26 U.S.C. § 514 — Unrelated debt-financed income

(a) Unrelated debt-financed income and deductions. When an organization calculates unrelated business taxable income under section 512 for a taxable year: (1) Percentage of income counted. For each debt-financed property, the organization must count as gross income from an unrelated trade or business a percentage of the property’s total gross income for the year. The percentage is the property’s average acquisition indebtedness for the year, as defined in subsection (c)(7), divided by the average adjusted basis of the property during the time the organization held it during that year. The percentage cannot be more than 100 percent. (2) Percentage of deductions counted. For each debt-financed property, the organization may deduct the percentage from paragraph (1) multiplied by the total deductions described in paragraph (3). This rule does not apply to a deduction for a capital loss carried back or carried over under section 1212. (3) Allowable deductions. The total is the deductions under this chapter that are directly connected with the property or its income. If the property may be depreciated under section 167, depreciation must be calculated using only the straight-line method. (b) Definition of debt-financed property. (1) In general. “Debt-financed property” means property held to produce income that has acquisition indebtedness, as defined in subsection (c), at any time during the taxable year. If the property was disposed of during the year, it means property that had acquisition indebtedness at any time during the 12-month period ending on the disposition date. The term does not include: (A)(i) property whose use is substantially related, apart from the organization’s need for income or funds, to the organization’s charitable, educational, or other exempt purpose or function under section 501; or, for an organization described in section 511(a)(2)(B), to a purpose or function described in section 501(c)(3); or (ii) property not covered by clause (i), to the extent its use is substantially related to that purpose or function; (B) property, except to the extent of income excluded under section 512(b)(5), to the extent its income is counted in the gross income of an unrelated trade or business; (C) property to the extent its income is excluded under section 512(b)(7), (8), or (9) when calculating an unrelated trade or business’s gross income; (D) property used in a trade or business described in section 513(a)(1), (2), or (3); or (E) property whose sale, exchange, or other disposition would produce gain or loss excluded under section 512(b)(19) when calculating an unrelated trade or business’s gross income. For subparagraph (A), almost all of a property’s use is treated as substantially related to the organization’s exempt purpose if the property is real property leased to a medical clinic mainly for purposes substantially related, apart from the organization’s need for income or funds or its use of rents, to that exempt purpose. (2) Special rule for related uses. When applying paragraph (1)(A), (C), or (D), use of property by an exempt organization related to another organization is treated as use by that other organization. (3) Special rules when land is acquired for exempt use within 10 years. (A) Neighborhood land. If an organization acquires real property mainly to use it, beginning within 10 years after acquisition, in the way described in paragraph (1)(A), and the property is near other property the organization owns and uses that way, the acquired property is not debt-financed property as long as the organization does not abandon that intended use during the 10-year period. This rule stops after the 10-year period. After the first 5 years, it applies only if the organization satisfies the Secretary that it is reasonably certain to use the land that way before the 10 years end. (B) Other cases. If subparagraph (A) does not apply only because (i) the land is not near the organization’s other property, or (ii) after the first 5 years the organization cannot satisfy the Secretary that the required use is reasonably certain before 10 years end, the property is still not debt-financed property for the period before the organization converts it to that use, if it does so within 10 years. For this subparagraph, using a structure that was already on the land when acquired does not count as using the land in the way described in paragraph (1)(A). (C) Limitations. Subparagraphs (A) and (B) apply to a structure already on the land, or to the land occupied by it, only while the intended exempt use requires demolishing or removing the structure. They do not apply to structures built after acquisition, or to property subject to a “business lease” as that term was defined immediately before the Tax Reform Act of 1976 was enacted. (D) Refund of taxes when subparagraph (B) applies. If the organization has not met subparagraph (B)’s actual-use condition by the legal deadline for filing the return, including extensions, the tax for that year is calculated without subparagraph (B). If the condition is later met, subparagraph (B) is then applied to that year. If the condition is met after the filing deadline and another law would prevent a credit or refund at the end of the year in which it is met, the credit or refund may still be allowed if the claim is filed before 1 year after that year ends. This exception does not apply when the prevention results from chapter 74, concerning closing agreements and compromises. (E) Special rule for churches. For a church or convention or association of churches, the periods in subparagraphs (A) and (B) are 15 years instead of 10 years. Subparagraph (A) and subparagraph (B)(ii) apply whether or not the land meets the neighborhood test. (c) Acquisition indebtedness. (1) General rule. “Acquisition indebtedness” means, for debt-financed property, the unpaid amount of (A) debt incurred to acquire or improve the property; (B) debt incurred before acquisition or improvement that would not have been incurred but for that acquisition or improvement; and (C) debt incurred afterward that