Tax Issues for Real Estate Trusts

The Power of Trust. The Power of Growth. The Power of Teamwork.
Income Tax Issues for Trusts
Invested in Real Estate
Selected Topics
Presented by: Amy Joyce
1

Overview
I. Non-Grantor* Trusts as Real Estate Professionals
II. Proper Reporting of Depreciation
III. Fiduciary Accounting Income
*The discussion herein relates solely to non-grantor trusts. Because grantor trusts are disregarded for
income tax purposes, the passive activity loss rules are determined at the grantor, not at the trust, level.
2

Trusts & Passive Activity Rules
3
Passive Activity Loss Rules for Trusts – Background:
 The Code Sec. 469 passive activity loss rules prevent taxpayers from deducting their
losses from “passive” activities against income from “non-passive.”
 Sec. 469(a)(2)(A) explicitly identifies estates and trusts as taxpayers to whom the
passive activity rules apply.
 Sec. 469 defines a passive activity as a trade or business in which the taxpayer does
not materially participate.
 A taxpayer materially participates if the taxpayer is involved in the activity on a
“regular, continuous, and substantial.” Reg. 1.469-5T(a) provides seven alternative
tests to determine material participation.
 Sec. 469(c)(2) treats a rental activity as per se passive. But Code Sec. 469(c)(7)
provides an exception for rental real estate activities performed by a taxpayer
engaged in the real estate business, i.e., a “real estate professional.”

Trusts & Passive Activity Rules
4
Passive Activity Loss Rules for Trusts – Background (cont’d):
 The real estate professional exception requires the satisfaction of a two-prong test.
For the tax year, the taxpayer must:
1. Perform more than half of his “personal services” in real property trades or
businesses in which he materially participates; and
2. Perform more than 750 hours of services in real property trades or businesses in
which he materially participates.
 Reg. 1.469-9(b)(4) defines “personal services” as any work performed by an individual
in connection with a trade or business.
 Although Regulations address in detail how individuals or corporations meet the
material participation requirement, the Treasury Department “reserved” regulations
addressing the application of the material participation rules in the context of an estate
or trust.
 Nearly twenty-five (25) years later and regulations still have not been issued!

Trusts & Passive Activity Rules (cont’d)
5
Material Participation by Trusts in Trade or Business Activities:
 1986 Legislative History: Can a trust materially participate?
S. Rept. No 99-313, at 735 (1986), 1986-3 C.B. 1, 735 states that a trust “is treated as
materially participating in an activity … if an executor or fiduciary, in his capacity as
such, is so participating.”
 2003 Case Law: Can a trust’s employees’ or agent’s participation be considered?
Mattie Carter Trust v. United States, 256 F. Supp.2d 536 (N.D. Tex. 2003)
• The Trust owned a 15,000 acre cattle ranch. The trust employed a ranch manager as well as
other employees to operate the ranch. The sole trustee oversaw all actions of the employees
and testified that he dedicated a substantial amount of time and attention to ranch activities.
• IRS, citing the legislative history, argued that the work performed by the trustee, individually, did
not amount to “regular, continuous, and substantial” participation by the trust. Actions of the
ranch manager and other employees were disregarded.
• The Court, however, ruled that “material participation” should be tested by whoever participates
on behalf of the trust, whether trustee or employee, since each represents the trust. The also
noted that that trustee’s activities alone, were regular, continuous and substantial.

6
Material Participation by Trusts in Trade or Business Activities (cont’d):
 2007 TAM: What if a “special trustee” is involved in the business?
In Technical Advice Memorandum 200733023, IRS refused to follow Mattie Carter and
continued to assert that the determination of whether a trust materially participates in a
trade of business is made based solely on the activities of trustees in their capacity as
trustees.
• The special trustee was involved in some of the day-to-day operations of the
business, however, the decision-making authority remained solely in the hands of
another trustee. IRS concluded that the “special” trustee was appointed solely to
satisfy the material participation standard of Section 469(h).
 2010 PLR: Can a trust materially participate in pass-through entity’s business?
Seemingly inconsistent with the 2007 TAM, IRS liberally applied the legislative history
language and did not even mention Mattie Carter.
• The issue was whether a trust could materially participate in the business of a
subsidiary (Sub 2) of a subsidiary (Sub 1) owned by a partnership in which the trust
owned an interest. IRS concluded that the trust could materially participate.

