Trusts May Qualify as Real Estate Professional and Find Tax Savings– April 01, 2014

A recently decided federal tax court case, Frank Aragona Trust v. Commissioner, held that a trust can qualify as a real estate professional under the IRC §469(c)(7) exception to the passive activity rules.Qualification as a real estate professional is important to trusts for two reasons:

  1. real estate losses may be deductible as nonpassive losses, and
  2. rental real estate income that is nonpassive can escape the additional 3.8% Medicare surtax imposed under IRC §1411. (Read our previous blog on a safe harbor for real estate professionals.)

Case Discussion

Previously, the IRS argued that a trust cannot qualify as a real estate professional under §469(c)(7)(B) because only individuals are capable of providing the “personal services” required in the regulations, and the IRS does not believe that trusts and estates fall into the definition of “individuals.” In Aragona, the IRS continued this line of reasoning, and further asserted that the real estate professional exception applies only to individuals and closely held C corporations, and that the legislation does not specifically include trusts.

Fortunately for taxpayers, the tax court took a broader view of the legislation and reasoned that, “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.’” Furthermore, the tax court noted that the language chosen by Congress in drafting §469(c)(7) does not explicitly exclude trusts from qualifying for the exception.

Although Aragona addressed the issue of whether the real estate professional exception applies to trusts, it also touched on another important outstanding trust issue: how to determine whether a trust is materially participating in an activity. The IRS has long argued that only the activities of the trustees can be considered in determining whether a trust is materially participating, despite losing in court on this issue in Mattie K. Carter Trust v. United States.

In Aragona, the trustees were also employees of a wholly owned, disregarded entity engaged in managing most of the trust’s real estate properties. The tax court noted that the activities of the trustees, including their activities as employees, should be considered in determining whether the trust materially participated in its real estate operation. Unfortunately, the court did not rule on whether the activities of the trust’s non-trustee employees should be considered, and it did not address how to apply or whether to apply the personal service or 750-hour requirement in determining whether the trust qualifies for the real estate professional exception.

Now What?

Several lingering, open questions remain particularly in regards to how to determine material participation for a trust. This case seems to suggest that all trusts, even those not in real estate, may be able to count their trustee’s involvement as an employee for purposes of determining material participation in a business. However, this question and others may only be settled when and if final regulations under §469 are released for trusts. However, the Aragona case is clearly a win for taxpayers, and trusts with significant real estate operations should review their activities to determine whether the real estate professional exception may apply.

Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this publication should be taken only after a detailed review of the specific facts and circumstances.