[Code of Federal Regulations]
[Title 26, Volume 7]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.514(c)-1]

[Page 196-201]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.514(c)-1  Acquisition indebtedness.

    (a) In general--(1) Definition of acquisition indebtedness. For 
purposes of section 514 and the regulations thereunder, the term 
acquisition indebtedness means, with respect to any debt-financed 
property, the outstanding amount of:
    (i) The principal indebtedness incurred by the organization in 
acquiring or improving such property.
    (ii) The principal indebtedness incurred before the acquisition or 
improvement of such property if such indebtedness would not have been 
incurred but for such acquisition or improvement; and
    (iii) The principal indebtedness incurred after the acquisition or 
improvement of such property if such indebtedness would not have been 
incurred but for such acquisition or improvement and the incurrence of 
such indebtedness was reasonably foreseeable at the time of such 
acquisition or improvement.

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Whether the incurrence of an indebtedness is reasonably foreseeable 
depends upon the facts and circumstances of each situation. The fact 
that an organization did not actually foresee the need for the 
incurrence of an indebtedness prior to the acquisition or improvement 
does not necessarily mean that the subsequent incurrence of indebtedness 
was not reasonably foreseeable.
    (2) Examples. The application of subparagraph (1) of this paragraph 
may be illustrated by the following examples:

    Example 1. X, an exempt organization, pledges some of its investment 
securities with a bank for a loan and uses the proceeds of such loan to 
purchase an office building which it leases to the public for purposes 
other than those described in section 514(b)(1) (A), (B), (C), or (D). 
The outstanding principal indebtedness with respect to the loan 
constitutes acquisition indebtedness incurred prior to the acquisition 
which would not have been incurred but for such acquisition.
    Example 2. Y, an exempt scientific organization, mortgages its 
laboratory to replace working capital used in remodeling an office 
building which Y rents to an insurance company for purposes not 
described in section 514(b)(1) (A), (B), (C), or (D). The indebtedness 
is acquisition indebtedness since such indebtedness, though incurred 
subsequent to the improvement of the office building, would not have 
been incurred but for such improvement, and the indebtedness was 
reasonably foreseeable when, to make such improvement, Y reduced its 
working capital below the amount necessary to continue current 
operations.
    Example 3. (a) U, an exempt private preparatory school, as its sole 
educational facility owns a classroom building which no longer meets the 
needs of U's students. In 1971, U sells this building for $3 million to 
Y, a corporation which it does not control. U receives $1 million as a 
down payment from Y and takes back a purchase money mortgage of $2 
million which bears interest at 10 percent per annum. At the time U 
became the mortgagee of the $2 million purchase money mortgage, U 
realized that it would have to construct a new classroom building and 
knew that it would have to incur an indebtedness in the construction of 
the new classroom building. In 1972, U builds a new classroom building 
for a cost of $4 million. In connection with the construction of this 
building, U borrows $2.5 million from X Bank pursuant to a deed of trust 
bearing interest at 6 percent perannum. Under these circumstances, $2 
million of the $2.5 million borrowed to finance construction of the new 
classroom building would not have been borrowed but for the retention of 
the $2 million purchase money mortgage. Since such indebtedness was 
reasonably foreseeable, $2 million of the $2.5 million borrowed to 
finance the construction of the new classroom building is acquisition 
indebtedness with respect to the purchase money mortgage and the 
purchase money mortgage is debt-financed property.
    (b) In 1972, U receives $200,000 in interest from Y (10 percent of 
$2 million) and makes a $150,000 interest payment to X (6 percent of 
$2.5 million). In addition, assume that for 1972 the debt/basis 
percentage is 100 percent ($2 million/$2 million). Accordingly, all the 
interest and all the deductions directly connected with such interest 
income are to be taken into account in computing unrelated business 
taxable income. Thus, $200,000 of interest income and $120,000 
($150,000x$2 million/$2.5 million) of deductions directly connected with 
such interest income are taken into account. Under these circumstances, 
U shall include net interest income of $80,000 ($200,000 of income less 
$120,000 of deductions directly connected with such income) in its 
unrelated business taxable income for 1972.
    Example 4. In 1972 X, an exempt organization, forms a partnership 
with A and B. The partnership agreement provides that all three partners 
shall share equally in the profits of the partnership, shall each invest 
$3 million, and that X shall be a limited partner. X invests $1 million 
of its own funds in the partnership and $2 million of borrowed funds. 
The partnership purchases as its sole asset an office building which is 
leased to the general public for purposes other than those described in 
section 514(b)(1) (A), (B), (C), or (D). The office building cost the 
partnership $24 million of which $15 million is borrowed from Y bank. 
This loan is secured by a mortgage on the entire office building. By 
agreement with Y bank, X is held not to be personally liable for payment 
of such mortgage. By reason of section 702(b) the character of any item 
realized by the partnership and included in the partner's distributive 
share shall be determined as if the partner realized such item directly 
from the source from which it was realized by the partnership and in the 
same manner. Therefore, a portion of X's income from the building is 
debt-financed income. Under these circumstances, since both the $2 
million indebtedness incurred by X in acquiring its partnership interest 
and $5 million, the allocable portion of the partnership'sindebtedness 
incurred with respect to acquiring the office building which is 
attributable to X in computing the debt/basis percentage (one-third of 
$15 million), were incurred in acquiring income-producing property, X 
has acquisition indebtedness of $7 million ($2 million plus $5 million). 
Similarly, the allocable portion of the partnership's adjusted basis in 
the office building

