Legal Considerations for Churches: Uses of Real Estate

Many churches in the greater New York area are situated on land that is very valuable. However, those same churches may be struggling to pay their bills or renovate aging church structures. We are seeing with greater frequency that churches in our area have growing congregations that require expanded facilities in order to accommodate this growth. Often times, these churches are approached by real estate developers looking to invest in churches to enhance their portfolios.

Some of these developers offer churches “easy” money in exchange for a transaction that can result in the church losing ownership of its property. In New York, the Charities Bureau of the Attorney General’s Office is a government agency that reviews, and must approve, sales or other dispositions (i.e., refinancing) of church properties for fairness. If the terms of the transaction appear to be fair and reasonable to the church based on an appraisal and other financial considerations (i.e. the influx of cash and the terms of a sale/lease back of the property) the Charities Bureau often approves these transactions.

We advise our church clients to be very careful in dealing with developers and to resist selling to them if doing so will result in loss of ownership. A number of banks lend to churches with limited cash flows or assets provided that the church has substantial equity in its property. In our experience, we have seen a growing number of successful loan transactions between churches and banks with favorable terms for the churches, including reasonable interest rates. Most importantly, the church gets to keep its deed.

A church is more likely to qualify for a loan from a bank if the proposed use of funds includes a plan for the church to generate income. One way churches can generate an income stream is by building residential rental units on their properties. In keeping with their charitable and religious missions, helping the needy by building affordable housing units is attractive to churches and local governments. Churches can often find low interest or government backed loans to build affordable housing.

There are also churches in this area whose facilities are underutilized. This can be a substantial opportunity for a particular church, as better utilization of the property can both add vitality to the community and contribute to the church financially at the same time. At Alcott Law Group, we assist churches in evaluating how they might make the most advantageous use of their real estate assets.

The Church As A Landlord: Lease vs. License

The ability of prospective renters to pay the agreed rent is the most critical issue in deciding whether to rent to a particular individual or family. Because it can be difficult to evict a tenant who is not paying rent or is misusing the property, the church must make sure that the tenant is credit worthy. The church should gather as much information about the prospective renter as possible, including undertaking a background and credit check, and obtaining references. In addition, the church should require the payment of first and last month’s rent plus one month’s rent as a security deposit to protect the church against the possibility of default and of damage. If a tenant is not credit worthy, the church can require a co-signer who is and require the co-signer to execute a personal guaranty.

Lease vs. License Agreement

As a landlord, the church’s goal should be to grant the tenant a minimum amount of rights, so as to make dispossession or eviction of the user as easy as possible in the event of default or at the end of the lease term. New York’s Landlord and Tenant Law imposes heightened requirements on residential tenancies, and those formalities and requirements must be strictly followed. Therefore, churches should consider having their attorney draft a license agreement rather than a lease for the occupiers of its rental units.

The distinction between a lease and a license is that a lease is a conveyance of exclusive possession of specific property usually in consideration of the payment of rent, which vests an interest in the property to the resident. In contrast, a license merely gives permission to a person, who would otherwise lack permission, to occupy and use the property of the church.

When drafted properly, a license is revocable at the will of the licensor and creates no estate. The agreement should specify exactly what the user can and cannot do with the property, including physical changes to the involved space. With a license, the church can revoke the license “at will” and use self-help options, such as changing the locks, if the licensee violates the terms of the license by failing to pay rent or occupy the premises peacefully. With a lease, the tenant has a stronger legal position and a landlord can encounter months or years of lengthy litigation to regain possession of its real estate.

To create a license that would be interpreted by a court as a license as opposed to a lease, the following three criteria should be drafted into the document:

(1) a clause allowing the licensor to revoke “at will”;
(2) the retention by the licensor of absolute control over the premises; and
(3) the licensor’s supplying to the licensee all of the essential services required for the licensee’s permitted use of the premises.

Managing Liability: Insurance

A church has exposure to liability whenever someone walks through its doors. As a property owner, the church is liable for injuries that occur on its premises. Property rental means additional users and potential claimants, which individuals do not have the same level of concern for the longevity or condition of the church as its congregation and leadership. Since elimination of all risk is not possible, even through proper maintenance and operations, the church’s goal should be to shift that risk to others.

The first and best line of defense for a church and its officers is the church’s own insurance. The church should also require its tenants to purchase renter’s insurance policies. Insurance policies differ in terms of what they cover and deductible amounts. Thus, the church should work with a trusted insurance broker. A good insurance broker will be able to recommend how much coverage the church needs and get quotes from numerous insurers to get the most cost-effective policy.

A church increases the chances of avoiding loss if the renter/user has its own source of recovery in the event of a claim. As a practical matter, the church is more likely to avoid or minimize loss if the renter/user has its own insurance coverage. In particular, workers compensation and general liability coverage for the renter/user is important. Also, the church and the renter should understand what insurance applies in the event that the renter suffers damage or loss to its property, as through fire, flood, freezing, or theft.

Indemnification Agreements

The church’s lease agreement should contain a strong and unambiguous indemnification provision. The lease should provide that the renter will be responsible for losses arising out of its own use and occupancy of church property, and that it will protect the church from same. The language used in such agreements is highly variable, from aggressive language that indemnifies the church even if the church is at fault, to weaker language. Note, however, that indemnification is only as valuable as the assets that the tenant has; this is why ensuring that the renter has its own insurance is critical. If there is no insurance coverage, then the value of the indemnification depends on the renter’s own resources.

The best form of protection, more common for a major renter like a daycare center, is insurance coverage that names the church as an additional insured under the renter’s policy. This has several advantages. First, the church then is sure to have coverage for the risks covered under the policy. Second, the church will receive notice from the insurer if the policy is cancelled, such as for non-payment by the tenant.

Certificates of insurance are evidence that a particular insurance coverage exists. The certificate is not itself an insurance policy, nor is it a guarantee that the coverage will remain in place, but a certificate is a statement that coverage of a particular type exists as of the date of the certificate. To be binding, the certificate should be addressed to the church. Make sure that the certificate lists the types and amounts of insurance that the tenant has. The church should also request that the certificate be reissued every six to twelve months to evidence that the insurance remains in place.

Non-Liturgical Uses of a Church and Unrelated Business Taxable Income

When a church earns income from non-religious activities, for example running a restaurant, a nursery school, a day care center, or a social service program, the church risks diluting its main mission, which is normally limited to religious activities. If the church earns income on such endeavors unrelated to its mission, that income may be taxed under the Unrelated Business Income Tax (“UBIT”). If the church is generating too much unrelated business income, it could lose its tax-exempt status.

Exceptions to UBIT

Certain sources of income are excepted from UBIT. The most important exception in the case of renting property is the exception for passive income. Passive income includes income from rents and royalties. Therefore, there is no UBIT issue if the church receives income from affordable housing or other rental units. To avoid any issues, the church should consult with its legal counsel to structure the relationship legally and draft the lease.

Other Obstacles When Providing Housing

When adding residential units, the church will have to comply with municipal zoning regulations. Traditional church uses generally are exempt from use restrictions under zoning laws. However, a significant non-church use may draw attention and raise questions as to whether the use is allowed in the zoning district in which the church property is located. In addition, certain uses of property will require permitting. The types of permits that could be required are numerous. A church going through a redevelopment process must consult with competent counsel to navigate the applicable law.

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The article above is merely a summary of some of the issues a church can encounter when using real estate. If you are a church considering a real estate transaction or concerned about any of the issues set forth in the article above, please contact Alcott Law Group for additional assistance.