Tax Court Rules on Qualifying as Real Estate Professional

Tax Court: trust can qualify for real estate professional exception to PAL rules

April 2, 2014: Tax Court: trust can qualify for real estate professional - Frank Aragona Trust, (2014) 142 TC No. 9

The Tax Court has determined that a trust that owned real estate properties and engaged in other real estate activities qualified for the Code Sec. 469(c)(7) exception for real estate professionals and thus wasn't subject to the passive activity loss (PAL) limitations. In so concluding, the Court found that services performed on behalf of a trust may be considered personal services performed by the trust.

Background. Under Code Sec. 469(c)(1), a taxpayer's passive-activity loss (i.e., the amount by which the aggregate losses from all the taxpayer's passive activities for the year exceeds the aggregate income from all the taxpayer's passive activities for such year) is disallowed for the year if the taxpayer is “described in” Code Sec. 469(a)(2). Among the taxpayers “described in” that section are individuals, estates, trusts, closely held C corporations, and personal service corporations.

A passive activity is any activity which involves the conduct of any trade or business in which the taxpayer does not materially participate. (Code Sec. 469(c)(1)) In general, any rental activity is per se a passive activity, even if the taxpayer materially participates in the activity. (Code Sec. 469(c)(2)) However, there are exceptions to the general per se rule.

Under Code Sec. 469(c)(7), the Code Sec. 469(c)(2) per se rule for rental activities doesn't apply to a qualifying real estate professional. A taxpayer qualifies as such for a particular tax year if: (1) more than half of the personal services that he performs during that year are performed in real property trades or businesses in which he materially participates; and (2) he performs more than 750 hours of services during that tax year in real property trades or businesses in which he materially participates. (Code Sec. 469(c)(7)(B)).

Code Sec. 469(c)(7)(D)(i) provides a special rule for determining whether a closely held C corporation meets the requirements of Code Sec. 469(c)(7)(B). The regs construing Code Sec. 469(c)(7) provide that only a “qualifying taxpayer” falls within the exception. (Reg. § 1.469-9(e)(1)) “Qualifying taxpayer,” in turn, is defined as “a taxpayer that owns at least one interest in rental real estate and meets the requirements of” Reg. § 1.469-9(c). (Reg. § 1.469-9(b)(6)) Reg. § 1.469-9 (c) states that, in addition to owning at least one interest in rental real estate, a qualifying taxpayer must also satisfy the requirements of Code Sec. 469(c)(7)(B). That reg further provides that “personal services means any work performed by an individual in connection with a trade or business.”

Code Sec. 469(h) provides that a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operation of the activity on a basis which is regular, continuous, and substantial. This has two functions: to determine whether a particular activity is a passive activity, and to determine whether a taxpayer materially participates in real-property trades or businesses.

Facts. The Frank Aragona Trust (Trust) is a complex residuary trust that owns rental real estate properties and is involved in other real estate business activities such as holding real estate and developing real estate. It was formed by Frank Aragona in '79, with him as grantor and trustee and with his five children as beneficiaries.

Frank Aragona died in '81. He was succeeded as trustee by six trustees—his five children, one of whom acted as executive trustee, and one independent trustee. Although the trustees formally delegated their powers to the executive trustee, the trustees acted as a management board (Board) for Trust and made all major decisions regarding Trust's property. During 2005 and 2006, Board met every few months to discuss Trust's business. Three of the children also worked full time for, and received wages from, Holiday Enterprises, LLC (Holiday), which is wholly owned by 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.

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 and in which Frank Aragona and a son owned minority interests. It conducted its real estate holding and real estate development operations through entities in which it owned majority or minority interests and in which Frank Aragona and the son owned minority interests.

During the 2005 and 2006 tax years, Trust incurred losses from its rental real estate properties which were reported on the trust's income tax returns, Forms 1041, “U.S. Income Tax Return for Estates and Trusts” and on Schedules E, “Supplemental Income and Loss.” Some of the losses were reported as being associated with Holiday. On its returns, Trust treated its rental real estate activities, in which it engaged both directly and through its ownership interests in a number of entities, as non-passive activities. Accordingly, these losses contributed to Trust's net operating losses (NOLs), which Trust carried back to its 2003 and 2004 tax years. While reporting losses for its rental real estate activities, Trust also reported gains from its other (non-rental) real estate activities.

IRS issued a notice of deficiency determining that Trust's rental real estate activities were passive activities, which increased Trust's PALs for 2005 and 2006. This, in turn, resulted in a decrease in the allowable deductions from gross income for each of those years, which decreased the NOL carrybacks to the 2003 and 2004 tax years.

Issue. The issue presented in the case was whether Trust can qualify for the Code Sec. 469(c)(7) exception. IRS asserted that it can't, because “personal services” means work performed by an individual in connection with a trade or business. IRS cited certain legislative history underlying Code Sec. 469(c)(7), which states that the exception applies to individuals and closely held C corporations, as support.

Trust can perform personal services. The Court began its analysis by looking at the function of a trust— namely, an arrangement whereby trustees manage assets for the trust's beneficiaries. It concluded that 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.” (Reg. § 1.469-9(b)(4)) Accordingly, it concluded that a trust is capable of performing personal services and therefore can satisfy the Code Sec. 469(c)(7) exception.

RIA observation: The determination of whether a particular trade or business is subject to the 3.8% surtax on investment income and gains under Code Sec. 1411 is based in part on whether the trade or business is considered a passive activity with respect to the taxpayer under Code Sec. 469. Thus, the holding in this case could potentially result in fewer trusts being liable for the surtax.

The Court noted that, had Congress wanted to exclude trusts from the exception, it could have done so by explicitly limiting the exception to “any natural person,” which is the language used in Code Sec. 469(i). It also found IRS's reliance on legislative history unconvincing, noting that the cited explanation didn't say that the exception applies only to individuals and closely held C corporations.

Trust qualifies for exception. The Court then determined that 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 Trust materially participated. Thus, the Court took into account the activities of all six trustees in their roles as trustees and as employees of Holiday (which constituted full-time participation in Trust's real estate operations). It also found that Trust's real estate operations were substantial and that the trustees handled practically no other businesses on behalf of Trust. Finally, the Court found that Trust's rental real estate activities weren't passive activities.

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