Exempt organizations: basis of property at the time of loss of exemption or transfer to taxable subsidiary.

When an exempt organization with assets used in an exempt function transfers the assets to a taxable subsidiary or loses its exemption, the basis of the assets at the time of the transfer is their original cost, reduced for exhaustion, wear and tear, obsolescence, amortization and depletion during the period the organization was not subject to tax. This is the case even though the exempt organization may not have provided depreciation in its financial statements.

General rule

The basis of an asset is required to be reduced for exhaustion, wear and tear, obsolescence, amortization and depletion, to the extent that the amount was "allowed or allowable" as a deduction in computing taxable income (Sec. 1016(a)(2) and Regs. Sec. 1.1016-3). The question then arises as to what is the proper basis for purposes of depreciating property when the exempt organization loses its status or transfers assets for use in a taxable unrelated business, and no tax benefits were previously realized from these assets by reason of their prior exempt use.

Sec. 1016(a)(3)(B) provides that an adjustment is required to the basis of property for the period it was held by a person or organization not subject to tax. Regs. Sec. 1.1016-4(a) further indicates that an adjustment is required if the amounts are "actually sustained." Regs. Sec. 1.1016-4(b) describes amounts "actually sustained" as the amounts charged off on the taxpayer's books when the amounts are considered by the IRS to be reasonable. Otherwise, the amount "actually sustained" is the amount that would have been allowable as a deduction (under the straight-line method) if the taxpayer had been subject to income tax during the applicable period. Thus, a tax-exempt organization must reduce the basis of assets used in an exempt function for depreciation, depletion or amortization, even though no tax benefits accrued.

However, for purposes of computing ordinary gain on sale, Regs. Sec. 1.1245-2(a)(8) provides that, for property disposed of by an organization that is or was exempt from tax, adjustments reflected in basis include only depreciation or amortization allowed or allowable in computing unrelated business taxable income as defined by Sec. 512(a), or in computing the organization's taxable income for a period in which it was not exempt. This means that the basis for determining Sec. 1245 gain may differ from the basis used for determining taxable gain. See the example above.

Observation: In the example, sale of the asset prior to loss of exemption would avoid the tax on $25,000 of gain. Under Sec. 512(b)(5), gain on the sale of assets by an exempt entity is not subject to the unrelated business tax. However, if the same asset is sold the day after the entity becomes taxable (or it is transferred to a taxable subsidiary), the $25,000 gain would be subject to tax.

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