In light of the recent increase in property values experienced in many parts of the country, many churches have sold or are considering selling real property. Depending on the facts and circumstances, a sale of real property by a church can generate a significant federal and state tax liability, even though the church is "tax-exempt" under Section 501 of the Internal Revenue Code and comparable state law – a fact that is catching some churches by surprise.

Federal tax law contains provisions that tax certain income (generally, rental income and capital gains) from "debt-financed" property as unrelated business income ("UBI"). A property is generally "debt-financed" if debt was incurred in connection with the church's purchase of or improvement to the property. (The term for such debt in the Code is "acquisition indebtedness.")  It is important to note that acquisition indebtedness generally includes any­ debt incurred in connection with purchase or improvement, regardless of whether the property is used as collateral for the debt. The Code and Regulations have tracing rules to address refinancings and similar scenarios.

Example 1
Assume a church owns a parcel of land (Parcel A) worth $5,000,000 and has no outstanding debt. The church purchases an additional parcel of land (Parcel B) for $3,000,000 and borrows $2,000,000 to do so. The church uses Parcel A as collateral, and Parcel B has no mortgage or encumbrance on it. Parcel B is considered to have acquisition indebtedness. (Parcel A does not, despite the fact that it serves as collateral for the new debt.)

Example 2
Assume a church purchases a parcel of property (Parcel C), incurring debt in the amount of $1,000,000. The debt is paid down over time to $500,000. The church then purchases another parcel of property (Parcel D), and at the time of purchase, it refinances the remaining outstanding debt of $500,000 from the purchase of Parcel C into a new single loan in the amount of $2,000,000. After the new loan is closed, Parcel C is still considered to have acquisition indebtedness outstanding in the amount of $500,000. It does not matter whether Parcel C is used as collateral for the new loan.

When a church that owns debt-financed property considers selling such property, it must carefully evaluate whether the federal tax on unrelated business income may apply. If the property to be sold has not been used exclusively for exempt purposes, there is a significant likelihood that the tax can apply. The tax applies at regular corporate rates (assuming that the church is a corporation), which generally top out at 34%. State corporate tax also typically applies when federal tax applies, making the effective tax rate as high as 40% for a sizable transaction. There is no reduced tax rate for capital gains generated by corporations.

Example 3
Assume a church owns land that it bought seven years ago for $1,000,000. The church incurred debt in the amount of $800,000 to purchase the land. The debt has since been paid down to $400,000, and it has been at that balance for the past two years. The church bought the land with the original intent of using it for future expansion of its exempt activities. The church never used the land for such purpose or for any exempt purpose, and is now considering selling the land.  The land is worth $3,000,000 today. If the church sells the land, it will have a capital gain in the amount of $2,000,000 (the difference between the sales proceeds and what the church paid for it [which is its tax basis]). The portion of the gain that is taxable is 40%, which is calculated by dividing the highest amount of the property's acquisition indebtedness during the past 12 months ($400,000) by the church's tax basis in the property ($1,000,000). Therefore, $800,000 of the gain is taxable. If the church's combined federal and state tax rate is 37%, the tax is $296,000.

Churches facing the situation described in Example 3 should consider as a strategy paying off the applicable debt and deferring the closing on the sale of the property to a date more than 12 months after the debt is paid off. If done properly, such a strategy can eliminate the tax altogether. 

While rental income from real property is generally exempt from the federal tax on unrelated business income, the general rental income exclusion does not apply in the case of most debt-financed property. (There are, however, some specific exceptions to the general rule that taxes debt-financed rental income, including the "neighborhood land rule" and a provision that exempts property that is substantially all used for exempt purposes.) Issues associated with rental income from debt-financed property are outside the scope of this article.

The debt-financed income rules for tax-exempt organizations are not widely known or understood. They can, however, be very significant for churches that sell debt-financed property.  Any church contemplating such a transaction would be well-advised to consult a tax professional who is experienced in the area before entering into any sales contracts.

Michael Batts is the managing shareholder of Batts, Morrison, Wales & Lee, PA, a CPA firm dedicated exclusively to serving nonprofit organizations and their affiliates, www.nonprofitcpa.com.