United States: How A Trust Qualified For An Exception To PAL Rules

In a favorable decision for trusts that hold real estate assets, the U.S. Tax Court has held that such a trust qualified for the real estate professional exception and was therefore exempt from the limitations on passive activity losses (PALs). The court's holding also means the trust can avoid the new 3.8% net investment income tax (NIIT) that applies to passive activity income.

Real Estate Professional Rules

"Passive activity" is defined as any trade or business in which the taxpayer does not materially participate. "Material participation" is defined as involvement in the operations of the activity that is regular, continuous and substantial. Rental real estate activities are generally considered passive regardless of whether you materially participate.

Internal Revenue Code Section 469 grants an exception from restrictions on PALs for taxpayers who are real estate professionals. If you qualify as a real estate professional and you materially participate, your rental activities are treated as a trade or business, and you can offset any nonpassive income with your rental losses. You may also be able to avoid the NIIT as long as you are engaged in a trade or business with respect to the rental real estate activities (that is, the rental activity is not incidental to a nonrental trade or business).

To qualify as a real estate professional, you must satisfy two requirements: 1) More than 50% of the "personal services" you perform in trades or businesses are performed in real property trades or businesses in which you materially participate, and 2) you perform more than 750 hours of services in real property trades or businesses in which you materially participate.

The IRS Challenge

In Frank Aragona Trust v. Commissioner of Internal Revenue, the trustee had formed a trust in 1979, with his five children as beneficiaries. He died in 1981 and was succeeded as trustee by six trustees — the five kids and an independent trustee. Three of the kids worked full-time for a limited liability company (LLC), wholly owned by the trust, that managed most of the trust's rental properties and employed about 20 other individuals, as well.

During 2005 and 2006, the trust reported nonpassive losses from its rental properties, which it carried back as net operating losses to 2003 and 2004. The IRS determined that the trust's real estate activities were passive activities, and the challenge landed in the Tax Court.

A Trust as a Real Estate Professional

The IRS contended that a trust could not qualify for the real estate professional exception because a trust cannot perform "personal services," which regulations define as "any work performed by an individual in connection with a trade or business." The Tax Court rejected this argument. It found that, if a trust's trustees are individuals who work on a trade or business as part of their trustee duties, their work can be considered personal services that can satisfy the exception's requirements.

Evaluating Material Participation

The IRS alternatively argued that, even if some trusts can qualify for the exception, the Aragona trust did not, because it did not materially participate in real property trades or businesses. The agency asserted that only the activities of the trustees can be considered, not those of the trust's employees. And the IRS claimed the activities of the three trustees who worked for the LLC should be deemed activities of employees and not trustees.

The Tax Court did not decide whether the nontrustee employees' activities should be disregarded in determining if the trust materially participated in its real estate operations. But it held that the activities of the trustee employees should be considered. It also noted that trustees are not relieved of their duties of loyalty to beneficiaries just because they conduct activities through a corporation wholly owned by the trust.

Be Prepared

For technical reasons, the trust in this case was not required to prove that it satisfied the two-prong real estate professional test. Other trusts wishing to take advantage of the exception should be prepared to do so.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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