Trustees performing services on a trust’s behalf qualify the trust for the exception for real estate professionals to the passive activity loss disallowance.
The Tax Court held that a trust’s rental losses could be currently deducted since the trust qualified as a real estate professional. According to the court, the passive loss rules’ legislative history does not prevent a trust from being a real estate professional, as long as the trust materially participates in the activity.
Facts: Frank Aragona established the Frank Aragona Trust in 1979, naming himself as its sole trustee and naming his five children as beneficiaries. The trust owned rental real estate properties and developed real estate in Michigan. After Aragona’s death in 1981, the trust was managed by six trustees: his five children and one independent trustee. One of the children was “executive trustee” of the trust, and he and two other children were also full-time employees of Holiday Enterprises LLC, an entity wholly owned by the trust and disregarded for federal tax purposes that managed most of the trust’s rental real estate properties.
On its 2005 and 2006 income tax returns, the trust reported losses from its rental real estate activities and classified those losses as nonpassive, increasing the trust’s 2005 and 2006 net operating losses (NOLs), which were carried back to 2003 and 2004. The IRS issued a notice of deficiency after it classified the trust’s rental real estate activities as passive and in turn reduced the trust’s NOL carrybacks to 2003 and 2004. The IRS also reclassified as fiduciary fees $302,400 in trustee fees that the trust had deducted against rental income.
Issues: Generally, rental activities are considered passive activities regardless of whether the taxpayer materially participates in the activities, limiting the deductibility of any losses from those activities. However, rental real estate activities that a taxpayer materially participates in are not considered passive activities if the taxpayer qualifies as a real estate professional. A taxpayer is considered to materially participate in an activity if the taxpayer is involved in its operations on a regular, continuous, and substantial basis. To be a real estate professional, a taxpayer must perform personal services in real estate trades or businesses that exceed 50% of the personal services performed in all trades or businesses, and the taxpayer must perform more than 750 hours of services in those real property trades or businesses in which he or she materially participates.
Regs. Sec. 1.469-9(b)(4) defines personal services as work performed by an individual related to a trade or business. The IRS argued that no trust can qualify for the real estate professional exception because a trust cannot perform personal services. The IRS further argued that, even if a trust could qualify for the exception, the Frank Aragona Trust did not materially participate in real property trades or business because its employees’ activities should not be considered when determining material participation.
Holding: The court concluded that a trust can perform personal services when its “trustees are individuals, and they work on a trade or business as part of their trustee duties.” It added that if Congress had wanted to exclude trusts as real estate professionals, it could have limited the exception to natural persons.
In the absence of statutory and regulatory guidance concerning how a trust materially participates in an activity, the court held that the trustees’ activities on behalf of the trust and of the three trustees as employees of Holiday Enterprises should be considered because Michigan law requires trustees “to administer the trust solely in the interests of the trust beneficiaries.” The court did not rule out considering the activities of the nontrustee employees; however, it held that the trustees’ activities were sufficient to determine that the trust materially participated in the real estate operations.
While the 50% and 750-hour tests must also be met to qualify as a real estate professional, the court held that the IRS in this case did not argue those points; instead, the Service argued only that a trust can never be a real estate professional and that the Aragona trust did not materially participate in real property trades or businesses. As a result, the court held the trust was a real estate professional in the context of the arguments raised. Due to this finding, the court found it unnecessary to decide whether the trustee expenses were rental expenses or fiduciary fees.
By Charles J. Reichert, CPA, instructor of
accounting, University of Minnesota–Duluth.