Income from debt-financed property unrelated to an organization's exempt purposes is taxable as unrelated business taxable income ("UBTI"). "Debt-financed property" is any property held to produce income which is subject to acquisition indebtedness. The debt-financed property rules do not apply to income received by for-profit entities, but do apply to any §501(c)(2) corporations on income they receive as well as §501(c)(3) organizations.

"Acquisition indebtedness" includes the unpaid amount of debt incurred 1) in acquiring or improving property, 2) prior debt incurred in anticipation of such acquisition or improvement, and 3) later debt incurred by reason of the acquisition or improvement which was reasonably foreseeable at the time of acquisition or improvement.

Property acquired subject to a mortgage or other lien is treated as property subject to acquisition indebtedness. Nonetheless, property acquired by testamentary gift will not be treated as debt-financed property for 10 years. Property acquired by inter vivos gift will not be treated as debt-financed property if the indebtedness was placed on the property, and the property was held by the donor, more than five years prior to the date of gift.

Exceptions are provided for any property the use of which is substantially related to an organization's exempt purposes, or which is intended to be so used. Use of property is not substantially related to an organization's exempt function merely because it produces income used to support that function. Other exceptions are provided for property that is used in a trade or business for work performed by volunteers, for business carried on for the convenience of members, students, patients, officers or employees, or for sales of donated merchandise.

The debt-financed property rules apply to an organization, if at all, only in respect of income it receives. The character of any income received by a subsidiary which is debt-financed will not be attributed to a parent organization and will not implicate the parent organization for purposes of IRC §514, except in the case of a consolidated return (the filing of which is voluntary). Otherwise, the impact of the character of any subsidiary's income on a parent organization is limited to the question of whether the subsidiary is an impermissible business holding under IRC §4943 (and only if the parent is a private foundation).

In the event a private foundation uses its assets or income as a means of enabling a subsidiary to acquire or improve property which would be debt-financed property, such as by making or guaranteeing a loan for the benefit of the subsidiary, the proper framework for analysis is the prohibition on business expansion transactions under Regs. §53.4943-7(d)(2).

Income received by an exempt parent organization from a subsidiary will be taxable debt-financed income only when the organization's ownership interest in the subsidiary is itself "debt-financed property," that is:

1. The ownership interest in the subsidiary was itself subject to debt at the time it was acquired by an exempt organization; or
2. An exempt organization incurs debt in order to "improve" the value of a subsidiary, such as by making a capital contribution, etc.

Planning considerations:

1. Whether realty or personal property intended to be held for the production of income should be kept in separate corporations and not held by an organization directly.
2. Whether stock interests in subsidiary corporations should be free from debt and liens.
3. Whether an organization should incur debt in order to make capital contributions to a subsidiary.
4. Whether an organization should guarantee any loans for its subsidiaries, or make any loans to its subsidiaries, for the purposes of acquiring or improving property.

Consolidated returns: IRC §1504 (permitting a consolidated return for certain affiliated groups) does not apply where the parent corporation is exempt from tax under IRC §501, except to the extent a subsidiary corporation is also a title-holding company under §501(c)(2). However, filing a consolidated return is voluntary, not required. If a consolidated return is filed, all non-501(c)(2) subsidiaries are excluded. And, in that event, for purposes of computing UBTI, a subsidiary 501(c)(2) corporation is deemed to have the same exempt purposes as the parent organization (which prevents income received from the subsidiary from being taxed as UBTI to the parent).

Property owned by an exempt organization and used by a related exempt organization or by an exempt organization related to such related exempt organization will not be treated as debt-financed property to the extent such property is used by either organization in furtherance of the purpose constituting the basis for its exemption under §501.

IRC §514 and its regulations expressly recognize the applicability of other Internal Revenue Code provisions in determining gross income derived from or on account of each debt-financed property. Section 514 was not intended to render taxable a transaction which would not be taxable by virtue of a non-recognition provision of the Code if it were carried out by an entity which is not tax-exempt.

"Acquisition indebtedness" does not include debt incurred to finance the purchase, rehabilitation, or construction of housing for low and moderate income persons, to the extent it is insured by the Federal Housing Administration.

A loan by an exempt organization to its wholly-owned 501(c)(2) title holding company enabling it to acquire income producing property is not "acquisition indebtedness," and the property acquired is not debt-financed property, if none of the funds are borrowed from a third party and neither corporation assumes a debt in relation to the property which is payable to a third party. However, if the title holding company is a "substantial contributor" to a private foundation, the self-dealing rules will operate to prohibit such a loan.