Rental RE in a Trust - qualifies for $25,000 special allowance?

[zhpcapital]

Client inherited a rental property from father in 2009, but property is held in a Trust in client's name until she turns 45. I am doing the Trust's 1041 this year for first time. (Previous preparer had many, many errors from what I can tell, but that is a story or two for another day.) The client (both fiduciary and beneficiary of the Trust) definitely actively participates, arranging maintenance, repairs, purchases of appliances, approves renter etc.

It appears perfectly clear to me that the Trust cannot actively participate in the activity. And the depreciation must be allocated to the beneficiary, not to the Trust's Schedule E. So the K-1 produces net Rental RE income, and allocated depreciation, which offsets all the Net Income and then a bit. So when I transfer the K-1 activity to my client's individual return, the return shows a small loss. Since the loss is passive, she can't take it. But since she 'actively' participates in the rental activity, it seems she would be entitled to the $25,000 special allowance. Can the loss change it's nature transferring from the Trust return to my client's return, or do we have to carry the loss forward?

[Burke]

I am not sure what you mean by "the depreciation must be allocated to the beneficiary." When a trust owns a rental property, it takes all the usual deductions including depreciation. However, a trust cannot take a rental loss. Material participation is not considered. So it carries over within the trust from year to year until sold, or until it has a profit from that activity. If the property is disbursed to the beneficiary, then the bene takes the trust's adjusted basis, and it will be reported on the bene's tax return after that. The suspended losses go with the property. Whether the bene can take them or to what extent, will depend on his tax situation at that time.

[zhpcapital]

Burke, thanks for taking a look at this. I think we come to the same place, which is that my client does not get to take the loss despite her active participation.

BTW, here is the info I relied on for a Trust's depreciation, from Form 1041 instructions. Maybe I have mis-read something?

"A trust or decedent's estate is allowed a
deduction for depreciation, depletion,
and amortization only to the extent the
deductions are not apportioned to the
beneficiaries.
...
For a trust, the depreciation
deduction is apportioned between the
income beneficiaries and the trust on
the basis of the trust income allocable to
each, unless the governing instrument
(or local law) requires or permits the
trustee to maintain a depreciation
reserve. If the trustee is required to
maintain a reserve, the deduction is first
allocated to the trust, up to the amount
of the reserve. Any excess is allocated
among the income beneficiaries and the
trust in the same manner as the trust's
accounting income."

Since my client is the sole beneficiary, she is allocated 100% of the income, and hence 100% of the depreciation. The depreciation in effect skips the Trust's Schedule E. The beneficiary's K-1 reports Net Rental RE Income on Line 7 and then directly apportioned depreciation on Line 9, Code A.

[mastertaxguy]

Trust-rental property-specail allowance-personal services

A recent U.S. Tax Court Decision, Aragona Trust, 142 TC 9 (3-27-14) should be considered based on the original facts and post.
Tax Court rejected the IRS position that a trust cannot perform personal services due to services performed by individual trustees on behalf of the trust.

[Snaggletooth]

Allocation of Depreciation

BTW, here is the info I relied on for a Trust's depreciation, from Form 1041 instructions. Maybe I have mis-read something?

"A trust or decedent's estate is allowed a
deduction for depreciation, depletion,
and amortization only to the extent the
deductions are not apportioned to the
beneficiaries.

My understanding (upon which you should not solely rely) is that for the purposes above, there is NO allocation of anything to the beneficiaries unless there is a distribution giving rise to a K-1. And further, depreciation is an ordinary expense, meaning it only affects ordinary income, unless there is a special situation such as a s.179 which is allocated separately from the ordinary income.

[mastertaxguy]

My understanding (upon which you should not solely rely) is that for the purposes above, there is NO allocation of anything to the beneficiaries unless there is a distribution giving rise to a K-1. And further, depreciation is an ordinary expense, meaning it only affects ordinary income, unless there is a special situation such as a s.179 which is allocated separately from the ordinary income.

Interesting point.

However, in view of the Aragona decision it would appear that taking the real estate losses would reduce (or may reduce) DNI which may be of significant benefit to current income beneficiaries whether there is an actual distribution or not. In some cases, NOL's may result which can be carried back, or forward.

Certainly the Aragona decision will be appealed or even maybe re-heard by the Tax Court. Going forward, one can rely on it.