Do Nonprofits Pay Capital Gains Tax on Real Estate?

Nonprofit organizations often deal with real estate, raising questions about capital gains tax. While generally tax-exempt, this status doesn’t automatically cover all income, including profits from real estate sales. Tax treatment depends on the property’s use and sale nature, requiring an understanding of federal regulations.

Understanding Nonprofit Tax Exemption

Nonprofit organizations, particularly those recognized under Internal Revenue Code Section 501(c)(3), receive federal income tax exemption for their charitable, educational, religious, or scientific purposes. Income from activities directly aligned with their exempt mission is generally not subject to federal income tax. Other common tax-exempt types include 501(c)(4) social welfare organizations and 501(c)(6) business leagues.

To maintain tax-exempt status, a nonprofit must be organized and operated exclusively for its exempt purposes, ensuring no net earnings benefit private individuals. This principle extends to capital gains. If a nonprofit sells real estate substantially used for its tax-exempt activities, the gain is typically exempt from federal income tax. For instance, if a charitable organization sells its headquarters building, used solely for its operations, the capital gain on the sale would generally be tax-free.

When Capital Gains Are Taxable

While nonprofits are largely exempt from federal income tax, they can incur tax liabilities on income from an “unrelated trade or business,” known as Unrelated Business Taxable Income (UBTI). The Internal Revenue Service (IRS) imposes UBTI to prevent tax-exempt organizations from gaining an unfair competitive advantage over for-profit businesses.

An activity generates UBTI if it is a regularly carried-on trade or business not substantially related to the organization’s exempt purpose. If a nonprofit’s real estate sale meets these criteria, capital gains could be taxable. For example, if a nonprofit acquires property for speculative investment rather than its exempt function, the profit from its sale could be UBTI.

Similarly, if real estate is used in a for-profit venture unrelated to its mission, the gains from selling that property would likely be taxable. This could occur if a nonprofit runs a commercial parking lot on its property for the general public during non-program hours, and that activity is deemed a regularly carried-on business.

Specific Rules for Real Estate Sales

Not all real estate sales by nonprofits result in UBTI, as specific exclusions apply. Rents from real property are generally not UBTI, provided the organization does not provide substantial services beyond typical property management. This exclusion also extends to gains or losses from selling such rental property.

Gains from the sale of property substantially used in the organization’s exempt function are exempt from UBTI. For instance, if a church sells a parsonage used to house its minister, the gain would not be taxable. This applies even if the property was not exclusively used for the exempt purpose, as long as its use was substantial, generally defined as 85% or more.

The concept of “debt-financed property” means a portion of the gain from a real estate sale could be taxable. If a nonprofit sells property acquired or improved with debt, and that property was not substantially used for its exempt purpose, a percentage of the gain proportional to the average acquisition indebtedness could be subject to UBTI. For example, if an organization uses borrowed funds to purchase an investment property, a portion of the rental income and capital gain from its sale would be taxable.

Gains from involuntary conversions, like property taken by eminent domain or destroyed by casualty, are generally not UBTI if the property was used for an exempt purpose. Differentiating between active and passive real estate activities is also important. Passive investment activities, such as collecting rent from third-party managed property, are typically excluded from UBTI, while active business operations, like developing and selling properties, could generate taxable income.

Reporting Taxable Gains

If a nonprofit organization realizes taxable capital gains from a real estate sale that qualifies as Unrelated Business Taxable Income (UBTI), it is required to report this income to the Internal Revenue Service (IRS). This reporting obligation is fulfilled by filing Form 990-T, Exempt Organization Business Income Tax Return. This form specifically details the gross income from unrelated trades or businesses, along with any directly connected deductions.

Nonprofits must file Form 990-T if they have gross unrelated business income of $1,000 or more during their tax year. The tax calculated on UBTI is generally at federal corporate income tax rates. As of recent tax laws, the federal corporate income tax rate is a flat 21%.

The filing deadline for Form 990-T varies by organization type. Most tax-exempt organizations must file by the 15th day of the fifth month following their tax year-end. Trusts typically file by the 15th day of the fourth month. Organizations expecting an annual UBTI tax liability of $500 or more may also need to make estimated tax payments.