Passive Activity Rules for Trusts
Rental Property in a Trust

Why it’s different in a trust

When you own rental property personally, there is a built-in safety valve: you can deduct up to $25,000 of rental losses against your other income each year, as long as you actively participate in managing the property (and your adjusted gross income is below the phase-out threshold). Most hands-on landlords qualify for this.

Trusts do not get this $25,000 allowance. The tax code limits it to “natural persons,” with a limited extension to estates for two years after death. A trust is not a natural person. So when the same rental property sits inside a trust, the losses are “suspended”: they carry forward year after year and can only be used against passive income. They cannot offset the trust’s interest income, dividend income, capital gains, or any other non-passive income.

This doesn’t mean the losses are lost. They’re waiting. But they may wait for a long time.

Grantor trust vs. non-grantor trust

The first question is what kind of trust holds the property.

Grantor trust. If you created a revocable trust (or certain irrevocable trusts where you are still treated as the owner for income tax purposes), the rental income and losses flow to your personal tax return. The passive activity rules apply to you as an individual, and you may qualify for the $25,000 allowance based on your own participation. The trust-specific restrictions do not apply because, for income tax purposes, the IRS treats you as owning the property directly.

Non-grantor trust. If the trust is irrevocable and you are no longer treated as the tax owner, the trust is its own taxpayer. The rental income and losses stay on the trust’s Form 1041, and the stricter rules kick in: no $25,000 allowance, and the question of whose participation counts becomes complicated.

When the losses come off the shelf

Suspended passive losses become fully deductible in two situations:

• The trust sells the property. When the trust disposes of the rental property in a fully taxable sale, all accumulated suspended losses from that property are released. They become deductible in the year of sale, even against non-passive income. This is often the single biggest tax event for a trust with rental real estate
• The trust terminates. If the trust winds down and distributes its remaining assets to the beneficiaries, the suspended losses can pass through to the beneficiaries as part of the trust’s final-year deductions. But there’s a catch: the losses keep their “passive” label. The beneficiary can only use them against their own passive income, not against wages, salaries, or portfolio income

The material participation question

There is a potential argument for treating a trust’s rental activity as non-passive, but the law here is genuinely unsettled.

In 2014, the Tax Court ruled in Frank Aragona Trust v. Commissioner that a trust could materially participate in its real estate activities through the hands-on involvement of its individual trustees. If the trust qualifies for “real estate professional” status through its trustees, the rental activity is no longer automatically passive, and the losses may be deductible against other income.

However, the IRS has not accepted this decision. The regulations have not been updated to reflect it. If the trust takes this position, it may face scrutiny. The strength of the position depends on who the trustees are and how actively they are involved in the real estate operations.

This is not a do-it-yourself determination. It requires careful analysis of the trust’s structure, the trustees’ activities, and the specific facts.

Should the property stay in the trust?

The passive activity disadvantage sometimes leads people to ask: should I just take the property out of the trust?

Usually, the answer is that the trust serves other purposes that outweigh the passive activity cost:

• Estate planning. An irrevocable trust keeps the property out of your taxable estate. Removing it could pull it back in
• Asset protection. Trust property is generally beyond the reach of your personal creditors
• Management continuity. The trust ensures the property is managed according to your wishes if you become incapacitated or after you die

The better approach is usually to plan around the passive activity rules rather than undo the estate plan. Coordinating property sales with years when the trust has passive income, structuring the trust with individual trustees who are active in property management, and planning for trust termination can all help.

Related services