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which is attributable to X in computing the debt-basis percentage is $8 
million (one-third of $24 million). Assuming no payment with respect to 
either indebtedness and no adjustments to basis in 1972, X's average 
acquisition indebtedness is $7 million and X's average adjusted basis is 
$8 million for such year. Therefore, X's debt/basis percentage with 
respect to its share of the partnership income for 1972 is 87.5 percent 
($7 million/$8 million).

    (3) Changes in use of property. Since property used in a manner 
described in section 514(b)(1) (A), (B), (C), or (D) is not considered 
debt-financed property, indebtedness with respect to such property is 
not acquisition indebtedness. However, if an organization converts such 
property to a use which is not described in section 514(b)(1) (A), (B), 
(C), or (D) and such property is otherwise treated as debt-financed 
property, the outstanding principal indebtedness with respect to such 
property will thereafter be treated as acquisition indebtedness. For 
example, assume that in 1971 a university borrows funds to acquire an 
apartment building as housing for married students. In 1974 the 
university rents the apartment building to the public for purposes not 
described in section 514(b)(1) (A), (B), (C), or (D). The outstanding 
principal indebtedness is acquisition indebtedness as of the time in 
1974 when the building is first rented to the public.
    (4) Continued indebtedness. If:
    (i) An organization sells or exchanges property, subject to an 
indebtedness (incurred in a manner described in subparagraph (1) of this 
paragraph),
    (ii) Acquires another property without retiring the indebtedness, 
and
    (iii) The newly acquired property is otherwise treated as debt-
financed property,

the outstanding principal indebtedness with respect to the acquired 
property is acquisition indebtedness, even though the original property 
was not debt-financed property. For example, to house its administrative 
offices, an exempt organization purchases a building with $600,000 of 
its own funds and $400,000 of borrowed funds secured by a pledge of its 
securities. It later sells the building for $1,000,000 without redeeming 
the pledge. It uses these proceeds to purchase an apartment building 
which it rents to the public for purposes not described in section 
514(b)(1) (A), (B), (C), or (D). The indebtedness of $400,000 is 
acquisition indebtedness with respect to the apartment building even 
though the office building was not debt-financed property.
    (5) Indebtedness incurred before June 28, 1966. For taxable years 
beginning before January 1, 1972, acquisition indebtedness does not 
include any indebtedness incurred before June 28, 1966, unless such 
indebtedness was incurred on rental real property subject to a business 
lease and such indebtedness constituted business lease indebtedness. 
Furthermore, in the case of a church or convention or association of 
churches, the preceding sentence applies without regard to whether the 
indebtedness incurred before June 28, 1966, constituted business lease 
indebtedness.
    (b) Property acquired subject to lien--(1) Mortgages. Except as 
provided in subparagraphs (3) and (4) of this paragraph, whenever 
property is acquired subject to a mortgage, the amount of the 
outstanding principal indebtedness secured by such mortgage is treated 
as acquisition indebtedness with respect to such property even though 
the organization did not assume or agree to pay such indebtedness. The 
preceding sentence applies whether property is acquired by purchase, 
gift, devise, bequest, or any other means. Thus, for example, assume 
that an exempt organization pays $50,000 for real property valued at 
$150,000 and subject to a $100,000 mortgage. The $100,000 of outstanding 
principal indebtedness is acquisition indebtedness just as though the 
organization had borrowed $100,000 to buy the property.
    (2) Other liens. For purposes of this paragraph, liens similar to 
mortgages shall be treated as mortgages. A lien is similar to a mortgage 
if title to property is encumbered by the lien for the benefit of a 
creditor. However, in the case where State law provides that a tax lien 
attaches to property prior to the time when such lien becomes due and 
payable, such lien shall not be treated as similar to a mortgage until 
after it has become due and payable and the organization has had an 
opportunity to pay such lien in accordance with State law. Liens similar 
to mortgages include (but are not limited to):


