In a letter, dated April 11, 2012, to IRS Commissioner Shulman, the ABA Section on Taxation requested additional guidance concerning the application of the debt-financed income rules when an exempt organization borrows funds to conduct charitable programs or pay administrative expenses either before or after purchasing investment property. The Section on Taxation proposed examples that illustrate how the debt-financed income rules apply in four contemporary fact settings.

 Acquisition Indebtedness Defined

 Under §514, acquisition indebtedness is:

•  Debt incurred to acquire or improve property;
• Debt incurred before the acquisition or improvement of property, if the debt would not have been incurred but for the acquisition or improvement; or
• Debt incurred after the acquisition or improvement of property if the debt would not have been incurred but for the acquisition or improvement and incurring the debt was reasonably foreseeable at the time of the acquisition or improvement.

 Thus, the scope of acquisition indebtedness is not limited to debt acquired simultaneously with an asset purchase, such as with a purchase money mortgage. Indebtedness incurred before or after the acquisition of an asset may be treated as acquisition indebtedness with respect to the asset if certain conditions are present. The applicable rules depend on whether the debt is incurred before or after the asset is acquired.

 When debt is incurred before the acquisition of investment property, a “but for” test is applied. The indebtedness is acquisition indebtedness if the debt would not have been incurred but for the purchase of the property. When debt is incurred subsequent to a property acquisition, there is a two-fold test. The first part of the test is the same “but for” test applied when debt is incurred before the acquisition. The second part of the test asks whether having to incur the debt was reasonably foreseeable at the time of the purchase. These rules prevent exempt organizations from circumventing the debt-financed income rules by artificially timing incurrence of debt either before or after the acquisition of property.

 Debt Incurred Before Property Acquisition

 Reg. §1.514(c)-1(a)(2), Example (1) illustrates acquisition indebtedness incurred prior to the acquisition of investment property. An exempt organization pledges investment assets to secure a loan. Subsequently, the organization uses the borrowed funds to purchase property with a nonexempt use. The organization would not have borrowed the money but for the acquisition of the property. Thus, the loan is acquisition indebtedness and the purchased property is debt-financed property.

 Compare the foregoing example with an example proposed by the Section on Taxation:

 A an exempt school holds $ Z in money market funds in addition to the amount of working capital necessary to continue current operations. The organization needs approximately $ Z to construct a new classroom building. The current interest rates are quite low, and a lender is willing to provide a construction loan that will ultimately be converted into long-term loans secured by the new classroom building. Rather than using the $ Z in its money market funds, the organization decides to take out a construction loan, secured by a general pledge of its assets, to finance the construction of its new building. After taking out the loan and beginning the project, the organization is presented with an attractive investment opportunity that it did not foresee at the time of the borrowing, and it decides to use funds from the money market account to make that investment.

 The Section of Taxation correctly distinguishes its example from Example (1) of Reg. §1.514(c)-1(a)(2). In the example from the regulations, the exempt organization secures a loan but does nothing with the loan proceeds until it purchases the new nonexempt property. We are given no reason why the organization would borrow funds other than to make the subsequent purchase. The organization would not have borrowed the funds but for the purchase of the new property. In contrast, the ABA example gives the exempt organization an independent reason for financing the new classroom facility. Given the current interest rates, it makes business sense to finance the building rather than use the money market funds for the construction. The organization would have borrowed the funds even if the subsequent investment opportunity had not surfaced. Thus, there is no “but for” connection between the loan and the investment.

 Debt Incurred After Property Acquisition

 Example (2) of Reg. §1.514(c)-1(a)(2) illustrates acquisition indebtedness incurred after the acquisition of investment property. An exempt scientific organization used its working capital to remodel an office building which the organization leases for a nonexempt use. Subsequently, the organization mortgages its laboratory to replace the funds it used to remodel the building. Because the mortgage is on exempt use property, the organization may feel like the debt is not acquisition indebtedness. Under the two-fold rule discussed above, however, the organization would not have mortgaged its lab but for the remodel of the office building. Moreover, because the organization used its working capital to remodel the building, it was reasonably foreseeable that it would have to incur debt in order to fund its charitable programs. Thus, the mortgage is acquisition indebtedness with respect to the office building.

