Beneficiary lives in house owned by trust -- REVISITED

[appelman]

Let me rephrase this whole question:

A trust owns income-producing investments and a non-income-producing house lived in by the income beneficiary, who is also the trustee. Which, if any, of the current expenses of the house are deductible expenses of the trust? Maintenance? Utilities? Insurance? Real estate taxes? Capital expenditures? Other? If not deductible but are paid out of trust funds, are they considered distributions to the beneficiary?

[Bees Knees]

You cannot use a trust to turn personal expenses into tax deductible expenses. Thus, anything that is a non-deductible personal living expense to an individual is a non-deductible expense to the trust paying such expenses for an income beneficiary.

There are numerous court cases where tax scam promoters sell schemes to gullible taxpayers trying to deduct their living expenses by putting their house and other personal assets inside a trust. The courts always disregard the entity when the transaction is in fact just another personal living expense.

[Bees Knees]

If not deductible but are paid out of trust funds, are they considered distributions to the beneficiary?

You can call it what you want, but it is not deductible as an income distribution because income distributions are deductible by the trust (distributions deducted against income on Sch B only include distributions of taxable income, not distributions of corpus or tax-exempt income).

Keep in mind a trust is not like a partnership or a corporation where you have to attach a balance sheet. The 1041 has no reconciliation of funds being used for personal expenses or distributions of corpus. It’s an income tax return that only cares about taxable income and tax deductible expenses. Trust expenses that are non-deductible basically have no where to go on the 1041 so it really does not matter what you call them.

[Gretel]

Agreed but

...any trust has two components: 1041 income and expenses and trust funds and how they are used. I actually had the same questions on my mind, not for income tax purposes but for purposes of using funds from corpus to pay for home expenses. It seems this is more of a legal question, determined by State law? Maybe only if trust document stipulates that such expenses are to be paid from corpus can they be paid from corpus? Am I totally off?

[Burke]

Is this a simple trust or a complex trust? Simple trusts only pay trust income to the beneficiary. Complex trusts pay both income and principal. A complex trust shows all distributions on Line 10 of the 1041, which these personal living expenses would be considered as. The trust document would indicate which this is.

[appelman]

This is a complex trust.

It was set up as a revocable living trust by the settler during his lifetime. At his death, it became an irrevocable trust to support the income beneficiary/successor trustee for her lifetime, as well as to provide her with a place to live. At her death, a public charity is designated as the successor trustee, which will administer the trust for charitable purposes until its termination.

Since the income beneficiary has no terminal interest in the corpus of the trust, including the house, one might ask whether some expenses of the house might be deductible by the trust as investment expenses for the protection and preservation of the property.

[Burke]

Hmmm....what you have here, as far as the beneficiary is concerned, is a life estate situation. I still believe, however, that these are personal living expenses which the trust is paying for, and would be treated the same as if it were paying her health insurance, medical bills, car payments, etc etc. All of these are considered distributions and not deductible expenses. Unless the house is being rented for income, and the trust was filing a Schedule E, they would not be deductible. There might be a case for mortgage interest and real estate taxes. Interest and taxes are specifically allowed. Does the trust have the right to sell the property if necessary? You say the trust has a successor trustee, but at the current bene's death, who is the remainderman/beneficiary? You also state "until its termination." Is it specified in the trust?

[appelman]

Sale, termination, remainderman, etc.

Hmmm....what you have here, as far as the beneficiary is concerned, is a life estate situation. I still believe, however, that these are personal living expenses which the trust is paying for, and would be treated the same as if it were paying her health insurance, medical bills, car payments, etc etc. All of these are considered distributions and not deductible expenses. Unless the house is being rented for income, and the trust was filing a Schedule E, they would not be deductible. There might be a case for mortgage interest and real estate taxes. Interest and taxes are specifically allowed. Does the trust have the right to sell the property if necessary? You say the trust has a successor trustee, but at the current bene's death, who is the remainderman/beneficiary? You also state "until its termination." Is it specified in the trust?

