September 2007

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MONTH YEAR: Lead Article: 1 ¾ pages [2nd page about 45 lines]
Lead Article Title: Trusts and Passive Loss Rules:An increasing portion of wealth is structured to be held in trusts. Trusts hold an array of assets, including investments which might be subject to the passive loss limitations (e.g., losses from an equipment leasing or real estate rental LLC). Can the trust deduct those losses? A court said yes, the IRS recently said no, and a conflict is brewing. The tough issue is that there is really not much guidance for what to do with many common trust transactions.

What are the Passive Loss Rules

The passive loss rules of Code Section 469 limit your ability to deduct losses from passive real estate rental (e.g. an investment in a real estate limited partnership) and other activities in which you don’t “materially participate”. The initial goal of these rules was to prevent wealthy taxpayers from buying tax shelters that would be used to offset other income, such as income from a professional practice. Example: You buy a 10% interest in a limited liability company (LLC) that rents out a condo. You have no involvement in the rental activity. The LLC looses $100,000. Your share is a $10,000 loss. You can only deduct that loss against other passive income (e.g., from other passive real estate deals), not against your salary from your OB-GYN practice. Example: You buy a 30% interest in a widget manufacturing LLCs and devote substantial time to the businesses operations. The LLC looses $100,000. You have a $30,000 loss which you may be able to deduct against your salary from your accounting practice. Thus, if you’re treated as materially participating in the activity you’ll get a current tax write-off. If not, the write off could be deferred indefinitely and even lost.

Key to Your Write-Off: Material Participation

If you “materially participate” in a particular activity, then the tax losses from that activity would be considered “active” and can be used to offset your income from other “active” endeavors, such as salary, without limit.

Trusts and The Passive Loss Rules

As more wealthy taxpayers shift investment interests to trusts it becomes increasingly important to determine whether the trust is materially participating in the particular investment activity in order to apply the passive loss rules to the trust. Why care? Apart from all this helping you be the hit at your next cocktail party, this stuff can affect a lot of wealthy taxpayers who frequently use trusts. In the old days trusts held cash and marketable securities. No longer. Example: The Brady Trust is a dynasty trust that owns a personal use condo for each of Greg, Peter and Bobby, and bling for each of Marcia, Jan and Cindy. The trust has a marketable securities portfolio, and owns interests in several rental properties, each in a single member limited liability company (“LLC”) owned by a parent/master LLC. The trust owns an architectural supply manufacturing company. A bank is named investment adviser for the marketable securities. Alice is named investment adviser for the closely held business interests. The rental properties and the supply company all loose money this year. Can these losses be deducted? How is the material participation rule applied to a trust? Let’s look at the law and then analyze it. Here’s the line-up:

1: The Primary Source — The Statute: Material participation requires your involvement “on a regular, continuous, and substantial basis”. IRC Sec. 469(h)(1).

2: The Senate Finance Committee Report: Involvement in day to day operations, not merely intermittent management activity, is necessary. “An estate or trust is treated as materially participating in an activity … if an executor or fiduciary in his capacity as such, is so participating. Portfolio income of an estate or trust must be accounted for separately, and may not be offset by losses from passive activities. Footnote 21 states: “In the case of a grantor trust, however, material participation is determined at the grantor rather than the entity level.” S Rept No. 99-313 (PL 99-514) p. 735 [1986-3 C.B. (Vol. 3) 1]. A grantor trust is a trust whose income is reported by the grantor (usually the person who set up the trust), not to the trust itself. See Practical Planner June 2007.

3: Staff of the Joint Committee on Taxation Report: Footnote 33 says: “No special rule was provided for determining material participation by a trust…an arrangement will be treated as a trust …if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility…it is unlikely that a trust…will be materially participating in a trade or business activity, within the meaning of the passive loss rules. In the case of a grantor trust, to the extent that the grantor or beneficiary is treated as the owner for tax purposes…the material participation of the person treated as the owner is relevant to the determination of whether income or loss from an activity owned through the grantor trust is treated as passive in the hands of the owner…”

4: Regulations: There are no regulations (yet) so the general rules of the statute must be applied.

5. Case Law –The Mattie K. Carter Trust v. US: Mattie’s will set up a trust which managed assets including the Carter Ranch which had cattle, oil and gas. The trustee hired a ranch manager and other employees to carry out most ranching duties. The IRS argued that only the trustee’s efforts should be considered in determining if the trust met the test of materially participating in the ranch. If he did, almost $1.7 million in losses would have been deductible in the two years under audit. The steaks were high! The trust said that its involvement should be evaluated with consideration to all of its fiduciaries, employees and agents. The court said the law didn’t mandate that only the trustee’s activities could be considered. So when it considered the aggregate of the efforts of the trustee, ranch manager and others, it was regular, continuous and substantial involvement so that the trust was deemed to materially participate and could deduct the losses. 256 F. Supp. 2d 536 (Tex. 2003).

