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constitute inventory, however, and the sales activity does not further
charitable purposes (e.g., sales of commercial magazines), then the
income may be taxable.

(v) Deductions

501(c)(3) organizations are permitted a standard deduction in the amount of
$1,000 against any UBI earned in a taxable year, which effectively amounts to an
exemption from tax on the first $1,000 of UBI. Organizations may also deduct
expenses attributable to unrelated business activities in calculating net UBI.

(vi) Debt-Financed Income

While the types of income described above are generally excluded from UBI,
income from debt-financed property is not. For example, net rental income from

real property, or net gain from sale of stock may be subject to tax in whole, or in
part, because the underlying property is subject to debt financing. The rules
regarding debt-financed property are complex and confusing, and a full discussion
is beyond the scope of this text.

Essentially, the policy behind the rules is as follows: It may be appropriate
generally not to tax an organization on traditional investment income such as
interest, dividends and rents, because this is the type of income that a charity
typically earns from investment of its endowment. Such items should be taxed,
however, to the extent that the organization borrowed to acquire the income-
producing property, where the use of the property is not considered charitable.

For example, assume that an organization acquires a building, subject to a
mortgage for 80% of the purchase price, and uses half of the building for its
administrative offices and its charitable purposes, while it leases the other half of
the building to other unrelated organizations. The rental activity itself is not
charitable. Under the debt-financed income rules, 80% (the percentage that was
debt-financed) of the net rental income (after deduction of related expenses) will be
taxed as UBI.

d. Excessive UBI May Jeopardize Exemption

An exempt organization’s tax-exempt status may be jeopardized if more than
an insubstantial part of its activities constitutes unrelated business activities. While
there is no precise quantitative test for substantiality, the IRS has ruled that there is
no quantitative limit so long as an organization carries on a charitable program

WASHINGTON NONPROFIT HANDBOOK -107- 2018