When charitable organizations lease property, parcels that were once tax exempt can easily find their way back onto the tax rolls. A charity will lose all or part of its property tax exemption when it leases property it owns to another entity (whether for-profit, not-for-profit or a charity) unless certain requisites are met. This article discusses the various constitutional and statutory provisions by which charitable organizations must abide when leasing property in order to maintain the full or partial tax exempt status of that property.1

Qualifying as an Institution of Purely Public Charity
The first step to maintaining a real estate tax exemption is ensuring that the lessor/charity itself meets the statutory and constitutional definitions of a charitable organization. In many instances, the lessor/charity has already obtained a real estate tax exemption for its property; if so, it need only ensure that no material changes in organizational structure, compensation packages, and the like have occurred since the exemption was granted. However, when the property has recently been purchased or when the organization has only just been formed, the lessor/charity must first assess, and be able to prove, its status as a charitable organization.

The Pennsylvania Constitution provides the basis for charitable exemptions, declaring that the legislature has the power to exempt from taxation "institutions of purely public charity."2 In 1985, the Pennsylvania Supreme Court set forth the constitutional definition of a "purely public charity" (commonly referred to as "the HUP test"),3 and in 1997, the Pennsylvania General Assembly passed the Institutions of Purely Public Charity Act ("Act 55"),4 which codified that basic definition. At the same time, however, the legislature rejected certain judicial interpretations of the HUP test and adopted other interpretations. While an exploration of the differences between the HUP test, as judicially interpreted, and Act 55 is beyond the scope of this article, generally speaking both the HUP test and Act 55 require an organization to meet the following five "prongs" or "tests" before qualifying as an institution of purely public charity:
  1. the organization must advance a charitable purpose;
  2. the organization must donate or render gratuitously a substantial portion of its services;
  3. the organization must benefit a substantial and indefinite class of persons who are legitimate subjects of charity;
  4. the organization must relieve the government of some of its burden; and
  5. the organization must operate entirely free from profit motive. An organization does not qualify as a purely public charity merely because it is a non-profit entity.5
When an otherwise charitable organization seeks to lease its property, the "free from profit motive" prong is most often implicated. For instance, if the lease arrangement as a whole, including rent, utilities and other services, gives the owner-charity a substantial profit, the owner-charity may fail to satisfy the "free from profit motive" prong, and hence will not be deemed a "purely public charity" entitled to an exemption.

What "Charitable" Property May Be Exempted from Property Taxes

The Pennsylvania Constitution provides that the legislature is allowed to grant exemptions only for those portions of real property owned by a charitable institution that are "actually and regularly used for the purposes of the institution."6 Thus, property owned by an institution of purely public charity (as defined above) is not always tax exempt.

Further defining the constitutional use requirement, the Pennsylvania General Assembly has enacted two primary provisions under which charitable organizations may claim eligibility for property tax exemptions that they own and lease to a third party: Section 204(a)(9) and Section 204(a)(3) of the General County Assessment Law.7 Section 204(a)(9) exempts from taxation real property (a) owned by a charity; and (b) used or occupied jointly by the charity and another charity; so long as (c) the real property is necessary for the occupancy and enjoyment of the charities using it. Courts have generally held that in keeping with this provision, the lessee must share in the property's charitable mission.8 In contrast, Section 204(a)(3) exempts all "institutions of learning, benevolence, or charity... with the grounds thereto annexed and necessary for the occupancy and enjoyment of the same," provided that the entire revenue derived from the property is applied to the support, repair and increase of the building's facilities.

Clearing the Financial and Use Hurdles
When the owner/charity safely fits within either Section 204(a)(3) or 204(a)(9), the owner/charity then must clear the financial hurdles of both Sections 204(b) and 204(c). Under Section 204(b), the owner/charity must prove: (1) the property is not the source from which any income or revenue is derived; (2) any rent paid to use the property is merely nominal; and (3) the lessee receives the benefits of the owner's charity.