would not have been incurred but for the acquisition or improvement and whose incurrence was reasonably foreseeable when the acquisition or improvement occurred. (2) Property acquired subject to a mortgage or similar lien. (A) General rule. If property is acquired subject to a mortgage or similar lien, the debt secured by it is treated as debt incurred by the organization to acquire the property, even if the organization did not assume or agree to pay that debt. (B) Exceptions. If an organization acquires mortgaged property by bequest or devise, the secured debt is not acquisition indebtedness for 10 years after acquisition. The same 10-year rule applies when property is received by gift subject to a mortgage placed on it more than 5 years before the gift, if the donor held the property for more than 5 years before the gift. These rules do not apply if the organization assumes and agrees to pay the debt to obtain the property’s equity, or pays anything for the equity owned by the decedent or donor. (C) Tax and assessment liens. If State law makes a tax lien or a lien for an assessment by a State or political subdivision attach before the tax or assessment is due, the lien is treated like a mortgage only after the amount is due and the organization has had the opportunity to pay it under State law. (3) Extensions of obligations. Extending, renewing, or refinancing an obligation that proves existing debt is not treated as creating new debt. (4) Debt incurred in carrying out an exempt purpose. Acquisition indebtedness does not include debt whose incurrence is inherent in carrying out the organization’s exempt purpose or function, such as debt incurred by a section 501(c)(14) credit union when it accepts member deposits. (5) Annuities. Acquisition indebtedness does not include an annuity obligation that (A) is the only consideration, other than a mortgage covered by paragraph (2)(B), issued for property, if the annuity’s value when issued is less than 90 percent of the property’s value; (B) is payable for the life of one person living when issued, or for the lives of two such persons; and (C) is payable under a contract that (i) guarantees neither a minimum number of payments nor a maximum number of payments, and (ii) does not adjust payments by reference to income from the transferred property or other property. (6) Certain Federal financing. (A) In general. Acquisition indebtedness does not include (i) an obligation, to the extent insured by the Federal Housing Administration, to finance buying, rehabilitating, or building housing for low- or moderate-income people; or (ii) debt incurred by a small business investment company licensed after the American Jobs Creation Act of 2004 was enacted, under the Small Business Investment Act of 1958, if the debt is evidenced by a debenture (I) issued under section 303(a) of that Act and (II) held or guaranteed by the Small Business Administration. (B) Limitation. Subparagraph (A)(ii) does not apply while more than 25 percent of the company’s capital or profits interest is owned by an organization exempt from tax under this title other than a governmental unit, or while organizations exempt under this title, including governmental units other than a United States agency or instrumentality, own 50 percent or more in total. (7) Average acquisition indebtedness. “Average acquisition indebtedness” for a year means the average amount of acquisition indebtedness during the part of the year when the organization holds the property, determined under the Secretary’s regulations. For calculating the percentage of gain or loss counted on a sale or other disposition, it means the highest acquisition-indebtedness amount during the 12 months ending on the sale or disposition date. (8) Securities subject to loans. For this section: (A) payments relating to securities loans, as defined in section 512(a)(5), are treated as coming from the securities lent, not from collateral or investment of collateral; (B) deductions directly connected to collateral or its investment are treated as directly connected to the securities lent; and (C) an obligation to return collateral is not acquisition indebtedness. (9) Real property acquired by a qualified organization. (A) In general. Except as provided in subparagraph (B), acquisition indebtedness does not include debt incurred by a qualified organization to acquire or improve real property. An interest in a mortgage is never real property for this paragraph. (B) Exceptions. Subparagraph (A) does not apply if (i) the acquisition or improvement price is not fixed when the property is acquired or the improvement is completed; (ii) the debt, another amount payable on the debt, or the payment time depends partly on revenue, income, or profits from the property; (iii) after acquisition the property is leased to the seller or to someone related to the seller under section 267(b) or 707(b); (iv) a qualified trust acquires the property from, or later leases it to, a person related under section 4975(e)(2)(C), (E), or (G) to a plan for which the trust was formed, or related under section 4975(e)(2)(F) or (H) to such a person; (v) a person described in clause (iii) or (iv) finances the acquisition or improvement; or (vi) the property is held by a partnership unless the partnership meets clauses (i) through (v) and either (I) every partner is a qualified organization, (II) each allocation to a qualified-organization partner is a qualified allocation under section 168(h)(6), or (III) the partnership meets subparagraph (E). For subclause (I), an organization is not a qualified organization if any of its income is unrelated business taxable income. (C) Qualified organization. This term means (i) an organization described in section 170(b)(1)(A)(ii) and its affiliated support organizations under section 509(a)(3); (ii) a qualified trust under section 401; (iii) an organization under section 501(c)(25); or (iv) a retirement income account under section 403(b)(9). (D) Other pass-through entities; tiered entities. Rules similar to subparagraph (B)(vi) also apply to pass-through entities other than partnerships and