In the fourth article in our Form 990-T blog series, our expert advisors explain how borrowed funds used to acquire or improve income-producing property may create unrelated debt-financed income (UDFI). Learn how UDFI is calculated, when income and gains may be taxable, and how proactive planning can help tax-exempt organizations avoid unexpected Form 990-T filing obligations.
Read the third blog to learn about UBIT considerations facing 501(c)(7) organizations.
Tax-exempt status does not always mean that every dollar an organization earns is exempt from federal income tax. One area that can create an unexpected tax obligation is unrelated debt-financed income (UDFI).
UDFI may arise when a tax-exempt organization borrows money to purchase or improve income-producing property and uses that property for purposes unrelated to its exempt mission. The taxable amount is reported as unrelated business taxable income on IRS Form 990-T.
What Is Unrelated Debt-Financed Income?
UDFI is a category of unrelated business taxable income (UBTI). It can arise when a tax-exempt organization purchases or improves an income-producing asset using borrowed funds, debt remains connected to the property, and the property is not used substantially for the organization’s tax-exempt purpose.
Common examples of potentially debt-financed property include:
- Rental real estate purchased with a mortgage
- Securities purchased using margin debt
- Other investment property acquired or improved with borrowed funds
Passive investment income, such as rent, interest, dividends, and capital gains, is often excluded from UBTI. However, the debt-financed income rules can cause a portion of that otherwise excluded income to become taxable.
Importantly, using debt does not automatically create UDFI. The nature and use of the property, the relationship of the activity to the organization’s exempt mission, and certain statutory exceptions must also be considered.
How Is UDFI Triggered?
Three factors commonly lead to UDFI:
- Borrowed funds – The organization uses a mortgage, loan, margin account, or other form of debt to acquire or improve an income-producing asset. For tax purposes, qualifying debt associated with the property is called acquisition indebtedness.
- An unrelated use – The debt-financed property produces income from an activity that is not substantially related to the organization’s tax-exempt purpose.
For example, a nonprofit may purchase an investment property with a mortgage and rent it to an unrelated commercial tenant. Even though rent is passive income, the debt-financed portion may be treated as UDFI.
- The Form 990-T filing threshold – An exempt organization must file Form 990-T when its total gross income from unrelated trades or businesses is $1,000 or more during the tax year.
This is a gross-income filing threshold, not a $1,000 threshold based solely on taxable profit or tax due. The organization must consider all sources of gross unrelated business income, including any UDFI.
Only the Debt-Financed Portion Is Potentially Taxable
UDFI does not make all the property’s income taxable. Instead, the organization applies a debt-to-basis percentage to determine the portion associated with borrowed funds.
In simplified terms:
Debt-financed percentage = Average acquisition indebtedness ÷ Average adjusted basis of the property
That percentage is then applied to the property’s income and directly related deductions.
Simple Example
Assume a nonprofit owns a rental property with an average acquisition indebtedness of $50,000, an average adjusted basis of $100,000, and annual gross rental income of $10,000.
The debt-financed percentage is:
$50,000 ÷ $100,000 = 50%
The organization would initially treat 50% of the rental income, or $5,000, as gross debt-financed income.
This does not necessarily mean that $5,000 is the final taxable amount. The organization may deduct the same proportionate share of eligible expenses directly connected with the property.
Related Expenses May Reduce Taxable Income
After determining the debt-financed percentage, the organization may apply that percentage to allowable expenses associated with the property. These may include:
- Mortgage interest
- Depreciation
- Repairs and maintenance
- Property taxes
- Insurance
- Management fees
- Other directly connected operating expenses
If the property in the preceding example also had $4,000 of allowable expenses, applying the 50% debt-financed percentage would produce the amounts in the table below.
| Calculation | Amount |
| Gross rental income | $10,000 |
| Debt-financed percentage | 50% |
| Gross debt-financed income | $5,000 |
| Total allowable property expenses | $4,000 |
| Debt-financed share of expenses | $2,000 |
| Potential net UDFI | $3,000 |
This simplified example does not address every tax adjustment, limitation, or exception, but it demonstrates the general concept.
Why Average Debt Matters
The calculation does not ordinarily rely only on the loan balance at the end of the year. Instead, it considers average acquisition indebtedness during the period the organization holds the property.
The calculation also uses the property’s average adjusted basis, which may change because of depreciation, improvements, or other tax adjustments.
As a result, the taxable percentage can change from year to year even if the property’s income remains the same. Organizations should retain documents supporting:
- Beginning and ending loan balances
- Principal payments
- Loan statements
- The property’s tax basis
- Depreciation
- Capital improvements
- Income and expenses related to the property
What Happens When Debt-Financed Property Is Sold?
UDFI can affect more than annual rental or investment income. If an organization sells debt-financed property, a portion of the gain may also be included in unrelated business taxable income.
Because the calculation can depend on the property’s debt and adjusted basis during a specified period before the sale, organizations should consult their tax advisor before refinancing, transferring, or selling debt-financed assets.
Important Exceptions May Apply
Not every mortgaged or leveraged asset is treated as debt-financed property. Exceptions and special rules may apply, including situations involving:
- Property used substantially in carrying out an exempt purpose
- Certain property used by related exempt organizations
- Certain real property acquired by qualified organizations
- Certain neighborhood land held for future exempt use
- Debt incurred in performing an exempt function
- Specific financing arrangements that qualify for statutory exclusions
The application of these exceptions is highly fact-specific. An organization should not assume that an asset creates UDFI—or that it qualifies for an exception—without reviewing the arrangement.
Form 990-T Filing Deadlines
An organization with at least $1,000 of gross unrelated business income generally must file Form 990-T.
The return is generally due:
- Most tax-exempt organizations: The 15th day of the fifth month after the end of the tax year.
- Certain trusts and similar filers, including IRAs: The 15th day of the fourth month after the end of the tax year.
For calendar-year organizations, the regular deadline is May 15. For a calendar-year IRA or other filer subject to the fourth-month rule, the regular deadline is April 15. If the due date falls on a weekend or legal holiday, the deadline moves to the next business day.
An extension of time to file may be available, but it does not ordinarily extend the time to pay any tax due.
Key Takeaways
Tax-exempt organizations should remember the following:
- Borrowing money does not automatically create UDFI, but debt used to acquire or improve unrelated income-producing property can trigger it.
- Only the portion of income associated with the debt is included.
- The taxable percentage is based on average acquisition indebtedness compared with average adjusted basis.
- A proportionate share of directly connected expenses may reduce taxable income.
- Debt-financed gain from selling an asset may also be taxable.
- Form 990-T is required when total gross unrelated business income reaches $1,000.
- Exceptions and special rules may change the result.
Plan Before Borrowing or Investing
UDFI is often easier to manage when considered before an organization acquires, improves, refinances, or sells an income-producing asset. Before entering into a leveraged investment, management should evaluate the expected income, debt structure, property use, available deductions, potential exceptions, and the consequences under Form 990-T.
Early tax planning can help an organization avoid filing surprises, preserve accurate records, and understand the true after-tax return on an investment. Contact RKL’s expert nonprofit tax advisors for help navigating UDFI and Form 990-T for your organization.