6. IRS Ruling: In a recent private letter ruling, PLR 200733023, the IRS nixed a trust’s effort to characterize losses as not being passive (and hence deductible). The IRS maintained that the trustee’s activities alone should be considered. The IRS expressly addressed the court opinion above and stated that it disagreed. The will creating the trust in this Ruling permitted the appointment of a special trustee for any part or all of the trust property. The special trustee, except as limited in the trust, had all the rights of a trustee. The IRS seemed swayed in part by the fact that “ultimate decision-making authority remained vested solely with the trustees”. The IRS rejected the trust’s argument that these “special trustees” were “fiduciaries” for purposes of the Code Section 469 material participation test. The IRS then looked at the definition of “fiduciary” to evaluate this.

The tax law defines a “fiduciary” as a trustee or any other person acting in any fiduciary capacity for any person. IRC Sec. 7701(a)(6). If someone is granted broad discretionary power of administration and management over an asset, a fiduciary relationship exists. Rev. Rule. 82-177. If the person doesn’t have administrative duties, they aren’t a fiduciary. Rev. Rul. 92-51. Since the “special trustees” in this ruling were controlled by the trustees and had no power over the trust property, their participation was irrelevant to the analysis.

What Does it all Mean

The IRS clearly disagrees with the Carter court and insists only “fiduciary” activities, not those of managers or others, will count. A private ruling is not binding on taxpayers other than the one who received it. But, the ruling is an indication of the IRS view. Do you follow the court or the IRS? What about the various fiduciary positions encountered with many trusts: trust protectors, investment advisers, etc.? The IRS did not address these types of fiduciaries, but the IRS might have enunciated a test. If an investment adviser doesn’t have “broad discretionary power of administration and management” he will not be a fiduciary for this test. A trust protector whose role is usually limited may not qualify. Will the IRS consider the activities of all fiduciaries together in determining if the trust will qualify? The entire decision process, and tax result seems rather arbitrary. If the trust is structured as a grantor trust (e.g., Mike Brady remains taxable) then his efforts, not Alice’s would count. If the trust were structured with annual demand (Crummey) powers so that gifts to it qualify for the annual gift exclusion, then the six kids would be taxable on trust income. In this case the kids activities would be evaluated, not Alice’s or Mike’s. “That’s the way – we became the Brady Bunch!”

Checklist: Second Article 2 lines less than One Page [about 54 lines]:
Checklist Article Title: Housing Meltdown – Get Your Tax Pain

The housing market collapse affects more than the stock market. A host of tax issues are raised for homeowners, and different techniques are called for to sell a house in a buyer’s market.

Many homeowners leveraged their purchases with the maximum debt possible to get the largest McMansion possible. Often, as home values increased, home equity lines were used to extract cash. When the homeowner cannot meet mortgage payments, the house may be foreclosed by the lender. Unfortunately, many of the common scenarios in this type of market have lousy tax results. Use the following checklist to make sure you’re getting your share of tax pain:

No Deduction for Loss on Sale of Residence: When a homeowner sells a home at a loss, there is unlikely to be any tax deduction permitted for the loss. Treas. Reg. Sec. 1.165-9(a). A deduction is permitted for business property (e.g., a portion of the home is rented or used in a trade or business and depreciated). IRC Sec. 162(a). A deduction may also be permitted for a loss suffered as a result of a casualty affecting the residence. IRC Sec. 165.

Converting Residence to Business Property to Get Loss Won’t Work: Trying an end run around the above rule won’t work. A homeowner might think that if their home has declined in value, if they rent it out for a sufficient period of time to demonstrate that the property has transmuted into a rental property, then they can sell it at a loss and qualify to deduct that loss. No dice. First, the conversion process is not simple. The IRS and the courts are well aware of the potential for abuse. The conversion will require real independent steps to corroborate the conversion, demonstrating that the personal use of the property has been permanently abandoned, that a lease or other evidence of the business use exists, the quantum of business activity, reporting for tax purposes as a business property, not residence, etc. Merely attempting to rent the home may not suffice. Grohse, TC Memo 1968-47. But the real clincher is that any decline in value occurring prior to the conversion won’t be able to be deducted. Only declines in value after the conversion will be permitted. The mechanism by which the tax laws effect this is to provide that the homeowner’s tax basis (the amount on which gain or loss is calculated) is the lesser of the cost basis or fair value on the date of conversion. Treas. Reg. Sec. 1.165-9(B)(2). Tip: Obtain a written appraisal of the value of the house on conversion.

Renting the House You Cannot Sale May Not Provide Deductions: Some homeowners may legitimately want to convert their home to a rental if they cannot sell it. Unlike the homeowner above seeking to take a tax deduction for the loss on sale, this homeowner may hope to use the tax losses from the rental to offset other income. Good try, but the passive loss limitation rules may prevent this benefit from being realized.