An overall lease arrangement can satisfy these requirements even if the rent charged is at or near market rates.9 For instance, in Borough of Homestead v. St. Mary Magdalene Church,10 the court held that the Diocese of Pittsburgh was entitled to a property tax exemption for a building it owned (the Bishop Boyle Center) despite the fact that it used only 5% of the Center itself, rented 16% of the Center's space to for-profit entities and 79% of the Center's space to non-profit entities (the lessees). The lessees paid rents to the Diocese that were close to the going commercial rate. The court examined the entire leasing arrangement and found that the fees paid by the lessees were below market value once the costs of the services provided by the Diocese were taken into account, and although some lessees made improvements at their own expense, the court found that they were mostly cosmetic and relatively insubstantial. Moreover, each of the lessees conducted a business that furthered the Diocese's charitable mission. Based upon these facts, the court concluded that the lessees were recipients of the Diocese's charity and hence, any income or revenue generated by the lease of a portion of the property did not preclude a continuation of the tax exemption for the entire Bishop Boyle Center.11

In contrast, in Appeal of Archdiocese of Philadelphia,12 the court characterized the lease between the owner charity and another charitable organization as "an arm's length transaction between landlord and tenant for market value." In addition to rent, the lessee was responsible for utilities and maintenance and made substantial investments in improvements that reverted to the owner/Archdiocese. Under those circumstances, the lessee could not be described as a recipient of the owner/Archdiocese's charity. Because the entire property was leased and because the financial and use hurdles had not been cleared, the court declared the entire property taxable.13

The final hurdle for an owner-charity seeking a charitable tax exemption for property it owns but leases to a third party is contained in Section 204(c), which provides that the owner/charity must both occupy the property and have a continuing right of possession and control over the premises. Although courts have not defined "occupied" with particular specificity, it is clear that the term requires the owner/charity to prove that it actually and regularly uses more than a de minimis portion of the property for its own charitable work. Two cases illustrate that minimal use of a building is not enough to prove occupancy. In Archdiocese of Philadelphia, the court held that the owner/charity did not prove use and occupancy merely by parking its bus in a garage on the premises.14 Similarly, in Greater Erie Economic Development Corp. Appeal,15 the owner/charity did not "occupy" the building simply by conducting its board meetings on the premises.

Thus, the key to satisfying the financial hurdles of Section 204(b) and the use hurdles of Section 204(c) is carefully crafting and structuring the lease so that a "typical" or "arms-length" landlord/tenant relationship is not created. The following is a list of factors courts have considered when deciding whether an owner/charity has satisfied these hurdles:
  • Whether the lease favors the owner/charity;
  • Whether the lessee is responsible for paying most or all costs associated with the use of the property;
  • Whether the lessee is responsible for maintaining insurance;
  • Whether the lessee is responsible for costs pertaining to zoning, use and occupancy permits or licenses;
  • Whether the lessee is responsible for the payment of real estate taxes and any other taxes or assessments resulting from the leasing of the facilities;
  • Whether the lessee is responsible for the costs of remodeling and any repairs necessary to prepare the premises for occupancy;
  • Whether the lessee is responsible for the costs of utilities used on the premises;
  • Whether the lessee is responsible for interior and exterior regular maintenance and upkeep, including such things as cutting and trimming the lawn, trees and plants; janitorial service and trash removal, maintenance of pavements and parking area, etc.;
  • Whether the lessee must indemnify and defend the lessor from costs and expenses, losses or liabilities arising from occurrences on or about the premises;
  • Whether the lessee is responsible for the costs of any improvements to the property and whether those improvements revert to the lessor at the end of the lease term;
  • Whether the owner/charity retained the right to terminate the leasehold and, if so, for what reasons;
  • Whether the lease provides for use or occupancy of the property by the owner/charity;
  • Whether the lessee has the unrestricted right to sublet all or a portion of the property; and
  • Whether the annual rent is above, below or at market value.16
"Splitting the Baby:" Awarding Exempt Status to Part of the Property
Courts have circumvented the sometimes harsh application of the foregoing statutory requirements by "splitting the baby." For example, in In re Appeal of Sewickley Valley YMCA,17 the Commonwealth Court affirmed a decision granting tax exempt status to 92% of the YMCA's property (the part used by the YMCA) and denying tax exempt status to the remaining 8% of the property, which the YMCA had leased to a third party. Charitable organizations should keep the courts' power to make these equitable splits in mind.