 In contrast, the Section of Taxation proposes the following scenario:

 A charitable organization traditionally makes grants of $ X each year and funds those grants from interest, dividends, and capital gains on its investments. Due to increased need among the charitable class the organization serves, it decides to increase its grantmaking. In a particular year, interest, dividends and capital gains are insufficient to enable the organization to increase its grants and pay its administrative expenses. The Trustees reasonably determine that it would not be advantageous to liquidate any of the organization’s various investments at this time. On that basis, the Trustees decide to fund the organization’s grants and administrative expenses by borrowing from a line of credit secured by the organization’s existing investments. When the investments were purchased, the organization did not anticipate that it would later need to increase its grants at a time when its income was insufficient to fund its programs and when it was also reasonable to hold its investments rather than to liquidate them. Accordingly, any income from the existing investments will not generate UBIT solely because of the funds borrowed under the line of credit.

 Once again, the example proposed by the Section of Taxation is distinguishable from the example in the regulations. In Example (2) of Regs. §1.514(c)-1(a)(2), the organization knew it would have to borrow funds for its charitable activities when it used working capital to renovate a nonexempt use building. In contrast, in the Section on Taxation example, the organization anticipated its charitable giving levels would remain consistent when it purchased the investments. Due to the recession, however, the needs of the beneficiaries it served increased, causing it to need more than anticipated in its exempt activities. It was the increased need, rather than the earlier purchase of the investments, that motivated the borrowing. Although the organization could have sold the investments rather than borrowing, it was advised not to sell the investments at a depressed value. Thus, neither part of the two-part test for later borrowing is satisfied. It was not the existing investments that motivated the organization to borrow funds for its charitable activities. Moreover, when the organization purchased the investments, it was not reasonably foreseeable that a need would later arise to step up its grantmaking.

 Conclusion

 The letter from the Section of Taxation to the Commissioner Shulman raises some practical factual settings that exempt organizations may be facing currently. The examples proposed in the letter are well thought out and consistent with the language of §514 and the examples in Reg. §1.514(c)-1(a)(2). If adopted by the IRS, the examples would be helpful to exempt organizations in the conduct of their exempt activities and investments.

In PLR 201147035, a charitable organization devoted to disaster relief and general charitable purposes amended its articles to permit ownership and operation of community activity centers throughout country. The proposed community centers would offer a broad range of programs designed to serve all community members and would be accessible to the public through memberships. The organization was controlled by a fraternal beneficiary society described in §501(c)(8).

 In the ruling, the organization proposed to acquire its first community center. The acquisition was financed primarily through the issuance of long-term bonds. The community center would offer the following activities: 

•  Exercise and fitness, with programs and classes to emphasize community health and wellness;
• Youth camps, sports camps, and other educational camps
• Charitable community services, such as meals-on-wheels, food bank drives, and blood drives
• Charity events and disaster relief activities
• Space for community events, community social activities, and school activities, such as swim meets
• After-school and tutoring programs for children
• Sports leagues

 The following uses of the community center were specifically examined:

1. Leasing not more than 10% of the total square footage of the center as office space to employees and independent contractors of the fraternal beneficiary society at fair rental value
2. Providing meeting space to local nonprofit organizations, such as American Red Cross chapters, chambers of commerce, and scouts, at actual cost
3. Leasing the banquet room to individuals and groups for private functions at fair rental value
4. Leasing not more than 15% of the total space in the center to the city to house its recreation department for a one-time unspecified payment

 Here are the issues raised by the facts of PLR 201147035:

 1) Because there is a change in the organization’s articles, the impact of the change on the organization exempt status

2) Because the center provides services, whether any of the services constitute unrelated trades or businesses

3) Because space in the center is leased to third parties, whether the rents received are covered by the rental exclusion to the UBIT

4) Because the property is financed, the application of the debt-financed income rules

 The IRS ruled that the ownership and operation of community centers was within the organization’s general charitable purposes and would not jeopardize its tax exemption. Moreover, all the bulleted activities listed above are substantially related to the organization’s exempt purposes. Income from memberships and other community activities would not generate UBTI, other than under the debt-financed income rules.

 Regarding the numbered activities, the leasing of office space to employees and contractors of the fraternal beneficiary organization was a related use under a special rule. Reg. 1.514(b)-1(c)(2) provides that use of an exempt organization’s property by a related exempt organization constitutes a related use to the extent the property is used by either organization in furtherance of its exempt purposes. Organizations are considered related if one organization controls the other. Thus, use of the organization’s community center by the fraternal beneficiary society constitutes a related use by the organization.

 According to the ruling, however, the other numbered activities were not related uses. Thus, the use of office space by the city recreation department, the use of meeting rooms by local nonprofit organizations, and the use of the banquet hall by private parties were not substantially related to the organization’s exempt purposes and would constitute unrelated trades or businesses. Absent the debt-financed income rules, however, the rental payments for the unrelated uses would be covered by the exclusion of rents for real property under §512(b)(3).

