Unrelated business taxable income on refinanced property
TAX BLOG |
Tax-exempt investors deploy a considerable amount of capital to real estate funds as a way to diversify their portfolios. In many cases, income from real estate investments is not altogether free from tax for these investors, despite their tax-exempt status. Federal and state tax may be imposed when a tax-exempt investor has income that is unrelated to their exempt purpose. This income is referred to as Unrelated Business Taxable Income (UBTI).
For rental real estate investments, acquiring a property using debt financing may result in UBTI. To determine the amount of income that is UBTI, the acquisition indebtedness as a percentage of the basis of the property is applied to the gross income derived from the property and the directly related deductions. The difference is the amount of unrelated business taxable income. Most often, debt that is used to acquire or improve real property is considered acquisition indebtedness. There is an exception related to refinancing proceeds, which may result in less UBTI exposure than may otherwise be reported.
Refinancing proceeds in excess of the original debt are not considered acquisition indebtedness if:
- the refinancing was not reasonably foreseeable at the time the property was acquired; and
- the proceeds were not used to improve the property.
As with most areas of the tax law, the determination of acquisition indebtedness is based on facts and circumstances. Each scenario should be carefully reviewed before determining the amount of acquisition indebtedness for a particular investment.