- DENNIS FORDHAM
- Posted On
Estate Planning: Good news for trusts that manage real estate
In the recent Frank Aragona Trust case, 142 T.C. No. 9 (2014), the US Tax Court reached a taxpayer favorable decision, one that benefits trusts that materially participate in real estate business activities.
For years, the IRS has steadfastly refused to allow trusts to deduct net operating losses related to real estate activities against other ordinary income unrelated to the real estate; based on the so-called “passive activity loss” limitations.
Now, it may be possible for such trusts to deduct the losses associated with the real estate against other profitable activities to reduce income taxes.
In Frank Aragona Trust, the trust owned rental real-estate properties and was involved in other real-estate business activities such as holding real estate and developing real estate that are considered per se passive activities unless the Trust qualified for the “material participating exception.”
At issue was whether the activities of the individual trustees would be treated as materially participating in real-property trades or businesses.
That is, could the trustee(s)’ own involvement in the operation of real-property trades or businesses on a regular, continuous, and substantial basis count as material participation.
The material participation exception applies when more than one-half of the personal services performed in trades or businesses by the taxpayer are performed in real-property trades or businesses where the taxpayer materially participates and performs more than 750 hours of services during the year in real-property trades or businesses in which the taxpayer materially participates.
The Tax Court held that, “[a] trust is capable of performing personal services within the meaning [because …] services performed by individual trustees on behalf of the trust may be considered personal services performed by the trust.”
The Tax Court rejected the IRS’s argument that a trust is incapable of providing personal services, reasoning that, “[I]f 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.’”
Also, the Tax Court rejected the IRS’s argument the work of certain trustees as employees of an LLC that managed most of the Trust’s rental real estate properties – which was wholly owned by the Trust – should not count because such work was performed as employees and not as trustees.
The Tax Court counted the work of the trustees which they performed as employees of the Trust’s wholly owned LLC because, “trustees are not relieved of their duties of loyalty to beneficiaries by conducting activities through a corporation wholly owned by the trust.”
However, the Tax Court did, “not decide whether the activities of the trust’s nontrustee employees should be disregarded.”
Given that the IRS expressly disregards the work of non trustee employees towards the material participation test, what is certain is that trusts can count the work of their trustees (even if performed as employees of a corporation wholly owned by the same trust).
Work performed by trustees as employees of a corporation that is unrelated to the trust might not count.
The Frank Aragona Trust decision is good news for those ongoing trusts that actively manage real properties as a business and have income tax losses in such activities. It may now be possible for such losses to be deducted against other activities.
While the case resolves some uncertainties it does not resolve all uncertainties, most importantly whether to include the activities of trust employees who are not themselves trustees towards satisfaction of the material participation requirement.
Dennis A. Fordham, attorney (LL.M. tax studies), is a State Bar Certified Specialist in Estate Planning, Probate and Trust Law. His office is at 870 S. Main St., Lakeport, California. Fordham can be reached by e-mail at This email address is being protected from spambots. You need JavaScript enabled to view it. or by phone at 707-263-3235. Visit his Web site at www.dennisfordhamlaw.com .