By Zachary S. Kester, Executive Director and Robert Miller, Program Officer, Charitable Allies
Misconceptions abound in the public charity sector. Even those familiar with public charities often fail to understand or are unaware of certain aspects of the law related to public charities. One of the most common misconceptions among the general public is that public charities cannot earn money or make a profit. However, public charities can and should earn money and make a profit or the organization will not survive long enough to accomplish its mission. But, there is a more specific issue regarding public charities earning money that involves more potential pitfalls when public charities get involved than simply earning money or making a profit: rent.
How can a nonprofit charge rent?
Many public charities own or have access to a building that would allow the organization to rent out a portion of the building to another organization or person. There are three main ways that public charities can typically earn rental income:
- As program service revenue
- As passive investment income
- As an insubstantial part of the organization’s activity
For some public charities rental activity is a key aspect of the organization’s mission and can be charged and earned as program service revenue. This means for a public charity to charge and earn rent as program service revenue, but the rental income must be directly connected to the organization’s charitable purposes. For example, a public charity can be involved in providing low-cost housing to people with low-income, housing for the elderly, or even renting office space to other organizations to operate an incubator of sorts to help those organizations fulfill their missions. There are many other potential ways for public charities to charge rent as part of its charitable purposes of which the previous list are just a few.
Another possible way for public charities to charge rent, if the rent is not related to the charitable purposes of the organization, is as passive investment income. Passive investment income involves income resulting from cash flow received on a regular basis, requiring minimal to no effort by the recipient to maintain it.
However, there are several exceptions to this general rule that make the rental payments earned unrelated business income. Unrelated business income (UBI) is defined as income from a trade or business that is regularly carried on, and is not substantially related to furthering the exempt purpose of the organization.
UBI is taxable for the organization if:
- The rent charged also includes substantial additional services being provided to the people or organization renting the property that are not customarily provided in a rental situation, then the rent will be considered UBI. Such customary services that are allowed without triggering UBI can include “the furnishing of heat and light, the cleaning of public entrances, exists, stairways, and lobbies, the collection of trash, etc.” See 26 CFR 1.512(b)-1(c)(5). But, if the public charity provides supplies used by the renters, covers any operating costs for the renters, offers services of administrative staff, etc. would go above and beyond the customarily provided services.
- More than 50% of the rent is for the use of personal property rather than real property, then the rental income will be considered UBI. For example, if a public charity is renting a building, but also all of the supplies, desks, computers, etc. inside the building, then the rental income could be deemed to be due more to the personal property than the real property.
- The property is debt-financed or leased to a controlled entity, then the rental income will be considered UBI.
- The organization is exempt under Internal Revenue Code Sections 501(c)(7), 501(c)(9), or 501(c)(17), then the rental income will be considered UBI.
The most common and important of the above exceptions are furnishing services that are not customarily offered in a rental relationship and renting debt-financed property.
As always, there are exceptions to the exceptions, and so a public charity can charge rent as an insubstantial part of its activities and avoid earning money that might be considered UBI entirely, regardless of whether it meets one of the four exceptions above. However, the Internal Revenue Service views the terms insubstantial or “regularly carried on” as very subjective. Ostensibly any activity is substantial or “regularly carried on” if it shows a frequency and continuity, and is pursued in a manner similar to comparable commercial activities of nonexempt organizations. But what this actually means in practice varies widely and, therefore, relying on this method to charge some limited rent might not be worth the potential for violation of the Internal Revenue Service regulations.
Additional considerations
One additional consideration when deciding whether it is right for your public charity to charge rent is the people or organizations that the rent would be charged to and the exact amount of that rent. Charging rent to people or other organizations that are connected to or have an interest in the public charity charging the rent might result in a conflict of interest. The exact issues involved in determining whether there is a conflict of interest are beyond the scope of this article, but generally if the person or the organization had some control or influence that might have affected the decision to rent to them, then there is likely a conflict of interest.
As in any other issue where conflicts of interest might exist, public charities must ensure that the actions being taken are reasonable. In this case, the public charities must ensure that the rent being charged is reasonable based on the fair market value of the property, which can be determined by using comparability data of the rent charged for other similar properties in the area. Then, if the public charity can be assured that the rent being charged is in line with the reasonable fair market value and that the public charity meets any other requirements laid out by the states involved or the Internal Revenue Service, then renting to the person or organization in question is likely permitted.
Another consideration is very simple, but still must be addressed. Public charities cannot simply re-characterize the rental payments as donations from the people or organization paying the rent. This may seem obvious, but it happens and is an issue that be addressed when public charities are involved in charging rent or any other income that is not specifically a donation. Rent is rent.
Conclusion
Most public charities would benefit by an additional revenue stream in order to better and more fully accomplish its purposes. However, it can often be difficult to bring in more revenue for a public charity for a number of reasons. But being able to rent property the public charity already owns or has access to could provide such a revenue stream. So long as the rent charged by the public charity is done so in a manner that meets one of the above criteria, then it is permissible. Overall, charging rent can offer public charities an easy increase in revenue if the public charity can be sure that it is following the rules associated with it.
Attorney Zac Kester provides generalist and strategic nonprofit legal and consulting services. He holds a Master of Laws, a post-law school advanced degree, in which he studied the unique needs of tax-exempt nonprofit organizations. His legal and consulting career has focused on nonprofit organizations.
Attorney Robert Miller is an attorney in the State of Indiana and holds a Doctorate of Jurisprudence with a certificate in Corporate and Commercial Law. He focuses his practice on representing nonprofit organizations.
With highly experienced legal and training personnel, Charitable Allies provides all manner of legal and educational services for boards, officers, management and staff of myriad charities throughout the sector. From basic one-time questions about a single matter to training for boards and officers to complex reorganization or merger of activities, Charitable Allies is your go-to cost-effective provider of legal services to nonprofit organizations.
Contact us at 463-229-0229 with questions.
Substantiation
26 CFR 1.512(b)-1(c)(5)
https://www.irs.gov/charities-non-profits/regularly-carried-on
https://www.irs.gov/charities-non-profits/unrelated-business-income-defined