to tiered partnerships and other entities. (E) Certain allocations permitted. (i) In general. A partnership meets this subparagraph if (I) an allocation to a qualified-organization partner cannot give that partner a share of overall partnership income for any year greater than its share of overall partnership loss for the year in which its loss share will be smallest, and (II) every partnership allocation has substantial economic effect under section 704(b)(2). Items allocated under section 704(c) are not counted for this clause. (ii) Special rules. (I) Unless regulations provide otherwise, the partnership may use chargebacks without violating this subparagraph for disproportionate losses previously allocated to qualified organizations and disproportionate income previously allocated to other partners. A chargeback may not use a ratio greater than the ratio used for the original loss or income allocation. (II) To the extent regulations allow, the partnership may provide reasonable preferred returns or reasonable guaranteed payments without violating this subparagraph. (iii) Regulations. The Secretary must issue regulations needed to carry out this subparagraph, including regulations that may exclude or segregate items. (F) Special rules for section 501(c)(25) organizations. (i) In general. When calculating under section 512 the unrelated business taxable income of a disqualified holder of an interest in a section 501(c)(25) organization, the holder’s pro rata share of the organization’s items of income described in clause (ii)(I) is counted as unrelated-trade-or-business gross income, and the holder’s pro rata share of the organization’s deductions described in clause (ii)(II) is allowed as a deduction. The amounts are counted for the holder’s taxable year in which, or with which, the organization’s taxable year ends. (ii) Description of amounts. Income is described in clause (i)(I) to the extent it would be unrelated-trade-or-business income under subsection (a) without this paragraph. A deduction is described in clause (i)(II) to the extent it would be allowed under subsection (a)(2) without this paragraph. (iii) Disqualified holder. This means a shareholder or beneficiary not described in clause (i) or (ii) of subparagraph (C). (G) Special rules for the exceptions. Unless regulations provide otherwise: (i) a lease to a person described in subparagraph (B)(iii) or (iv) is disregarded if it covers no more than 25 percent of the leasable floor space in a building or building complex and is on commercially reasonable terms; and (ii) subparagraph (B)(v) does not apply to financing on commercially reasonable terms. (H) Qualifying sales by financial institutions. (i) In general. In a qualifying sale by a financial institution, clauses (i) and (ii) of subparagraph (B) do not apply, unless regulations provide otherwise, to financing provided by that institution for the sale. (ii) Qualifying sale. A qualifying sale occurs if (I) a qualified organization acquires property described in clause (iii) from a financial institution and the institution’s gain is ordinary income; (II) the financing’s stated principal does not exceed the institution’s outstanding debt on the property, including accrued unpaid interest, immediately before the acquisition; and (III) the present value, at the sale and using the applicable Federal rate under section 1274(d), of the maximum financing amount tied to the property’s revenue, income, or profits is no more than 30 percent of the total purchase price, including contingent payments. (iii) Covered property. The property must be foreclosure property, or real property (I) acquired by the qualified organization from a financial institution in conservatorship or receivership, or from its conservator or receiver, and (II) held by that institution when it entered conservatorship or receivership. (iv) Financial institution. This means (I) an institution under section 581 or 591(a); (II) another corporation directly or indirectly owned by such an institution, but only if affiliation subjects it to supervision and examination by a Federal or State agency regulating such institutions; or (III) a conservator or receiver of such an entity, or a government agency or corporation succeeding to that person’s rights or interests. (v) Foreclosure property. This means real property acquired by the financial institution after it bid on the property at foreclosure, or acquired it through an agreement or legal process, following a default or an imminent default on debt secured by the property. (d) Basis of debt-financed property acquired in corporate liquidation. If an organization receives property in a complete or partial corporate liquidation in exchange for its stock, the property’s basis is the basis it would have had in the transferor corporation’s hands, increased by (1) gain recognized to the transferor corporation on the distribution and (2) gain to the organization that was included in unrelated business taxable income because of the distribution. (e) Allocation rules. If debt-financed property is held for a purpose described in subsection (b)(1)(A), (B), (C), or (D) and also for other purposes, the organization must properly allocate the property’s basis, debt, income, and deductions. The allocations must follow the Secretary’s regulations to the extent appropriate to carry out this section. (f) Personal property leased with real property. For this section, “real property” includes personal property owned by a lessor and leased to the lessee of the lessor’s real estate, if the personal-property lease is under or connected with the real-estate lease. (g) Regulations. The Secretary must issue regulations needed or appropriate to carry out this section, including regulations preventing a person from avoiding any provision through segregated asset accounts. The supplied section does not define the quoted terms “debt-financed property,” “acquisition indebtedness,” “business lease,” “qualified organization,” “qualified allocation,” “disqualified holder,” “financial institution,” or “foreclosure property” outside the definitions and rules stated here.