Recently, our attorney Michael Haviland received a question from a church on the potential implications of leasing space to a for-profit organization. The answer was complex. In addition to discussing the legal complications with the church, Michael suggested speaking with an accountant due to the significant tax implications the issue raised.
If you’re confronting a similar New Jersey real estate legal question, this explanation may be helpful. If you have questions that are not addressed below, please contact us for a more thorough discussion with a land use and real estate attorney serving New Jersey or Philadelphia.
New Jersey Property Tax Exemptions for Religious Organizations
New Jersey state law has a special tax exemption for religious institutions that own their own real estate. This tax exemption is located in New Jersey Revised Statutes 54:4-3.6, which exempts from property taxes “…all buildings actually used in the work of associations and corporations organized exclusively for religious purposes, including religious worship, or charitable purposes[.]”
The law goes on to say that if the religious group leases part of its building to another tax-exempt organization for a tax-exempt purpose, that part of the building remains tax-exempt. By contrast, if the religious group leases part of its building to a “profit-making organization”—generally a for-profit business—or is used for non-tax-exempt purposes, the religious group does have to pay taxes for the leased portion of the building.
Land Use Law for Churches in New Jersey
A church recently came to us because it was considering leasing space within its building to a for-profit organization and wanted to know whether there was a way to do so without having to pay property taxes.
We offered several suggestions for mitigating the tax cost to the church. For example, the church—just like any landlord—may incorporate the cost of property taxes into the lease as additional rent. Because the church’s entire tax bill would be attributed to the for-profit organization’s lease, we advised the client that it could bill the tenant for the entire tax bill in equal installments over a twelve (12) month period.
Licensing the Church Space
We also considered whether the church could license a portion of the property to a for-profit corporation rather than lease it. Legally speaking, there is an important difference between a lease and a license. A lease gives the for-profit company exclusive possession of the premises, whereas a license gives the company permission through the owner to use it for specific purposes. A license is also generally revocable at the owner’s discretion and only gives rights to perform the agreed upon services i.e., the licensee may only occupy the space to the extent it is necessary to engage in the agreed upon services. Those services would be outlined in their contract.
A license would keep the control of the licensed portion with its owner—the church. Since New Jersey’s tax exemption for religious institutions applies taxes only to a portion of a building that “is leased to a profit-making organization” (emphasis added), the church could argue that the licensed portion of the building is not subject to taxation.
The state would likely try to tax the licensed section of the building, however, because the law also applies tax when a portion of the exempt building “is otherwise used for purposes which are not themselves exempt from taxation.”
If the for-profit company’s use of the church’s property is not clearly tax-exempt, the state may decide that this section applies, which could lead to a lengthy and expensive court case.
Non-Tax Advantages of Licensing
That said, licensing has additional advantages for commercial landlords in New Jersey when compared to leasing. Since licensing allows the landlord to remain in control of the premises, it permits landlords to revoke a licensee’s use of the premises when significant issues arise, which avoids lengthy and expensive litigation. Potential interpretation issues as to what qualifies as a “significant issue” can be avoided by defining the term in the license agreement.
By contrast, New Jersey law gives commercial tenants—like the for-profit company seeking to lease space from the church—exclusive possession of the leased premises. Under New Jersey Revised Statute 2A:18-53, removing commercial tenants requires landlords to go to court, even if the tenant has stopped paying, will not leave after the lease ends, or has harmed the property.
Federal Income Taxes for Religious Nonprofits
The church was also concerned with whether it would be subject to federal taxes on the income received from leasing the premises to a for-profit company. Normally, as the IRS explains here, the federal government does not charge income taxes to religious organizations or other charitable groups organized as 501(c)(3) nonprofits.
However, religious nonprofits (like other 501(c)(3) nonprofits) that have income from a business that’s unrelated to their religious mission may have to pay unrelated business income tax. According to the IRS, this tax applies when the organization has at least One Thousand and 00/100 Dollars ($1,000.00) in gross income from a business it regularly conducts that isn’t part of its religious mission. Leasing out property is one example cited by the IRS that will be subject to unrelated business income tax.
Workarounds for Unrelated Business Income Tax
A small amount of unrelated business income tax obligation can create complications for churches, such as by requiring them to file estimated taxes four (4) times a year. If a church makes a lot of money, the IRS may even revoke their tax-exempt status.
There are exceptions and exclusions, however, including an exception for some rental income. The IRS says that other major exceptions and exclusions from unrelated business income tax include:
Bring Tricky Questions to an Experienced Real Estate Lawyer
Because rental income may or may not trigger unrelated business income tax, we needed more information before we could give the church a clear answer on the potential tax implications, which is often the case when you’re confronting questions of how your use of real estate may affect your taxes.
If you have a similar complex question about Philadelphia or New Jersey real estate law and you’d like to speak to an experienced real estate attorney, please don’t hesitate to contact Earp Cohn.