Real Estate Issues Affecting Not-For-Profit Organizations
 
January 22, 2002
 

Not-for-profit organizations have many purposes. Conducting a real estate operation is seldom one of them. Directors, officers and staff of not-for-profit organizations, and the attorneys who represent them, usually are not involved with real estate as a primary responsibility. But not-for-profit organizations require office space, sometimes substantial space, in which to conduct their activities. The cost of office space is likely to be a major item in the entity's operating budget, perhaps the largest after personnel costs for many organizations.

Not-for-profit organizations buy, sell, lease and operate property in the same manner as business entities. Managing the real estate function for non-profits requires above all a knowledge of real estate transactions and property management generally. There are, however, many issues specifically relevant to not-for-profit organizations, which will of course vary with the type and size of the entity. A large not-for-profit hospital or university's need for staff or student housing will differ from the needs of a small theater company desiring to lease office or production space. The topics discussed below are nevertheless relevant to not-for-profit organizations generally.

Know Your Governing Law

Not-for-profit entities usually are organized in corporate form under state statutes that differ from statutes governing business corporations. These entities generally are not "owned" in the sense that a for-profit entity is owned; state laws permit these organizations to be formed either with or without members. The typical member of a non-for-profit organization is an individual or group that shares the organization's goals and joins by paying membership dues, and perhaps by making an additional contribution.

Real estate transactions by not-for-profits, particularly major transactions such as the disposition of property by sale or lease, are generally governed by specific statutory provisions. The law of a particular state may require approval by some percentage of the organization's board of directors, which could be a super-majority requirement such as two-thirds or three-quarters, if a major disposition is contemplated. If the organization has members, the consent of a particular percentage of members, represented in person or by proxy at a duly called meeting at which a quorum is present, may be required as well. Requirements such as these will almost certainly apply if the property disposition is a transfer of substantially all of the organization's assets or is in connection with a liquidation or termination of the organization.

Real estate transactions, particularly sales and leases of properties used to carry out the organization's purposes, may require court approval as well. State authorities responsible for regulating charities also may have a right to participate, either by having a consent right or the right to appear in the court proceeding seeking approval of the transaction. Procedures for notice to these authorities and for service of process in the judicial proceeding, if required, should be followed carefully.

Not-for-profit organizations, like business entities, will be governed by their organizational documents and provisions in a certificate of incorporation and by-laws will determine the minimum procedural requirements for a real property transaction. Requirements for board or member approval contained in these documents should be reviewed first. Statutory requirements for higher percentages of consents, judicial review and action by regulatory authorities are in addition to, and not in lieu of, those contained in the organizational documents.

In addition to general legal authority regarding not-for-profits, there are state statutes for particular types of organizations containing special requirements for real estate transactions. Common examples include religious corporations, cemeteries and schools.

Long Lead Time Items May Be Longer for Non-Profits

It should be clear from the above that a sale or lease by a not-for-profit organization is not a matter of negotiating the documents and proceeding quickly to a closing or lease signing. If state regulatory involvement is required, the appropriate authorities should be contacted as early as possible so any concerns they may have can be addressed. If judicial approval is required, even in the absence of controversy, the ability to obtain a court order in a timely manner will depend on court calendars and the availability of judges.

To the extent member approval of a real estate transaction is necessary, sufficient time must be provided for scheduling a meeting of members, distributing and receiving proxies and assuring that a quorum can be obtained. If the proposed transaction is controversial, the matter may not be resolved at the meeting and could drag on for some time.

As to approval of the requisite percentage of the board of directors, keep in mind that many not-for-profit organizations have very large boards where board membership is for many individuals an honorary position for large contributors or sympathetic celebrities. In such cases, very few board members are actively involved in management or organizational affairs and many cannot be expected to attend board meetings. Giving all required notices to the board, and tracking down a majority, or two-thirds, or whatever the required percentage may be, might be a major undertaking that will take time under the best of circumstances.

All of this must be dealt with in selecting a closing date under a contract of sale or the effective date of a lease. Clearly this is not a situation for a "time of the essence" clause.

Transfer Taxes

Many states and municipalities impose transfer taxes on conveyances of property. In some jurisdictions, these taxes cover other transfers such as leases. In some cases exemptions may be available where not-for-profits are involved. There are no general rules and counsel to the organization must check the applicable law if a real property transaction is contemplated. An exemption may apply only to the entity (so that a transferring organization need not pay, with the transferee required to pay the tax if the relevant law so provides), or to the transaction itself, so no tax is payable if the organization is involved either as transferor or transferee.

