from selling property held for investment purposes can also be excluded. If a nonprofit rents out a building, the rental income is often excluded from UBIT. Consequently, the capital gain from the eventual sale of that same investment property is also generally excluded from UBIT.

The Debt-Financed Property Rule

An exception can override the statutory exclusions and expose a portion of real estate gains to taxation: the debt-financed property rule. If a nonprofit used debt to acquire or improve a property, and that debt was outstanding during the 12-month period ending with the date of sale, a percentage of the capital gain becomes subject to UBIT.

Acquisition indebtedness is any unpaid debt incurred by the organization to buy or improve the property, including mortgages assumed when receiving a property as a gift. The rule is designed to prevent nonprofits from using their tax-exempt status to leverage debt and compete unfairly with for-profit investors.

The taxable portion of the gain is calculated based on a specific formula. It is determined by the ratio of the “average acquisition indebtedness” on the property to the property’s “average adjusted basis.” For example, if the average mortgage balance over the 12 months prior to sale was $100,000 and the property’s average adjusted basis was $200,000, then 50% of the capital gain would be taxable as unrelated business income.

This calculation means that the more heavily the property is financed with debt, the larger the portion of the gain that will be taxed. The rule applies even if the gain would otherwise be excluded, such as from the sale of donated property or a long-term investment.