Leasing Church Property to a Tenant: What Churches Need to Know.
First Congregational Church United Church of Christ has a large church building with a separate two-floor education wing that has eight separate classrooms and its own restrooms. The church previously held children’s Sunday School in the education wing, but in the past several years—prior to COVID—the church has been holding a combined Sunday School class in Fellowship Hall, which works for the current demographics of the church. As the church considers its return to in-person worship, it is also considering what a different use of its building space might look like, and how the building can benefit the church’s ministries. After determining that leasing its space was a good fit with the church’s mission priorities, and that the church’s staff had the capacity to act as a landlord, the council appointed a small committee to look into leasing the education wing to a long-term tenant.
Leasing church space to a tenant can be a good source of income for the church, but there are several legal and tax issues that may impact the financial return to the church. This doesn’t mean the church shouldn’t pursue leasing its space, but it does mean that the church should factor in the cost of quality legal and tax advice in assessing whether leasing space is a good option for the church.
What legal issues might First Congregational, or other churches planning to rent out all or part of their spaces, want to consider? This article discusses some of the most important legal and tax considerations.
Zoning, Deed Restrictions, and Restrictive Covenants
Before planning to rent its property, a church should investigate how its property can legally be used. Whether all or part of a church building can be rented to a tenant for a particular use may be affected by deed restrictions, restrictive covenants, and zoning regulations or other municipal ordinances that affect whether certain businesses can operate in certain locations. While churches may be protected under the First Amendment, the Religious Land Use and Institutionalized Persons Act, and state laws for religious purposes, these protections likely will not extend to renting property to a tenant.
A church’s deed may also include a reversionary interest, a possibility of reverter, a right of re-entry, or another type of restriction that allows the grantor of the property the right to take the property under certain conditions, such as if the property ceases to be used as a church. These types of provisions are common if the church was granted property initially by the Conference or a donor. The church’s property may also be subject to a special mortgage or grant mortgage made years ago that does not need to be repaid unless the building is used for a purpose other than a church. Knowing about these restrictions is essential for those churches that are planning to rent all or a substantial amount of their building to a non-church organization. In some states, laws against restraints on the transfer of property may affect the enforceability of these provisions.
Some churches have restrictive covenants on their property that limit what the property can be used for in the neighborhood. Ordinarily, these restrictive covenants will be included in the deed to the church property, but could be in other recorded documents. Restrictive covenants may affect a church’s ability to rent the property for certain uses, and may also provide that the church will be liable for any costs that other property owners incur in enforcing the restrictions. It is also possible that restrictive covenants may no longer be valid.
A local real estate attorney can advise on zoning, deed restrictions, and restrictive covenants.
Property Tax Exemption
All states provide some form of property tax exemption for churches. Some states exempt only buildings used exclusively as places of worship. Leasing all or part of your church’s building may result in the church losing its property tax exemption on at least the portion of its property that is no longer being used for its ministry. This may be true even if the church rents its property to another charity, tax-exempt organization, or even another church. Property tax exemptions may apply exclusively to uses for religious worship and receiving rental income is likely not considered exclusive use for religious worship by the state. If the church will incur property taxes, it will want to ensure that the tenant is responsible for reimbursement of some or all of the property tax amount. Because property tax exemptions for churches vary from state to state, it is important to check with a local attorney on how the rented portion of the property will be treated and whether the church will need to notify local property tax authorities.
Written Lease Agreement
A successful landlord-tenant relationship begins with mutual expectations, which should be included in a written lease agreement. A lease is a legal document, and should be drafted by an experienced attorney that is hired by the church for this purpose. The attorney can advise the church on its rights under state and federal law to impose any particular provisions on its tenant. Avoid downloading template lease agreements from the internet— these leases may not take into account your state’s laws and definitely do not address your church’s unique circumstances.
A good lease agreement will address standard contractual provisions like payment of rent, termination of the lease, and default, as well as how costs of utilities will be assessed and shared; the use of common areas like restrooms and kitchen space; the tenant’s share of any expected property tax; the tenant’s ability to change the space to suit their needs; and perhaps most importantly, any unique circumstances or needs the church may have to make the relationship successful. Should the landlord-tenant relationship need to come to an end, the attorney can advise the church on how to terminate the relationship under the provisions of the agreement.
The lease agreement must also address insurance and indemnification requirements. The church should consult its insurance company for any requirements the insurance company may have for the church’s lease agreement. A tenant should be required to carry insurance and to name the church as an additional insured on a certificate of insurance, which should be collected and maintained by the church. The tenant should agree to indemnify the church for any third-party claims arising out of the tenant’s use of the property. The attorney can provide appropriate language for the circumstances.
Know how the church’s rental income will be treated by federal and state taxing authorities to prevent costly penalties!
Federal Income Tax
Church settings are ordinarily exempt from federal income tax because they are 501(c)(3) organizations. But a church that engages in a trade or business that is regularly carried on and which is unrelated to its religious purpose may be subject to a tax on income from that business. The tax is called the unrelated business income tax, or UBIT. The church’s need for the income that comes from business does not make it related, nor does the church’s use of the income for a religious purpose.
Rental income is ordinarily excluded from UBIT. If the church borrowed money to acquire its property and still owes that debt, the property is debt-financed. Rental income from debt-financed property is subject to UBIT. An exception to this rule is that if 85% or more of the property is used for exempt purposes, the rental income on debt-financed property will not be subject to UBIT. It’s essential that a church consult a qualified CPA or attorney on these issues, which can be complicated if the church has borrowed money to purchase its property.
For more information on UBIT, please see IRS Pub. No. 598.
State Income Tax
While most states exempt religious organizations from corporate income taxes, it is important to know how your church’s rental income will be treated in your state. Additionally, some states do not exempt churches from excise taxes on gross income.
For more information on applicable state taxes, check your state department of taxation’s website and check with your CPA.
Knowing how your church’s rental income and property tax status will be treated will enable you to make good stewardship decisions about leasing your church’s property to a tenant!
For additional practical information, you may also wish to view United Church of Christ Church Building & Loan Fund’s Building Church Differently webinar on renting your church’s facilities.
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