Can a church or nonprofit do a 1031 exchange?

Most property sales by an exempt organization are already outside the tax

Exempt organizations pay income tax only on unrelated business taxable income. Section 512(b)(5) says 'there shall be excluded all gains or losses from the sale, exchange, or other disposition of property' other than inventory and property 'held primarily for sale to customers in the ordinary course of the trade or business'.

So the sale of a parsonage, a closed school or land held for appreciation normally produces no federal tax, and a 1031 exchange adds paperwork and deadlines without saving anything. The organization can simply sell and redeploy the cash.

Dealer property is excluded twice over: its gain is taxable under section 512(b)(5), and section 1031(a)(2) bars exchanges of 'real property held primarily for sale'. A church subdividing and selling lots should look at 1031 for developers rather than expect an exchange to help.

Debt-financed property pulls part of the gain back into tax

Section 512(b)(4) overrides the exclusion for debt-financed property. Section 514(b)(1) defines it as property 'held to produce income' with acquisition indebtedness at any time during the year, or, on a sale, 'at any time during the 12-month period ending with the date of such disposition'.

IRS Publication 598 gives the formula: the organization includes a percentage of the gain equal to 'the highest acquisition indebtedness with respect to the property during the 12-month period preceding the date of disposition, in relation to the property's average adjusted basis'. An exempt corporation pays tax on it at the 21% rate in section 11(b), through section 511.

Two carve-outs keep church buildings out. Property is not debt-financed if 'substantially all' its use relates to the exempt purpose, which Reg. section 1.514(b)-1 sets at 85% or more. Land bought for future exempt use gets a grace period, and section 514(b)(3)(E) gives churches 15 years instead of 10 and drops the neighborhood test.

Worked example: a mortgaged strip center sold by a church

Hypothetical, round numbers; run your own numbers with your CPA. A church bought a small strip center as an investment with a loan and leases it to unrelated tenants. It sells for $2,000,000 with an average adjusted basis of $1,000,000, so the gain is $1,000,000, and the loan balance was $500,000 during the prior year.

The debt/basis percentage is $500,000 over $1,000,000, or 50%. Half the gain, $500,000, is unrelated business income, and at 21% the federal tax is about $105,000, reported on Form 990-T.

Now suppose the board pays off the loan from reserves 13 months before the sale. No acquisition debt existed in the 12-month lookback, the property is no longer debt-financed for the sale, and the full $1,000,000 gain is excluded under section 512(b)(5). No exchange is needed.

• Loan outstanding within 12 months of sale: about $105,000 of federal tax in this example.
• Loan retired more than 12 months before sale: no federal tax on the gain.
• Exchange into new leveraged property: the debt-financed rules apply again to the new rents.

When an exchange is still worth doing, and how to set it up

An exchange makes sense when debt cannot be retired in time and the gain share is large. An exempt organization computes unrelated business income from recognized gain, and Publication 598's own example applies a different nonrecognition rule, section 351, to a hospital's transfer of debt-financed property. Confirm with counsel that section 1031 will be respected on your facts before you list the property.

The mechanics are the same as for any owner: a qualified intermediary engaged before closing, written identification by day 45 and closing by day 180 under section 1031(a)(3). Title to the replacement must go to the same organization that sold.

Taxable subsidiaries are a separate case. A for-profit corporation owned by a nonprofit is an ordinary taxpayer, so its rental sales are fully taxable and the standard exchange analysis applies, starting with what a 1031 exchange is.

Leverage in the replacement, including inside a trust, carries the problem forward

Replacement property bought with a loan is debt-financed property, so part of its rent becomes unrelated business income every year and part of the next sale's gain is taxable again. An organization that wants clean income usually buys without debt.

A Delaware Statutory Trust allocates its loan to each investor in proportion to the interest held, which is why it counts as replacement debt for individual exchangers; see does a DST loan count as replacement debt. For an exempt investor the same allocation is likely to make its share of the income debt-financed, so a trust carrying no loan fits better.

Trust interests also carry illiquidity, sponsor fees and no control over the property. For individual donors weighing a gift of property against an exchange, see charitable remainder trust vs 1031.