Passive Activity Rules for Trusts
Material Participation After Aragona

What §469 does to trusts

Section 469(a)(2)(A) applies the passive activity loss rules to individuals, estates, and trusts. A trust with passive activity losses can use those losses only against passive income. Losses that exceed passive income are suspended and carried forward until the trust has passive income to absorb them, or until it disposes of the activity in a fully taxable transaction.

For trusts, this creates a practical problem. Many trusts hold rental real estate, which generates losses (depreciation, interest, maintenance) that often exceed rental income. Under the passive activity rules, those losses pile up unused while the trust may be paying tax on other income that the rental losses cannot offset.

What is settled

Several points are not in dispute:

• Trusts are subject to §469. The statute explicitly includes trusts in §469(a)(2)(A)
• Rental activity is per se passive. Under §469(c)(2), any rental activity is treated as passive regardless of whether the taxpayer materially participates, unless an exception applies (principally the real estate professional exception under §469(c)(7))
• The $25,000 rental loss allowance does not apply to trusts. Section 469(i) provides up to $25,000 in deductible rental losses for natural persons who actively participate in a rental activity. This allowance is extended to estates for two tax years after the decedent’s death under §469(i)(4), but it is not available to trusts
• Suspended losses are released on a fully taxable disposition. Under §469(g)(1), when the taxpayer disposes of its entire interest in a passive activity in a fully taxable transaction, all suspended losses from that activity become deductible
• Grantor trusts report on the grantor’s return. For a trust treated as owned by the grantor under §§671–679, the passive activity rules apply to the grantor individually, using the grantor’s own participation. The trust-specific issues discussed here apply to non-grantor trusts

What is not settled: material participation

The seven material participation tests in Temp. Reg. §1.469-5T(a) were written for individual taxpayers. They measure participation in hours (500 hours, 100 hours, etc.) and refer to “the taxpayer’s” participation. The regulations do not address how these tests apply when the taxpayer is a trust.

The central question is: whose participation counts?

The IRS has historically taken the position that trusts participate only through their fiduciaries, and in some rulings has questioned whether trusts can materially participate at all. The Tax Court disagreed in the most significant case to address the issue.

Frank Aragona Trust v. Commissioner (142 T.C. 165, 2014)

The facts: the trust owned and operated rental real estate. The trustees included the decedent’s sons (individuals who were personally active in the real estate business) and a bank. The individual trustees spent substantial time on the trust’s real estate activities.

The IRS argued two things: (1) that trusts cannot materially participate in an activity at all, and (2) that even if they can, the trust did not qualify as a real estate professional under §469(c)(7).

The Tax Court held:

• A trust can materially participate in an activity. The court looked at the activities of the trust’s individual trustees and attributed those activities to the trust
• The trust qualified as a real estate professional under §469(c)(7) through its individual trustees’ activities, because the trustees satisfied both the more-than-half and 750-hour tests
• The trust’s rental real estate activities were therefore not per se passive

Important limitations of Aragona:

• The IRS has not acquiesced to the decision. The Service may continue to challenge trusts claiming material participation
• The temporary regulations under §1.469-5T have not been updated to address trusts
• The decision relied on the activities of individual trustees. Whether activities of employees, agents, or corporate co-trustees count remains an open question
• Aragona is a Tax Court decision, not an appellate ruling. Other courts are not bound by it, though it is the most authoritative guidance available on this issue

The real estate professional exception

Under §469(c)(7), a taxpayer who qualifies as a “real estate professional” can elect to treat rental real estate activities as non-passive. This requires meeting two tests:

1. More than half of the taxpayer’s personal services during the year are performed in real property trades or businesses in which the taxpayer materially participates
2. The taxpayer performs more than 750 hours of services in real property trades or businesses in which the taxpayer materially participates

Aragona held that a trust can satisfy these tests through its individual trustees’ activities. But this holding carries the same limitations noted above: the IRS has not acquiesced, and it is unclear whether non-trustee activities count.

Practically, this means a trust’s ability to claim real estate professional status depends heavily on who the trustees are and what they actually do. A trust with individual trustees who are personally active in the real estate business is in a much stronger position than a trust with a corporate trustee that delegates management to third parties.

Grouping elections

Regulation §1.469-4 allows a taxpayer to group activities for passive activity purposes. This is particularly important for trusts that own multiple rental properties or have both rental and non-rental real estate activities.

Grouping can allow a trust to combine activities so that losses from one can offset income from another. Once a grouping election is made, it generally cannot be changed unless the original grouping was clearly inappropriate.

Key considerations for trusts:

• Rental activities can generally be grouped only with other rental activities (unless the trust qualifies as a real estate professional, in which case rental activities can be grouped with non-rental real property trades or businesses)
• The grouping election is made on the trust’s return for the first year the activities are reported together
• Consistency across years matters. Changing groupings without a valid reason invites scrutiny

Suspended losses at trust termination

When a trust terminates and distributes its assets to beneficiaries, the question is what happens to suspended passive activity losses. Two provisions interact:

• §469(g): suspended losses are allowed in full upon a fully taxable disposition of the entire interest in the activity
• §642(h): excess deductions in the final year of a trust pass through to beneficiaries on their K-1s

Under the final regulations (Reg. §1.642(h)-2), excess deductions on termination retain their character when they pass to beneficiaries. Passive losses that pass through to a beneficiary remain passive in the beneficiary’s hands and can only offset that beneficiary’s passive income. This is an important limitation: a trust termination does not convert suspended passive losses into fully deductible losses for the beneficiary.

Documentation

Regardless of the legal uncertainty, thorough documentation is essential. If a trust is claiming material participation or real estate professional status:

• Maintain contemporaneous time logs for each trustee showing hours spent on each activity
• Document the nature of the work performed (management decisions, property inspections, tenant relations, etc.)
• Keep records of trustee meeting minutes that reflect active involvement in operations
• Distinguish between trustee activities and activities performed by employees, property managers, or agents
• Preserve evidence that individual trustees (not just the corporate co-trustee) are making operational decisions

The burden of proof is on the taxpayer. In an area where the IRS has not acquiesced to the leading case, documentation is the difference between a defensible position and a losing one.

What we need to evaluate the issue

• Trust instrument: trustee powers, identity of trustees, any restrictions on trustee activities
• Schedule of activities: what the trust owns, what type of income and loss each activity generates
• Trustee participation records: hours and activities for each trustee
• Property management arrangements: are properties managed by trustees, employees, or third-party managers?
• Prior year returns: how passive activities have been reported and whether grouping elections have been made
• Suspended loss carryforwards: the current balance of suspended passive losses by activity

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