April 8, 2014

Marcum Expert Responds to Tax Court Ruling Recognizing Trusts as Real Estate Professionals

Marcum Expert Responds to Tax Court Ruling Recognizing Trusts as Real Estate Professionals

Broader Definition of Material Participation Means Potential Tax Benefits for All Trusts with Business Ownership Interests

New York City, NY Michael D’Addio a principal in the Tax & Business Services Division of accounting and advisory firm Marcum LLP, today responded to the recent ruling of the United States Tax Court enabling a trust to qualify as a real estate professional for tax purposes. The ruling enables trusts meeting specified thresholds to benefit from tax provisions governing losses from material participation in a business interest.

“This decision creates a number of planning opportunities for trusts to maximize the benefits of business losses and to avoid the new net investment income tax,” said Mr. D’Addio, who is based in Marcum’s New Haven, Connecticut office. “This decision becomes applicable to a broad range of business interests and is not limited to real estate rentals.”

The Tax Court’s decision resolved a challenge brought by the Michigan-based Frank Aragona Trust, which argued that the trust materially participated in its real estate rental activities and therefore should be treated as a real estate professional. As such, the trust would be entitled to deduct losses from its real estate rental activities and would not be subject to passive activity loss rules that exclude such losses from deductibility.

“The Tax Court rejected the IRS’ categorical position that a trust cannot satisfy the requirements for real estate professional status, which the Service claimed could only be granted to an individual,” Mr. D’Addio said. “Rental activities are generally treated as passive regardless of the level of participation, unless a specific exception applies. An exception exists for real estate professionals, based on the amount of time the professional spends on personal services performed in conducting such activities.”

The Court determined that a trust can be a real estate professional with respect to a rental activity if it spends more than 750 hours in the activity and more than 50% of time spent providing all personal services. If these tests are satisfied, then the activities in which the trust materially participates will be considered non-passive.

“The court’s analysis of the types of trustee actions which demonstrate material participation by the trust makes this decision significant for a broad range of businesses,” Mr. D’Addio stated.

There are two major consequences to a trust if a business interest is considered to be a passive activity:

  • Any tax losses generated by the passive business interests can only be applied against income generated for other passive activity interests and cannot be used to offset investment income or other non-passive activity business interests.
  • The new 3.8% net investment income tax applies to trusts with modified adjusted gross income above $11,500, and also applies to gains generated from a sale of the business interest.

“It has been a major concern for trustees to determine how they can avoid passive activity status on a trust. The court’s decision will allow more trusts to use current losses generated by the business and to avoid the net investment income tax on income generated by the business, including gains on ultimate sale,” Mr. D’Addio said.

For a more detailed analysis of Frank Aragona Trust v. Commissioner of Internal Revenue.

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