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    (i) Deeds of trust,
    (ii) Conditional sales contracts,
    (iii) Chattel mortgages,
    (iv) Security interests under the Uniform Commercial Code,
    (v) Pledges,
    (vi) Agreements to hold title in escrow, and
    (vii) Tax liens (other than those described in the third sentence of 
this subparagraph).
    (3) Certain encumbered property acquired by gift, bequest or 
devise--(i) Bequest or devise. Where property subject to a mortgage is 
acquired by an organization by bequest or devise, the outstanding 
principal indebtedness secured by such mortgage is not to be treated as 
acquisition indebtedness during the 10-year period following the date of 
acquisition. For purposes of the preceding sentence, the date of 
acquisition is the date the organization receives the property.
    (ii) Gifts. If an organization acquires property by gift subject to 
a mortgage, the outstanding principal indebtedness secured by such 
mortgage shall not be treated as acquisition indebtedness during the 10-
year period following the date of such gift, so long as:
    (a) The mortgage was placed on the property more than 5 years before 
the date of the gift, and
    (b) The property was held by the donor for more than 5 years before 
the date of the gift.

For purposes of the preceding sentence, the date of the gift is the date 
the organization receives the property.
    (iii) Limitation. Subdivisions (i) and (ii) of this subparagraph 
shall not apply if:
    (a) The organization assumes and agrees to pay all or any part of 
the indebtedness secured by the mortgage, or
    (b) The organization makes any payment for the equity owned by the 
decedent or the donor in the property (other than a payment pursuant to 
an annuity excluded from the definition of acquisition indebtedness by 
paragraph (e) of this section).

Whether an organization has assumed and agreed to pay all or any part of 
an indebtedness in order to acquire the property shall be determined by 
the facts and circumstances of each situation.
    (iv) Examples. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. A dies on January 1, 1971. His will devises an office 
building subject to a mortgage to U, an exempt organization described in 
section 501(c)(3). U does not at any time assume the mortgage. For the 
period 1971 through 1980, the outstanding principal indebtedness secured 
by the mortgage is not acquisition indebtedness. However, after December 
31, 1980, the outstanding principal indebtedness secured by the mortgage 
is acquisition indebtedness if the building is otherwise treated as 
debt-financed property.
    Example 2. Assume the facts as stated in example 1 except that on 
January 1, 1975, U assumes the mortgage. After January 1, 1975, the 
outstanding principal indebtedness secured by the mortgage is 
acquisition indebtedness if the building is otherwise treated as debt-
financed property.

    (4) Bargain sale before October 9, 1969. Where property subject to a 
mortgage is acquired by an organization before October 9, 1969, the 
outstanding principal indebtedness secured by such mortgage is not to be 
treated as acquisition indebtedness during the 10-year period following 
the date of acquisition if:
    (i) The mortgage was placed on the property more than 5 years before 
the purchase, and
    (ii) The organization paid the seller a total amount no greater than 
the amount of the seller's cost (including attorney's fees) directly 
related to the transfer of such property to the organization, but in any 
event no more than 10 percent of the value of the seller's equity in the 
property transferred.
    (c) Extension of obligations--(1) In general. An extension, renewal, 
or refinancing of an obligation evidencing a preexisting indebtedness is 
considered as a continuation of the old indebtedness to the extent the 
outstanding principal amount thereof is not increased. Where the 
principal amount of the modified obligation exceeds the outstanding 
principal amount of the preexisting indebtedness, the excess shall be 
treated as a separate indebtedness for purposes of section 514 and the 
regulations thereunder. For example, if the interest rate on an 
obligation incurred prior to June 28, 1966, by an exempt university is 
modified subsequent to such date, the modified obligation

[[Page 200]]

