In a highly anticipated decision that could save substantial taxes for trusts that manage real estate investments, the Tax Court recently ruled in favor of a Michigan real estate developer’s estate that an estate can be treated as a “real estate professional.”
The Tax Court ruled in favor of the taxpayer – the Frank Aragona Trust – that a trust that owned real estate properties and engaged in other real estate activities qualified for the exception to the passive activity loss rules for real estate professionals.
A passive activity is any activity conducted by a trade or business in which a person does not materially participate. Material participation is a key issue with real estate investors, more so today with the new Medicare tax, which imposes a 3.8 percent tax on net investment income.
In general, any rental activity is considered a passive activity, even if the person materially participates in the activity. However, there are exceptions.
For example, the rule for rental activities does not apply to a qualifying real estate professional if:
- More than half of the personal services the real estate professional performs during the year are performed in real property trades or businesses in which the professional materially participates; and
- The real estate professional performs more than 750 hours of services during that tax year in real property trades or businesses in which the professional materially participates.
In this case, the Frank Aragona Trust owns rental real estate properties and is involved in other real estate business activities, such as holding and developing real estate. Frank Aragona created the trust in 1979, with him as trustee and his five children as beneficiaries.
Frank Aragona died in 1981. He was succeeded as trustee by six trustees – one independent trustee and Aragona’s five children, one of whom acted as executive trustee.
Three of the children also worked full time for, and received wages from, Holiday Enterprises, LLC, which is wholly owned by the trust and a disregarded entity for federal income tax purposes. Holiday managed most of the trust’s rental real estate properties and had a number of other employees in addition to the three children.
The trust conducted some of its rental real estate activities directly, some through wholly owned entities and the rest through entities in which it owned majority interests. It conducted its real estate holding and real estate development operations through entities in which it owned majority or minority interests.
The issue presented in the case was whether the Frank Aragona trust can qualify as a real estate professional. The IRS asserted that it cannot because “personal services” means work performed by an individual in connection with a trade or business. As support, the IRS cited certain legislative history stating that the exception applies to individuals and closely held C corporations.
The Tax Court concluded that, if the trustees are individuals and they work in 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.” Accordingly, it concluded that a trust is capable of performing personal services and therefore can be considered a real estate professional.
The court then determined that the trust materially participated in its real estate operations and thus qualifies for the exception. The court concluded that the activities of the trustees, including their activities performed as employees of Holiday, should be considered in determining whether the trust materially participated (Frank Aragona Trust v. Commissioner, 142 TC No. 9, March 27, 2014).
The determination of whether a particular trade or business is subject to the 3.8 percent surtax on investment income is based in part on whether the trade or business is considered a passive activity. The holding in this case could potentially result in fewer trusts being liable for the surtax.