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Residuary Trust Eligible to Deduct Real Estate Losses: Implications for the 3.8% Medicare Tax

Saul Brenner, CPA, J.D., LL.M. 05.29.2014 | eVisor

On March 27,2014, the U.S. Tax Court held that a residuary trust that held rental and other real estate properties, and developed properties, could qualify as a real estate professional under Section 469(c)(7). Specifically, the Tax Court concluded that the trustees of that trust could be classified as “real estate professionals” due to the services they performed, as a result; the trust could deduct passive losses generated from its real estate activities 1.

This boon to taxpayers enables the trust to fully deduct its expenses, including trustee fees, because the services performed by individual trustees constituted personal services by the trust and the trust materially participated in the real property business.  Going further, the decision may be significant in the application of the 3.8% Medicare tax on net investment income. This tax is generally applied to income from passive activities with the definition of Section 469(c)(7) incorporated for this purpose. Conceivably, if a trust can qualify for the passive activities exception, it would avoid the Medicare tax on income earned in real estate rental activities. However, the Tax Court has still left many unanswered questions, including whether the activities of non-trustee employees could be considered as meeting the material participation requirements.

In his opinion, Judge Richard T. Morrison rejected the IRS’s argument that Section 469(c)(7) limited the exception to individuals. “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,” Morrison said.  A trust is capable of performing personal services — satisfying the Section 469(c)(7) exception.  The judge also noted that had Congress intended to limit the exception to natural persons, it would not have used the word “taxpayer”.  

1 Frank Aragona Trust, Paul Aragona, Executive Trustee v. Commissioner of Internal Revenue, T.C., No. 15392-11, 142 T.C. No. 9, 3/27/14.

 

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