Navigating NY’s property tax exemption minefield for nonprofits - by David Wilkes

Tax exempt organizations that consider owning real estate or leasing their owned space to others to offset operating costs, face a complex minefield of restrictions that can be difficult to analyze and that present significant financial consequences if violated. New York’s highest court seems to annually take up new, complex, and unforeseen exemption fact patterns that provide guidance to those who are planning real estate activity involving a non-profit organization. It is no surprise that tax exemption controversies are a growth area of the law, especially considering heightened scrutiny over the public fisc, rising real estate ownership costs, and increased reliance on nonprofits to provide some public services.

The most common controversies involve a religious, charitable, hospital, or educational organization that seeks exempt status. An applicant must prove to the taxing jurisdiction that the real estate is exclusively owned and used consistent with the non-profit’s mission. However, the meaning of “exclusively” is where things can get murky, both in ownership and use.

A common misconception is that an organization that owns real property and has obtained tax exempt status under the Internal Revenue Code has automatically satisfied the first prong of the real estate exemption requirement. While a Code 501(c)(3)-approved organization is likely to satisfy the ownership requirement, the federal exemption determination is only an item of proof and is not conclusive. A local exemption application goes well beyond supplying an IRS determination of exempt status.

There are also a variety of IRS exemptions other than 501(c)(3), such as for civic and political activities (Code Section 501(c)(4)), labor unions (Code Section 501(c)(5)), social clubs (Code Section 501(c)(7)), and others, that are likely to be heavily scrutinized by the tax assessor and often result in a denial of the exemption.

Another misconception is that the legal standards are applied uniformly througout New York state even though the ultimate source is state law. While the ownership requirement tends to be rigidly applied in most municipalities, New York City has (perhaps surprisingly) taken a more progressive and thoughtful approach to this prong of the review than most of the rest of the state. Recognizing that the best interests of a real estate transaction often dictate ownership in an entity that is not a non-profit, such as a single-purpose limited liability company, the New York City Department of Finance (DOF) will consider exemption applications in which the LLC “SPE” is effectively a disregarded entity that acts as a stand-in for the non-profit so long as it is not merely a disguise for a venture that would violate the exemption requirements. Likewise, DOF has provided a creative mechanism by which a nonprofit may receive exempt status as a lessee – which is normally fatal to the exemption – when it owns a condominium unit subject to a long-term lease of at least 30 years with an otherwise non-exempt landlord. The rule effectively views the long-term lease as satisfying the ownership requirement of the governing statute.

A warning: the fact that DOF offers expansive interpretations of ownership ends at the borders of the five boroughs, and is not likely to be persuasive to a suburban tax assessor.

The use of the property tends to be the cause of most tax exemption litigation. Often the facts involve a lease between the exempt owner and a tenant that may or may not be exempt itself, in which the tenant’s use of the property may foil the owner’s exemption. Nonprofits that own real estate are forever attempting to offset costs, and rental revenue from a tenant is always a tempting opportunity. Generally, a lease to another nonprofit is permissible so long as the rent paid does not exceed carrying, maintenance, and depreciation costs. “Carrying” costs have been defined as the types of items that are paid to avoid foreclosure, such as mortgage payments. It sometimes proves challenging for a small nonprofit with limited resources to assemble this information, but a good rule of thumb is to charge a below-market rent. This helps prove that the nonprofit landlord is not receiving pecuniary profit from the rental but rather just covering its costs.

Still more challenging is the lease with a for-profit tenant, which must be shown to be providing services that are vital and necessary to the nonprofit mission of the owner. A conservative approach is recommended here when considering a new lease. Many court decisions addressing this issue reflect an overly optimistic view by transaction counsel that the services provided by the tenant in some way fall under the umbrella of the landlord’s mission.

For brief examples: recently, it was held that a for-profit dialysis services tenant did not provide services incident to the owner’s purpose even though the owner was created to provide charitable healthcare-oriented fundraising. Too much of a stretch there. In contrast, a lease between an exempt educational institution and a for-profit restaurant that operated a cafeteria within the campus served a vital and necessary service to students and college faculty that allowed them to better accomplish the owner’s non-profit mission, and was therefore allowed.

To paraphrase an observation often used by the courts in this field, while the goals carried out by the tenant may be laudable, they are not charitable, and it is best to carefully examine the substance of the proposed lease and the real objectives of the parties.

David Wilkes, Esq., CRE, FRICS is president of the National Association of Property Tax Attorneys and is a partner at Cullen and Dykman, LLP, Manhattan, NY.