 Notwithstanding the related uses and the rental exclusion for the unrelated uses, the debt-financed income rules require income from debt-financed property to be included in UBTI to the extent the property is debt-financed. The long-term bonds used to finance the center constitute acquisition indebtedness. Thus, unless an exception applies to exclude the property from being treated as debt-financed property, part of the income from the community center is debt-financed income.

 There is a two-part exception under §514(b)(1) under which substantially related use property is not treated as debt-financed property. First, property acquired by an exempt organization is not debt-financed property if substantially all of the use of the property is substantially related to the organization’s exempt purposes. Second, even if substantially all of the use of property is not substantially related to the organization’s exempt purposes, the property is not debt-financed property to the extent that its use is substantially related. To the extent property is not treated as debt-financed property, rents and other income from the property are not debt-financed income subject to taxation under the UBIT.

 The organization in the ruling was able to satisfy the first and most favorable part of the substantially related use exception, with the result that no part of the community center was treated as debt-financed property. Under Reg. §1.514(b)-1(b)(1), property satisfies the first part of the substantially related use test if 85% or more of the property is devoted to a substantially related use. In the ruling, the unrelated uses represent less than 15% of the total use of the community center. Thus, none of the rentals were debt-financed income subject to the UBIT. 

 Because the unrelated uses did not cause any of the property to be treated as debt-financed property, the characterization of the use by the city recreation department and the local nonprofit organizations did not prejudice the exempt organization requesting the ruling. For the sake of discussion, however, there are good arguments that uses of the community center by the city and some of the nonprofit groups were substantially related uses.

Regarding the occupation by the city recreation department, the organization and the city had a written agreement under which the city was responsible for hiring, supervising, and directing all personnel working at the center. The organization had the right to provide input to the city concerning the employment of the center’s manager, programmer, and marketing director. In connection with this agreement, the city relocated the administrative offices of its recreation department to the center. It appears that over half of the activities to be conducted at the center involve community recreation. Having the city recreation department on the premises would contribute importantly to the center’s ability to offer recreation services. Considering that the city also employed the management and staff of the center, it appears that the city purposes were so intertwined with the organization’s charitable purpose in operating the center that the one-time payment from the city could well be considered income from a related trade or business and that use of the center by the city could be a substantially related use.

 There is also a reasonable argument that leasing meeting space to some community nonprofit organizations is also substantially related to the organization’s charitable purposes. Here are the local groups to which the center would lease meeting space: local chapters of the American Red Cross, the United Way and its affiliated agencies, local chambers of commerce, boy scouts, and local historical associations. Allowing the Red Cross to meet at the center is directly related to the organization’s disaster relief purpose and its community benefit purpose. Similarly, scouts groups are community organizations involving children, who are important recipients of the center’s recreational and educational services. In contrast, chambers of commerce benefit the community only in a commercial sense; their use of the facility would not seem to constitute a related use. At a minimum, the leases to the nonprofit groups should be evaluated on an organization-by-organization basis.

 If an exempt organization earns income from the use or sale of debt-financed property, income or gain from the sale of the property is subject to the UBIT to the extent the property is financed. Under an exception called the neighborhood land rule, land acquired for future exempt use may be excepted from classification as debt-financed property for a10-year period (15 years for churches). The rule allows an exempt organization to use land purchased for prospective exempt use in a nonexempt activity pending conversion of the property to the exempt use. Meanwhile, income from the property, such as rents, is not subject to the UBIT.

 Note: The neighborhood land rule applies only when an exempt organization acquires property for future exempt use. Once the property is converted to an exempt use, it is not debt-financed property because of another exception for property used in an exempt purpose.

 The neighborhood land rule does not apply after the first five years from the acquisition date unless the organization shows that the property is reasonably expected to be used in an exempt function within the applicable period. Such a showing is made in a ruling request filed at least 90 days before the end of the fifth year. In PLR 201205018, the IRS ruled that the church was eligible to take advantage of the final 10 years in the 15-year period.

 The following factors convinced the IRS that the exempt use was reasonably expected before the termination of the 15-year period:

● The organization demolished structures that were on the land when acquired.

● The organization had incurred substantial expenses for engineering, design, construction, documentation, infrastructure, and more.

● Several new church facilities were already constructed on the land, including a worship center, a children’s facility, classrooms, and parking lots.

● The congregation was already using the completed facilities.

● Additional planned improvements were expected to take an additional (unspecified) time period not to exceed 10 years.

● The former church property was listed for sale.

See §514(b)(3); §1.514(b)-1(d).