Who Has Standing to Challenge the Denial of an Exemption?

As a final note, it is important to consider what happens when a taxing body challenges the exempt status of charity-owned real estate. In the absence of a lease provision on point, do both the owner/charity and the lessee have standing to champion the exemption? It depends. If the lessee has taken on the characteristics of an "equitable owner," either the owner/charity or the lessee may pursue the exemption. For example, the Pennsylvania Commonwealth Court recently ruled that when title to the improvements and to the leasehold itself are granted to the lessee during the term of the lease, the lessee has standing to appeal the property's tax status.18

Be careful, however; the ability to challenge a taxing authority's decision regarding an exemption does not equate to eligibility for an exemption. While lessees may be able to champion a real estate tax exemption by virtue of their relationship to the property, exempt status generally cannot be granted on the basis that the lessee (as opposed to the owner/charity) is an institution of purely public charity.19 Rather, the property generally must be owned by a charity in order to be eligible for real estate tax exemption.

Conclusion: General Principles to Abide by When Structuring a Lease
Exempt status is granted on a case-by-case basis after a complete exploration of the variables at play. However, charitable organizations should keep the following general principles in mind when structuring their lease arrangements: (1) the lessee should share in the owner/charity's mission and use the property in furtherance of that mission; (2) the overall leasing arrangement should not be profitable: the lease should provide for rent that is at or below market rates, and the owner/charity should be responsible for building maintenance and improvements; and (3) the owner/charity should continue to occupy a portion of the leased property and should maintain its right to continued possession and control of the premises.

This information has also been printed in the Pennsylvania Bar Institute's 2003 Spring Health Care Law Committee Newsletter.

1 This article does not, and cannot, substitute for legal advice. As this article attests, maintaining tax exempt status despite a leasing arrangement can be difficult. Accordingly, a charitable organization considering or drafting a lease should consult with counsel first.
2 Pa. Const. art. VIII, ŧ 2(a)(v).
3 Hospital Utilization Project v. Commonwealth 507 Pa. 1, 487 A.2d 1306 (1985).
4 10 Pa. Stat. Ann. ŧ ŧ 371-385 (West 1985). The constitutionality of Act 55 is at issue in Community Options, Inc. v. Board of Property Assessment, Appeals and Review, 764 A.2d 645 (Pa. Commw. 2000), appeal granted, 567 Pa. 730 (2001). As of the date this article was written, the Supreme Court had not yet issued its decision.
5 Couriers-Susquehanna, Inc. v. County of Dauphin, 693 A.2d 626, 629 (Pa. Commw. 1997).
6 Pa. Const. art. VIII, ŧ 2(a)(v).
7 General County Assessment Law, 72 Pa. Cons. Stat. Ann. 5020-204 (West 1995).
8 See generally Borough of Homestead v. St. Mary Magdalene Church, 798 A.2d 823 (Pa. Commw. 2002) (finding property entitled to exemption even though for-profit entities rented space from the owner charity because they shared in the mission of the owner charity and because they were recipients of the owner's charity due to the fact that the owner provided services to them at a substantial loss).
9 Although note that if an owner charity is trying to qualify for an exemption based on Section 204(a)(3), any surplus revenue derived from rent must be applied to repair, maintenance and improvements for the facility.
10 798 A.2d 823 (Pa. Commw. 2002).
11 Id. at 827-28.
12 617 A.2d 821 (Pa. Commw. 1992).
13 Id. at 823-24.
14 Id. at 824-26.
15 433 A.2d 568, 570 (Pa. Commw. 1981).
16 See, e.g., Appeal of Archdiocese, 617 A.2d at 824-25.
17 774 A.2d 1 (Pa. Commw. 2001).
18 In re Pittsburgh International Airport Tax Exemptions, 797 A.2d 414, 416-17 (Pa. Commw. 2002).
19 72 Pa. Cons. Stat. Ann. ŧ 5020-204(c) (West 1995).