Good News For Trusts that Manage Real Estate.

          In
the recent Frank Aragona Trust case, 142 T.C. No. 9 (2014), the US Tax
Court reached a taxpayer favorable decision, one that benefits trusts that
materially participate in real estate business activities.  For years, the IRS has steadfastly refused to
allow trusts to deduct net operating losses related to real estate activities
against other ordinary income unrelated to the real estate; based on the
so-called “passive activity loss” limitations.
 

Now, it may be possible
for such trusts to deduct the losses associated with the real estate against
other profitable activities to reduce income taxes.

          In
Frank Aragona Trust, the trust owned rental
real-estate properties and was involved in other real-estate business
activities such as holding real estate and developing real estate that are
considered per se passive activities unless the Trust qualified for the “material
participation exception”. 

At issue was whether the activities of the individual
trustees would be treated as materially participating in real-property trades
or businesses.  That is, could the
trustee(s)’ own involvement in the operation of real-property trades or
businesses on a regular, continuous, and substantial basis count as material
participation.    

The
material participation exception applies when more than one-half of the
personal services performed in trades or businesses by the taxpayer are
performed in real-property trades or businesses where the taxpayer materially
participates and performs more than 750 hours of services during the year in
real-property trades or businesses in which the taxpayer materially
participates.

          The
Tax Court held that, “[a] trust is capable of performing
personal services within the meaning [because …] services performed by
individual trustees on behalf of the trust may be considered personal services
performed by the trust.”

          The Tax Court rejected the IRS’s
argument that a trust is incapable of providing personal services, reasoning
that,  “[i]f 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.’”

          Also, the Tax Court rejected the IRS’s
argument the work of certain trustees as employees of an LLC that managed most
of the Trust’s rental real estate properties — which was wholly owned by the
Trust — should not count because such work was performed as employees and not
as trustees.   The Tax Court counted the
work of the Trustees which they performed as employees of the Trust’s wholly
owned LLC because, “trustees are not relieved of their duties of loyalty to
beneficiaries by conducting activities through a corporation wholly owned by
the trust.”

          However, the Tax Court did, “not
decide whether the activities of the trust’s nontrustee employees should be
disregarded.”  Given that the IRS
expressly disregards the work of non trustee employees towards the material participation
test, what is certain is that Trusts can count the work of their Trustees (even
if performed as employees of a corporation wholly owned by the same
trust).  Work  performed by Trustees as employees of a corporation
that is unrelated to the Trust might not count.

          The Frank Aragona Trust
decision is good news for those ongoing trusts that actively manage real
properties as a business and have income tax losses in such activities.  It may now be possible for such losses to be
deducted against other activities.
While the case resolves some uncertainties it does not resolve all
uncertainties, most importantly whether to include the activities of  trust employees who are not themselves
trustees towards satisfaction of the material participation requirement.