Different results may apply to the same transaction. Suppose a not-for profit corporation sells property in New York City to a third party. New York state has no exemption from its transfer tax for not-for-profits and the transfer tax of 0.4% would be payable by the organization. New York City, on the other hand, exempts transfers either by or to various charitable, religious and educational institutions.

Real Property Tax Exemptions

Most jurisdictions provide exemptions from local real property taxes for many not-for-profit organizations, including those formed and operated for charitable, religious, educational and hospital purposes.

A not-for-profit that owns real estate should be diligent to obtain the benefit of such exemptions, as its resources should be devoted to carrying out its mission, not paying taxes.

Requirements for real property tax exemptions are set forth in state and local laws. If an organization has obtained tax-exempt status under Section 501(c)(3) of the Internal Revenue Code as a charitable entity, that does not necessarily mean that it qualifies under a state or local law that may be more narrow. However, most not-for-profits that qualify for a local property tax exemption will also qualify for Section 501(c)(3) status, and the issue of such status will be raised in an application for the real property tax exemption. It is unlikely that the exemption will be granted to an applicant that does not have Section 501(c)(3) status, or a pending application, without good reason.

Exemption statutes commonly require both qualifying ownership and qualifying use. A school or place of worship owning and occupying the entire property should have no problem. If part of the property is not used, or is leased to others, the transaction may be lost in whole or in part. Therefore, if the not-for-profit organization has excess space it desires to lease, the leasing plan must take into account the effect on the tax exemption. In a jurisdiction that permits the exemption to be retained only if the lease is to another qualifying not-for-profit, the need to maintain the exemption may limit the choice of tenants to such an entity. In such a case, a lease at a rental that covers the costs of operating the leased space probably is acceptable, but the exemption might be jeopardized in the case of a rental that generates a profit. If a lease to a business entity is desired and the exemption can be retained for the portion still used by the not-for-profit, it becomes a business issue whether the economic effect of the lease, taken as a whole, is worthwhile.

Exemption statutes are strictly construed against the taxpayer, and as a result, a not-for-profit organization seeking a real property tax exemption must scrupulously follow all procedural requirements for obtaining and maintaining the exemption. Deadlines for applications and periodic filings should be followed carefully. Any applications should be submitted before any threshold dates for the determination by a municipality of the tax status of real estate.

Leasing Issues

A lease by a not-for-profit organization as tenant will not differ from any other lease, but a few issues merit consideration. Foremost among these is the use clause.

First, the use clause must be consistent with the organization's charitable, educational, religious or other purposes. Then, since many not-for-profits have very specialized activities, the use clause must be sufficiently specific to permit these activities without uncertainty over whether they are permitted. On the other hand, the use clause cannot be so narrow as to limit the organization's flexibility if it desires to engage in other activities. And, as is the case with any lease, the use clause should be read together with provisions on assignment and subletting. Any rights to assign or sublet that may be bargained for should not be frustrated by a use clause that is so narrow that the organization cannot locate an assignee or subtenant that would conduct a permitted use. At a minimum, the lease should permit a not-for-profit entity to assign or sublet to other not-for-profits, or to a broad use category like "commercial," "warehouse" or "cultural and artistic uses." Alternatively, the landlord might be required to act reasonably if a permitted assignee or subtenant requests a change in the use clause.

If a not-for-profit organization desires to dispose of excess space by leasing owned property or subleasing rented property and has the ability to do so at a profit (i.e., if the lease rent exceeds operating costs or sublease rents exceed lease rents and subleasing costs), certain issues must be considered. State law limitations on activities that generate profit or financial gain must be taken into account. Such limitations may restrict such activities altogether or require that any profit be used to support the organization's non-profit activities. The possibility of unrelated business taxable income (UBTI) resulting from the transaction also must be considered. UBTI is a complicated subject that does not lend itself to generalizations. However, UBTI may be applicable, especially if the organization is leasing or subleasing only part of its premises and provides services, however minimal, to the tenant or subtenant. And, as mentioned above, a lease of excess space for a non-exempt use, or at a profit, or both, may adversely affect the real property tax exemption of an organization that owns real estate.

Conclusion

The expertise needed by not-for-profit organizations for the acquisition, ownership, management, leasing and disposition of real estate is the same as that needed by others. However, as this article demonstrates, there are many issues unique to this type of entity.

For more information, contact Steven Linde at 888-688-8500 or via e-mail at salinde@hklaw.com.