Trust may sell property as deemed necessary. Trust terminates 21 years after death of income beneficiary. The successor trustee (a public charity) is also the remainderman.

And to muddle things further, there is a clause "Protection of Trust Property," that reads:

"The trustee shall pay, out of trust estate, the property taxes, assessments, insurance, maintenance and repairs on the trust property."

[Burke]

The trust may direct whatever the grantor wishes as far as what it should pay for or distribute. That doesn't make it a deductible expense on the tax return. The document can direct the trust to pay for the bene's medical expenses, for instance, but that doesn't mean the trust can deduct it. Generally, estates will deduct these items as it only holds the property long enough for it to sell. What we have to determine here is, what is a deductible expense and what is a distribution to (or on behalf of) the beneficiary. So, the trust could sell the house at any time, regardless whether the bene is still living or not? I still think interest and taxes are the only 2 items it can deduct. Will try to research further and let you know if I find anything. One other thing, does the trust direct that the bene is to receive only the income, or does it have the discretion to make distributions from principal as well?

[appelman]

Further facts.

The trust may direct whatever the grantor wishes as far as what it should pay for or distribute. That doesn't make it a deductible expense on the tax return. The document can direct the trust to pay for the bene's medical expenses, for instance, but that doesn't mean the trust can deduct it. Generally, estates will deduct these items as it only holds the property long enough for it to sell. What we have to determine here is, what is a deductible expense and what is a distribution to (or on behalf of) the beneficiary. So, the trust could sell the house at any time, regardless whether the bene is still living or not? I still think interest and taxes are the only 2 items it can deduct. Will try to research further and let you know if I find anything. One other thing, does the trust direct that the bene is to receive only the income, or does it have the discretion to make distributions from principal as well?

If the trust sells the property, it is supposed to provide alternative accommodation for the beneficiary. It can distribute anything as needed to meet the reasonable needs of the beneficiary, without regard to beneficiary's other resources.

And the provision that deductions are allowed "for the management, conservation or maintenance of property" would seem to offer some wiggle room.

[Burke]

I think I found what you need. "No deduction is allowed for expenses of non-income producing property, such as a family residence, even though the trust may provide for such payments in its document." See Alfred I Dupont Testamentary Trust vs Commissioner, 514 F 2d 917 (5th Circuit Court); and Fuller vs Commissioner, 9 TC 1069.

[appelman]

Thank you, Burke.

I think I found what you need. "No deduction is allowed for expenses of non-income producing property, such as a family residence, even though the trust may provide for such payments in its document." See Alfred I Dupont Testamentary Trust vs Commissioner, 514 F 2d 917 (5th Circuit Court); and Fuller vs Commissioner, 9 TC 1069.

That seems to settle it, with the exception of real estate taxes, which should be deductible regardless of income production. The moral is not to trust your intuitions.

[Burke]

I said real estate taxes earlier, as I was falling back on my experience with estates where the property is held for sale. But I cannot say for certain even they would be allowed here. The court case I cited did not deal with that item, just other maintenance and upkeep, improvements, etc.

[appelman]

Well, I think we have a good case there.

Considering that the owner of real property can deduct the property tax under pretty much any circumstances. Thanks again for the good info.

I said real estate taxes earlier, as I was falling back on my experience with estates where the property is held for sale. But I cannot say for certain even they would be allowed here. The court case I cited did not deal with that item, just other maintenance and upkeep, improvements, etc.

[Burke]

I believe you are on pretty firm ground. The instructions for Form 1041 specifically indicate real estate taxes, sales taxes or state and local income taxes, and personal property taxes without any exceptions. Also, just FYI, for mortgage interest.... a "qualified residence of a beneficiary is treated as qualified (principal residence or second home) residence interest, if it would be a qualified residence if owned by the beneficiary. The bene must have a present interest in the trust or an interest in the residuary of the trust."