shall be deemed to have been incurred prior to June 28, 1966. Thus, such 
an indebtedness will not be treated as acquisition indebtedness for 
taxable years beginning before January 1, 1972, unless the original 
indebtedness was business lease indebtedness (as defined in Sec. 
1.514(g)-1).
    (2) Extension or renewal. In general, any modification or 
substitution of the terms of an obligation by the organization shall be 
an extension or renewal of the original obligation, rather than the 
creation of a new indebtedness to the extent that the outstanding 
principal amount of the indebtedness is not increased. The following are 
examples of acts which result in the extension or renewal of an 
obligation:
    (i) Substitution of liens to secure the obligation;
    (ii) Substitution of obligees, whether or not with the consent of 
the organization;
    (iii) Renewal, extension or acceleration of the payment terms of the 
obligation; and
    (iv) Addition, deletion, or substitution of sureties or other 
primary or secondary obligors.
    (3) Allocation. In cases where the outstanding principal amount of 
the modified obligation exceeds the outstanding principal amount of the 
unmodified obligation and only a portion of such refinanced indebtedness 
is to be treated as acquisition indebtedness, payments on the amount of 
the refinanced indebtedness shall be apportioned prorata between the 
amount of the preexisting indebtedness and the excess amount. For 
example, assume that an organization has an outstanding principal 
indebtedness of $500,000 which is treated as acquisition indebtedness. 
It borrows another $100,000, which is not acquisition indebtedness, from 
the same lending institution and gives the lender a $600,000 note for 
its total obligation. In this situation, a payment of $60,000 on the 
amount of the total obligation would reduce the acquisition indebtedness 
by $50,000 and the excess indebtedness by $10,000.
    (d) Indebtedness incurred in performing exempt purpose. Acquisition 
indebtedness does not include the incurrence of an indebtedness inherent 
in the performance or exercise of the purpose or function constituting 
the basis of the organization's exemption. Thus, acquisition 
indebtedness does not include the indebtedness incurred by an exempt 
credit union in accepting deposits from its members or the obligation 
incurred by an exempt organization in accepting payments from its 
members to provide such members with insurance, retirement or other 
similar benefits.
    (e) Annuities--(1) Requirements. The obligation to make payment of 
an annuity is not acquisition indebtedness if the annuity meets all the 
following requirements:
    (i) It must be the sole consideration (other than a mortgage to 
which paragraph (b)(3) of this section applies) issued in exchange for 
the property acquired;
    (ii) At the time of the exchange, the present value of the annuity 
(determined in accordance with subparagraph (2) of this paragraph) must 
be less than 90 percent of the value of the prior owner's equity in the 
property received in the exchange;
    (iii) The annuity must be payable over the life of one individual in 
being at the time the annuity is issued, or over the lives of two 
individuals in being at such time; and
    (iv) The annuity must be payable under a contract which:
    (a) Does not guarantee a minimum number of payments or specify a 
maximum number of payments, and
    (b) Does not provide for any adjustment of the amount of the annuity 
payments by reference to the income received from the transferred 
property or any other property.
    (2) Valuation. For purposes of this paragraph, the value of an 
annuity at the time of exchange shall be computed in accordance with 
section 1011(b), Sec. 1.1011-2(e)(1)(iii)(b)(2), and section 3 of Rev. 
Rul. 62-216, C.B. 1962-2, 30.
    (3) Examples. The application of this paragraph may be illustrated 
by the following examples. For purposes of these examples it is assumed 
that the property transferred is used for purposes other than those 
described in section 514(b)(1) (A), (B), (C), or (D).

    Example 1. On January 1, 1971, X, an exempt organization, receives 
property valued at $100,000 from donor A, a male aged 60. In return X 
promises to pay A $6,000 a year for

[[Page 201]]

the rest of A's life, with neither a minimum nor maximum number of 
payments specified. The annuity is payble on December 31, of each year. 
The amounts paid under the annuity are not dependent on the income 
derived from the property transferred to X. The present value of this 
annuity is $81,156, determined in accordance with Table A of Rev. Rul. 
62-216. Since the value of the annuity is less than 90 percent of A's 
equity in the property transferred and the annuity meets all the other 
requirements of subparagraph (1) of this paragraph, the obligation to 
make annuity payments is not acquisition indebtedness.
    Example 2. On January 1, 1971, B transfers an office building to Y, 
an exempt university, subject to a mortgage. In return Y agrees to pay B 
$5,000 a year for the rest of his life, with neither a minimum nor 
maximum number of payments specified. The amounts paid under the annuity 
are not dependent on the income derived from the property transferred to 
Y. It is determined that the actual value of the annuity is less than 90 
percent of the value of B's equity in the property transferred. Y does 
not assume the mortgage. For the taxable years 1971 through 1980, the 
outstanding principal indebtedness secured by the mortgage is not 
treated as acquisition indebtedness. Further, Y's obligation to make 
annuity payments to B never constitutes acquisition indebtedness.

    (f) Certain Federal financing. Acquisition indebtedness does not 
include an obligation to finance the purchase, rehabilitation, or 
construction of housing for low and moderate income persons to the 
extent that it is insured by the Federal Housing Administration. Thus, 
for example, to the extent that an obligation is insured by the Federal 
Housing Administration under section 221(d)(3) (12 U.S.C. 1715(I)(d)(3)) 
or section 236 (12 U.S.C. 1715z-1) of title II of the National Housing 
Act, as amended, the obligation is not acquisition indebtedness.
    (g) Certain obligations of charitable remainder trusts. For purposes 
of section 664(c) and Sec. 1.664-1(c), a charitable remainder trust (as 
defined in Sec. 1.664-1(a)(1)(iii)(a) does not incur acquisition 
indebtedness when the sole consideration it is required to pay in 
exchange for unencumbered property is an annuity amount or a unitrust 
amount (as defined in Sec. 1.664-1(a)(1)(iii)(b) and (c)).

[T.D. 7229, 37 FR 28151, Dec. 21, 1972; 38 FR 21918, Aug. 14, 1973; T.D. 
7698, 45 FR 33973, May 21, 1980]