7
Material Participation by Trusts in Trade or Business Activities(cont’d):
 2013 TAM: IRS’s Most Recent Strict Attack – Activities of Co-Trustee Who Was
President of Business Not Counted in Determining Trust’s Material Participation.
In Technical Advice Memorandum 201317010, IRS again refused to follow Mattie
Carter and continued to assert that the determination of whether a trust materially
participates in a trade of business is made based solely on the activities of trustees in
their capacity as trustees.
• The Trust had interests in two S corps. The co-trustee, A, served as president of S Corp. 1 and
owned shares in S Corp. 2 but did not participate in the day-to-day operations of the companies.
• Taxpayer asserted that the co-trustee’s duties as fiduciary, president and shareholder were
interrelated and that such duties were performed simultaneously. Therefore, all the activities
should be considered and credited in determining whether the trusts materially participated.
• The IRS, however, focused on two issues: (1) A’s power as special trustee was limited to voting
and selling stock, and (2) A’s activities as president were not conducted in A’s fiduciary role as a
trustee of the trust. IRS concluded that the special trustee’s activities did not rise to the level of
“regular, continuous, and substantial” participation by the trust.

8
Material Participation by Trusts in Rental Activities: CCA
 2012 CCA: Trusts Cannot Satisfy the Real Estate Professional Exception
In CCA 201244017, IRS stated explicitly that a trust cannot meet the special material
participation test of a real estate professional in Sec. 469(c)(7). IRS theory is:
• Only individuals are capable of performing “personal services” (as defined in 1.469-
9(b)(4)), and the statute specifically states that the personal services must be
performed by the taxpayer.
• Sec. 469(c)(7)(D)(i) provides a separate “gross income” test for closely held C
corporations to qualify for treatment under section 469(c)(7), but the statute
otherwise does not provide any rules for trusts, estates, or personal service
corporations.
• Legislative history for Sec. 469(c)(7) explicitly states that the provision is intended to
apply to individuals and closely held C corporations. Therefore, trusts, estates, and
personal service corporations do not fall within the definition of “individuals” for this
purpose.

9
Material Participation by Trusts in Rental Activities: Aragona Trust
Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014).
Brief Facts:


10
Material Participation by Trusts in Rental Activities (cont’d): Aragona Trust
Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014).
Full Tax Court addressed two major issues:
1. The Court held that a trust can qualify as a real estate professional, rejecting the IRS
argument that a trust is incapable of performing personal services.
 The Court observed that if the trustees are individuals, and they work on a trade or
business as part of their trustee duties, their work can be considered work performed
by an individual in connection with a trade or business.
2. The Court held that a trust can materially participate in a business – and it isn’t only the
fiduciary acting solely in his fiduciary capacity that counts in making that determination.
 The Court rejected the Service’s argument that even if some trusts can qualify for the
real estate professional exception, the Aragona Trust did not qualify because it had
not materially participated in its real estate trade or business activities (which is
required to satisfy both the personal services and 750 hour requirements of Sec.
469(c)(7)).

11
What Aragona does tell us (explicitly):
1. Trusts Can Satisfy the Real Estate Professional Exception (IF the trustees are individuals).
2. Activities of Trustee-Employees are Counted for Material Participation – Trustees are not relieved of
their duty of loyalty to the beneficiaries by conducting activities through an entity wholly owned by the
Trust. Under state law, the “Trustee Hat” cannot be removed and replace with the “Employee Hat.”
3. Activities of Trustees Who Also Co-Own Minority Interests in the Business are Counted – Trustees’
interests as owners are compatible with the Trust’s goals for the success of the business.

