Case — Trusts and Passive Activity Losses

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TL Case Summ

THE QUESTION

Can a trust meet the requirements for claiming the “real estate professional” exception to the passive activity rules?

THE DISPUTE

Taxpayer Says: The word “individual” in the regulation should be interpreted to include a trust.

Internal Revenue Service Says: A trust is incapable of performing “personal services” because the regulation defines “personal services” to mean “any work performed by an individual in connection with a trade or business”, and a trust is not an individual.

THE LAW

From Internal Revenue Code Section 469(a)(1): Provides that a taxpayer’s passive-activity loss is disallowed for the year if the taxpayer is “described in” section 469(a)(2).

From Internal Revenue Code Section 469(a)(2): Describes the following taxpayers: individuals, estates, trusts, closely held C corporations, and personal service corporations.

From Internal Revenue Code Section 469(c)(2): Any rental activity is considered a passive activity, even if the taxpayer materially participates in the activity.

From Internal Revenue Code Section 469(c)(7): Provides that section 469(c)(2) does not apply to the rental real-estate activity of any taxpayer who meets the requirements of section 469(c)(7)(B).

From Internal Revenue Code Section 469(c)(7)(B): Consists of two tests. The first test is met if more than one-half of the “personal services” performed in trades or businesses by the taxpayer during the taxable year is performed in real-property trades or businesses in which the taxpayer materially participates. The second test is met if the taxpayer performs more than 750 hours of “services” during the year in real property trades or businesses in which the taxpayer materially participates. Both tests must be met.

From Treasury Regulation 1.469-9(b)(4): Defines “personal services” to mean “any work performed by an individual in connection with a trade or business.”

THE CAUSE OF THE DISPUTE

The passive activity rules limit the amount you can currently deduct from rental real estate activities. In general, losses from rental activities are passive, unless an exception applies.

One exception is when you qualify as a “real estate professional.” You’re considered a real estate professional when more than half the personal services you perform during the year are in real property businesses, and you work more than 750 hours during the year in real property businesses.

Both criteria require that you materially participate in the real estate activity, which means you must be regularly, continuously and substantially involved in the activity. (Activity means the rental property, either individually, or collectively if you have made a valid “grouping” election to combine your properties.)

The question in this case is twofold: 1) Whether the trust can qualify as a real estate professional, and 2) whether the trust materially participated in real property trades or businesses.

Due to the detail of each argument, this Taxing Lessons case summary will deal with only the first question. A summary of the second question will be provided in a popup after the case discussion.

In this case, the taxpayer is a trust that owned rental real estate properties and also held and developed real estate. During 2005 and 2006, the real estate rentals generated losses, which the trust deducted on its federal income tax return as ordinary losses. Those losses offset gains from the other trust activities of real estate holdings and development projects.

The IRS disallowed the current losses from the real estate rentals. The IRS says that the exception to the passive loss rules for real estate professionals is not intended to apply to trusts, because a trust cannot perform “personal services”, which are defined by regulation 1.469-9(b)(4) as “work performed by an individual in connection with a trade or business.”

In addition, the IRS says congress did not intend the exception to apply to trusts, because the committee reports describing the regulation state the real estate professional exception “applies to individuals and closely held C corporations.”

The taxpayer argues that the word “individual” in the regulation should be interpreted to include a trust.

WHAT WOULD YOU DECIDE?

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THE COURT’S DECISION

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
Sorry, wrong answer :(
For the Taxpayer. We reject the IRS’s argument. A trust is an arrangement whereby trustees manage assets for the trust’s beneficiaries. 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.” We conclude that a trust is capable of performing personal services and therefore can satisfy the section 469(c)(7) exception. Indeed, if Congress had wanted to exclude trusts from the section 469(c)(7) exception, it could have done so explicitly by limiting the exception to “any natural person.” That Congress did not use the phrase “natural person” but instead used the word “taxpayer” in section 469(c)(7) suggests that Congress did not intend to exclude trusts from the section 469(c)(7) exception, despite what the IRS argues here.
The IRS argument is that the trust did not materially participate in real property trades or businesses because only the activities of the trustees can be considered, and the activities of the employees of the trust must be disregarded.

The court says there is no regulatory guidance for determining how a trust can materially participate in an activity. Following Michigan law, the court determined the activities of the employees should be considered, and that the trust did materially participate in real estate businesses.

The overall result: The court decided for the taxpayer on all issues finding that the trust qualified for the real estate professional exception, the trust performed personal services, the services of the individual trustees were personal services performed by the trust, and the trust materially participated in real property trades or businesses.

Editorial note: The court noted that the IRS raised only two arguments—first, that the real estate professional exception did not apply to trusts, and second, that this trust did not materially participate in the real property trades or businesses because the services of the trust employees did not count. The court reached its decision that the trust qualified for the real estate professional exception based only on those two issues.

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