Passive Activity Loss ATG - Exhibit 6.2: Trusts: Passive Loss Issues
Publication Date - December, 2004
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Exhibit 6.2: Trusts: Passive Loss Issues
LAW: Generally passive losses are limited at the trust level. Unused passive losses due to the limitations in IRC § 469 are suspended by the trust. Passive losses can offset only passive income at the trust level. Unused passive losses must be carried to next year per IRC § 469(b). The $25,000 rental real estate offset cannot be used by a trust because trusts are not natural persons as defined by IRC § 469(i)(1).
Note: Rental real estate losses should be reflected on line 3b, not line 1b. Thus, lines 1a, 1b and 1c should be blank. As a practical matter, it is of no consequence whether income is on line 1a or 3a as long as it is truly generated by a passive activity.
_____ Does trust have passive activities? Scrutinize Form 1041 line 3,5,6,8, and15 for losses which might be passive and may have been erroneously deducted. Rentals, whether real estate or equipment leasing, are generally passive. Furthermore, businesses in which trustee or executor does not materially participate are passive. All of a trust’s passive losses go on Form 8582 and are deductible only up to passive income.
_____ Verify rental real estate losses have been entered on Form 8582 line 3b (not line 1b which erroneously gives the benefit of the $25,000 offset). If losses are on line 1b, disallow losses on Form 1041 and secure beneficiaries returns and disallow losses which may have been deducted (unless there is passive income on the trust's FORM 8582 OR the activity was sold to a unrelated party). Rentals must be separated from interest, dividends, gains on stocks/bonds and other portfolio income. Trusts are not an individual and do not qualify under IRC § 469(i) for the $25,000 offset. Thus, rental losses are not deductible in the absence of passive income. Unused passive losses are suspended (not passed through to beneficiaries). If there are passive activities, the absence of FORM 8582 is an indicator that the passive loss limitations may not have been considered.
NOTE: For estates, if the taxpayer actively participated before he died, IRC § 469(i)(4)(A) provides the estate may use the $25,000 offset for 2 years after his death. However, IRC § 469(i)(4)(B) provides that the $25,000 offset is reduced by the portion of the $25,000 offset used by surviving spouse.
_____ Verify that Schedule E royalties are not improperly reducing rental losses. Royalties are not passive income. See IRC § 469(e) and Reg. § 1.469-2T(c)(3)(E).
_____ Verify that interest, dividends, capital gains from stocks and bonds, annuities, and royalties have not been entered on FORM 8582 line 1a no or 3a. While these types of income seem "passive", they are not passive under IRC § 469. Passive income is net rental income OR net income from businesses in which taxpayer does not materially participate. The Form 8582 is a computational form to limit passive losses to passive income. For every dollar of income removed from Form 8582, allowable passive losses are generally reduced by a dollar. Passive income, of course, is always reportable on the return, typically on Schedule E.
_____ Verify that income from land, whether leased or held for investment, has not been included on Form 8582 line 1a or 3a. Land income, including gain on sale, is non-passive. It may not be used as passive income. See IRC § 469(e)(1)(A)(ii)(II) property held for investment and Reg. § 1.469-2T(f)(3) leased land.
_____ Review the non-passive column on the back of Schedule E. Non-passive means the trustee materially participated in the partnership or S- Corporation. The trustee or fiduciary must work on a regular basis in the business before losses are deductible in the non-passive column. See IRC § 469(h). Passive business losses should be on Form 8582 line 3b and are not deductible without passive income. Portfolio income is not passive and should not be on Form 8582. IRC § 469(e)(1)(A)
_____ Verify Schedule F farm losses have been entered on Form 8582 line 3b unless trustee materially participates. For farm losses to be fully deductible without considering the passive loss limitations, the trustee must materially participate in the farm. Material participation does not simply mean making management decisions. It means working on a regular, continuous and substantial basis in operations. See IRC § 469(h).
_____ Verify that NOLs (Form 1041 line 8 or 15) are not, in fact, passive losses (rentals or passive business losses) - which should be on Form 8582 line 3c (not on the face of F1041 which will offset portfolio and other non-passive income). Remember, a passive loss cannot offset portfolio income. An NOL will however, offset portfolio income or any other kind of income on the Form 1041.
_____ If a rental property or passive partnership interest was gifted to a charitable organization or individual, verify current and suspended losses were not deducted. The IRC § 469(j)(6) requires passive losses to be added to donee's basis.
_____ If passive losses have been triggered due to a disposition, ask if the disposition was, in fact a distribution to beneficiary? If so, suspended losses from the trust are added to basis of asset. They are not a current deduction. If return reflects a disposition or large losses deducted, but no Form 4797, it is an indicator property was distributed to beneficiary. Final returns should be carefully scrutinized for this issue. Review trust Schedule K-1s and beneficiary's Form 1040 Schedule E to verify losses have not been improperly deducted. IRC § 469(j)(12) A distribution does not trigger losses under IRC § 469(j)(12). Furthermore, a beneficiary often is a related party. See IRC § 469(g)(1)(B).
_____ If a rental property or passive partnership interest is sold, ask if sale was to a beneficiary, trustee, or other related party. If so, losses may not be deducted. They remain suspended at the trust level until there is passive income or the property or interest is acquired by an unrelated party. The IRC § 469(g)(1)(B) Losses will, however, be triggered to the extent of net gain reported on the sale. Reg. § 1.469-2T(c). Passive income will always trigger passive losses. See IRC § 469(d).
_____ If you are reviewing a return for the year of an individual’s death, verify via review of the final Form 1040 that suspended passive losses are allowed only to the extent they exceed the step-up in basis (FMV) in the hands of the beneficiary. Frequently, the step-up in basis to fair market value absorbs all passive losses. Thus, none are deductible. See IRC § 469(g)(2).
Example in Pub. 925, Passive Activity and At-Risk Rules: If the basis of a passive activity in the hands of a transferee is increased by $6,000, and taxpayer had unused passive losses a date of death of $8,000, the decedent's deduction is limited to $2,000 (8,000 less 6,000).
GRANTOR TRUSTS: As a grantor trust is not an entity in the eyes of tax law, for purposes of the passive loss limitations, we ignore the trust and look directly to the grantor (individual taxpayer) to determine whether the active or material participation standard has been met. An examiner will generally know he is dealing with a grantor trust as no Schedule K-1 will be filed (generally taxpayer has only a letter or a statement) and losses are generally reflected on Schedule C or the front of Schedule E. Often no F1041 is filed for a grantor trust. However, if a Form 1041 is filed, the box in the upper left hand side of the F1041 will be checked “Grantor Type Trust”.