12
What Aragona does tell us (implicitly):
1. Multiple Fiduciaries – How many must be involved in the business for the trust to materially
participate? Probably not more than half. Three of the six Aragona trustees were employed full-time
in the business.
2. Can an Institutional Trustee Materially Participate? Probably no, because not an “individual.”
3. Can an Estate Materially Participate? The answer should be yes, as both executors and trustees
can be (and often are) individuals and both have the same duty of loyalty to the beneficiaries.
What the Aragona case does not tell us:
1. Are Activities of Non-Trustee Employees Counted? – The Aragona Court did not decide this issue
because it wasn’t raised and IRS has publicly refused to follow Mattie Carter.
2. How Does One Count Trustee Hours for Real Estate Professional Status? IRS did not argue, and
the Court did not address, the counting of hours.
3. Is Material Participation by a Decedent Tacked to the Estate? Not discussed in any case or ruling,
yet Sec. 469 explicit applies to trust and estates.

Proper Reporting of Depreciation
13
NON-GRANTOR TRUSTS
Default Rule – Depreciation must be allocated between the trust and its beneficiaries on the basis of
the amount of fiduciary accounting income (“FAI”) allocable to each. IRC 167(d). The trust document
or local law may override this allocation. FAI is determined before taking into account any depreciation
deduction.
Depreciation Reserve – If the trust document (or local law) requires the trust to establish a reserve for
depreciation, then the depreciation expense will be first allocated to the amount of income set aside in
the reserve, with the excess, if any, apportioned under the default rule.
Example (no reserve & FAI > depreciation): Trust has $15,000 net rental income (excluding
depreciation) and distributes $12,000 (80% of FAI) to the Beneficiary. $9,000 of depreciation is
permitted for the tax year. Beneficiary’s K-1 will reflect $12,000 of “net rental real estate income”
and $7,200 (80% of $9,000) of “directly apportioned deductions.”
Example (no reserve & depreciation > FAI): Assume $4,000 net rental income, $4,000
distributed to Beneficiary, and $7,000 depreciation. Beneficiary K-1 reflects $4,000 rental income
and $7,000 separately stated depreciation. Beneficiary may report a net loss of $3,000 on Form
1040, subject to passive activity loss rules. See Rev. Rul. 74-530.

Proper Reporting of Depreciation (cont’d)
14
ESTATES
Default Rule, Same as Trusts – Depreciation deductions are allocated to the Estate and Beneficiary
on the basis of the pro-rate FAI attributable to each, i.e., out of the total FAI how much was distributed
to the Beneficiary and how much was retained by the Estate?
Depreciation Reserve, Different than Trusts – A required reserve is not “subtracted off the top.”
Rather, is affects the amount of income (FAI) that serves as the denominator in applying the allocation
formula. The gross amount of the depreciation deduction is the amount allocated.
Example (no reserve & TAI > depreciation): The will does not require a depreciation reserve.
Estate has $35,000 of FAI, exclusive of $15,000 depreciation. Executor distributes $21,000 (60%
of FAI) to Beneficiary. Estate deducts depreciation of $6,000 (40% of $15,000 total depreciation)
and Beneficiary reports depreciation of $9,000 (60% of total $15,000 depreciation) .

Proper Reporting of Depreciation (cont’d)
15
THE PRACTICAL PROBLEM OF PASS-THROUGH DEPRECIATION
Rev. Rul. 61-211 – If the partnership agreement provides a special allocation of depreciation to a
partner that is an estate or trust, then such partner could look through the partnership and claims its
share of depreciation as if realized directly from the underlying property.
Rev. Rul. 74-71 – Modified Rev. Rul. 61-211 by dropping the requirement that the partnership
agreement permit or require a special allocation of depreciation. The Ruling required the trust or
estate to look through the partnership if not doing so would change the tax liabilities of the fiduciary
and beneficiary. This ruling conflicts with general reporting rules for partnerships.
Real Life – In practice, partnerships generally do not separately state depreciation due to the
administrative burden. Although a fiduciary could fulfill this requirement for separately stated
depreciation by requesting the specific information from the partnership after receiving the Schedule
K-1 from the partnership, it may be difficult or impossible to obtain this information in a timely manner.

Fiduciary Accounting Income
16

Tax Issues for Real Estate Trusts

Recommended

Recommended

More Related Content

Viewers also liked

Viewers also liked (7)

Similar to Tax Issues for Real Estate Trusts

Similar to Tax Issues for Real Estate Trusts (20)

Tax Issues for Real Estate Trusts