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Sunday, October 12, 2014

Trusts and Real Estate


Throughout my career, I have not encountered a better tax benefit than that afforded to real estate professionals.

Rental activities are generally regarded as passive, which means that losses from rental activities can only offset income from other passive activities. However, the Internal Revenue Code contains an exception. Losses from real estate activities may not be treated as passive (generally referred to as “nonpassive”) if the following assessments are met:

  • More than half of the personal services performed in trades or businesses by the taxpayer during the year are performed in real property trades or businesses in which he/she materially participates; and,
  • The taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which he/she materially participates.

Generally, only taxpayers who make a living in real estate meet the above criteria. However, those lucky enough to meet the above qualifications are allowed to offset their rental real estate losses with any type of income, whether it is passive or non-passive. But, what happens when real estate is held in a trust? Can a trust obtain the same benefits as a real estate professional?

Trusts are legal entities usually created so that property is held by one party (the trustee) for the benefit of another (the beneficiary). The trustee is given legal title to the trust property but is obligated to act for the good of the beneficiaries. (The trustee is said to have a fiduciary duty to the beneficiaries). Trusts generally own various assets such as stocks, bonds and real estate that generate income which may be distributed (and taxable) to the beneficiaries or kept (and taxed) inside the trust.

As previously mentioned, rental real estate losses generated by a real estate professional’s assets may generally offset other types of income including interest, dividends, capital gains, business income, etc.  However, what happens if the assets are transferred to a trust?

In a recent court case, Frank Aragona Trust, the Tax Court held the decision that a trust can qualify for the real estate professional exception to the passive loss rules in certain situations. The court found that the trust could perform personal services in the form of the services performed on its behalf by the individual trustees. In this court case, the trust conducted activities involving real estate, real estate holding operations and real estate development.

Some of the rental real estate activities were conducted directly, some through wholly owned entities, some through entities in which the trust owned majority or minority interests, and in which two of the trustees (who also happened to be beneficiaries) owned minority interests. In addition, a limited liability company (LLC), wholly owned by the trust, and managed most of the trust’s rental real estate properties. The LLC also employed three of the trustee beneficiaries on a full-time basis.

The Tax Court stated 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.” Additionally, the court found that the trust had materially participated in the real property trades or businesses and therefore qualified for the real estate professional exception even if their services were provided as employees of the LLC.

The court stated that the trustees were required by state law to administer the trust solely in the interest of the trust beneficiaries and were not relieved of that requirement by acting through an entity (the LLC) that was wholly owned by the trust. The court stated that the trustees participated in the trust’s real estate operations full-time, the trust’s real estate operations were substantial and the trustees handled practically no other businesses on the trust’s behalf.

This is good news for trusts that hold real estate assets and its trustees provide substantial services to qualify for the real estate professional exception. Trusts that qualify for the exception may offset rental losses with other types of income thereby reducing or eliminating tax that would have to be paid on trust income by either the trust or, if distributed, by the beneficiaries.

Another important factor to note is that the above court ruling impacts the effect of the Net Investment Income Tax. The Net Investment Income Tax imposes a 3.8% tax on net investment income (undistributed net investment income in the case of trusts) when Adjusted Gross Income surpasses a certain threshold. For individuals the threshold starts at $200k; for trust the threshold is $12,150.

For purposes of this tax, investment income includes: interest, dividends, annuities, royalties, rents derived other than in the ordinary course of a trade or business that is a nonpassive activity, and to income from passive activities. The holding of the Tax Court provides for planning opportunities for a trust to qualify rental losses as a nonpassive activity that may help avoid or reduce the net investment income tax.

This recent court case may have a substantial impact upon taxes paid by certain trusts and individuals who meet the above mentioned criteria.  We encourage you to contact your CPA to discuss whether and how this ruling may impact you.

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