Renting May Void your Home Sale Exclusion: Renting your home in a down market may also undermine the ability to take advantage of the home sale exclusion. This rule permits a homeowner to exclude the first $250,000 of gain, or $500,000 for a married couple. To qualify the home had to be used as a principal residence for 2 of the 5 years before sale. Too long a rental will disqualify the home. Example: If you bought your home for $800,000, it appreciated to $1.8 million, then dropped to $1.2 million you may have a psychological loss of $600,000, but you still have a tax gain of $800,000.

A Lease Option Arrangement May Trigger Gain: In tight real estate markets some homeowners will rent rather than sell and lock in their loss. However, to entice a tenant to consider buying at a later date, an option is sometimes included in the transaction. When an option to purchase is given to the tenant in the lease agreement the IRS may assert that the lease with an option to purchase should be re-characterized as a sale of the property on the installment method. If the homeowner is given a credit for a portion of each rental payment, as the percentage of that credit to the rent paid increases, the risk of re-characterization will also increase.

Mortgage Forgiveness Can Trigger Income: Generally, if a lender forgives a borrower’s debt, the borrower will realize income on the cancellation of the debt. If the borrower was insolvent or bankrupt, gain can be avoided. If the home is foreclosed, the excess of the debt over the fair value of the home (which is presumed to be the foreclosure sales price) is characterized as income from the discharge of debt.
Recent Developments Article 1/3 Page [about 18 lines]:

You can swap real estate and other assets tax free. It’s called a tax deferred like kind exchange under Code Section 1031. 1031 provides mandatory nontaxable exchange treatment if the requirements of the statute are satisfied: (1) The form of the transaction is a sale or exchange; (2) Both the property transferred and the property received are held either for productive use in a trade or business or for investment; and (3) The property transferred and received is like-kind property. A special rule is provided if the exchange is between related parties. Related parties include family members, limited liability companies in which the same individual owns more than 50% of the interests, etc. 267(b), 707(b)(1). If you exchange like-kind property with a related party, and either of you transfers the property received in the exchange within two years, the tax deferral of 1031 will be forfeited, and gain will have to be recognized. IRC Sec. 1031(f). This result won’t be triggered by death, as a result of a compulsory conversion, or if you can convince the IRS that the exchange and later disposition of the like-kind property were not intended to avoid tax. In a recent private letter ruling the IRS held that the taxpayer’s exchange of 1/3rd of property A for his brother’s and niece’s (she was the sole beneficiary of a deceased sibling’s trust) 2/3rds interests in property B was not done to avoid tax. The fact that one of the properties was sold to the city in which it was located within 2 years did not imply a tax avoidance motive. The tax deferral of Code Section 1031 was not tainted. The brother was the trustee of a trust of which the niece was a beneficiary. A trustee and a beneficiary are related parties for this test. However, the IRS noted that had the property been distributed to the niece on the trust’s termination, the brother and she would not have been related parties since there would have been no trustee/beneficiary relationship. Finally, a transaction involving an exchange of undivided interests in different properties that results in each taxpayer holding either an entire interest in a single property or a larger undivided interest in any of such properties, is generally not viewed as a tax avoidance motive.

Potpourri ½ Page:
When Should You Update Your Will? Careful What You Read: No shortage of newsletters in your mailbox or inbox, but can you really rely on what you read? A recent newsletter we received from a financial planner identified 6 reasons to update your will. Let’s review it. The newsletter advises you to revise your will if: (1) There is a birth or death in your family. Reasonable advice, but most wills are written with sufficient flexibility so that the birth or death of a beneficiary will often not require any modification.(2) Marriage, divorce or separation. This certainly is a time to revise your will, but that is never enough. Powers, living wills, beneficiary designations, and more, all need to be revised. Not just your will. (3) If your executor is disabled or dies. Reasonable, but its likely you’ve named successors and that if the current named executor cannot serve the successor would. (4) Revoking a bequest to a son-in-law or daughter-in-law who has divorced your child. Sure, you’d want to do that but very few people make such bequests, and generally when they do so, the bequest itself is contingent on a divorce not having occurred. (5) If the witnesses are not alive or cannot be located a codicil could be done with new witnesses. Does anyone actually track the status of witnesses? If you want to modify your will and you’re competent, why use a codicil instead of a new will? A codicil can often introduce interpretation and other problems such that it can be simpler and safer to sign an entirely new will revoking the prior will. Also, a codicil documents what you changed creating a more obvious trail that might attract a will challenge. (6) Tax law changes. That’s valid, but not enough. Apart from the newsletter listing reasons that probably won’t require action, it ignores many of the obvious and important reasons to change your will. If the value of your estate has changed. It might require additional tax planning, or the ability to forgo otherwise complex planning. Specific dollar bequests might have to be modified to reflect your changed net worth. . If the composition of your assets changes modification may be essential (e.g., you sold your business and now own only marketable assets). If laws other than tax laws change revision may be vital. This could include the rules governing investment, duration of trusts, and so on. Be careful what you read, too often articles in the mass media lack the sophistication and accuracy you need.

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