Exhibit 6.2:
Trusts: Passive Loss
Issues
LAW: Generally
passive losses are
limited at the trust
level. Unused
passive losses due
to the limitations
in IRC § 469 are
suspended by the
trust. Passive
losses can offset
only passive income
at the trust level.
Unused passive
losses must be
carried to next year
per IRC § 469(b).
The $25,000 rental
real estate offset
cannot be used by a
trust because trusts
are not natural
persons as defined
by IRC §
469(i)(1).
Note: Rental
real estate losses
should be reflected
on line 3b, not line
1b. Thus, lines 1a,
1b and 1c should be
blank. As a
practical matter, it
is of no consequence
whether income is on
line 1a or 3a as
long as it is truly
generated by a
passive activity.
_____ Does trust
have passive
activities?
Scrutinize Form
1041 line 3,5,6,8,
and15 for losses
which might be
passive and may have
been erroneously
deducted. Rentals,
whether real estate
or equipment
leasing, are
generally passive.
Furthermore,
businesses in which
trustee or executor
does not materially
participate are
passive. All of a
trust’s passive
losses go on Form
8582 and are
deductible only up
to passive income.
_____ Verify
rental real estate
losses have been
entered on Form 8582
line 3b (not
line 1b which
erroneously gives
the benefit of the
$25,000 offset). If
losses are on line
1b, disallow losses
on Form 1041 and
secure beneficiaries
returns and disallow
losses which may
have been deducted
(unless there is
passive income on
the trust's FORM
8582 OR the activity
was sold to a
unrelated party).
Rentals must be
separated from
interest, dividends,
gains on
stocks/bonds and
other portfolio
income. Trusts are
not an individual
and do not qualify
under IRC § 469(i)
for the $25,000
offset. Thus, rental
losses are not
deductible in the
absence of passive
income. Unused
passive losses are
suspended (not
passed through to
beneficiaries). If
there are passive
activities, the
absence of FORM 8582
is an indicator that
the passive loss
limitations may not
have been
considered.
NOTE: For
estates, if the
taxpayer actively
participated before
he died, IRC §
469(i)(4)(A)
provides the estate
may use the $25,000
offset for 2 years
after his death.
However, IRC §
469(i)(4)(B)
provides that the
$25,000 offset is
reduced by the
portion of the
$25,000 offset used
by surviving spouse.
_____ Verify that
Schedule E royalties
are not improperly
reducing rental
losses.
Royalties are not
passive income. See
IRC § 469(e) and
Reg. §
1.469-2T(c)(3)(E).
_____ Verify that
interest, dividends,
capital gains from
stocks and bonds,
annuities, and
royalties have not
been entered on FORM
8582 line 1a no or
3a. While these
types of income seem
"passive", they are
not passive under
IRC § 469. Passive
income is net rental
income OR net income
from businesses in
which taxpayer does
not materially
participate. The
Form 8582 is a
computational form
to limit passive
losses to passive
income. For every
dollar of income
removed from Form
8582, allowable
passive losses are
generally reduced by
a dollar. Passive
income, of course,
is always reportable
on the return,
typically on
Schedule E.
_____ Verify that
income from land,
whether leased or
held for investment,
has not been
included on Form
8582 line 1a or 3a.
Land income,
including gain on
sale, is
non-passive. It may
not be used as
passive income. See
IRC §
469(e)(1)(A)(ii)(II)
property held for
investment and Reg.
§ 1.469-2T(f)(3)
leased land.
_____ Review the
non-passive column
on the back of
Schedule E.
Non-passive means
the trustee
materially
participated in the
partnership or S-
Corporation. The
trustee or fiduciary
must work on a
regular basis in the
business before
losses are
deductible in the
non-passive column.
See IRC § 469(h).
Passive business
losses should be on
Form 8582 line 3b
and are not
deductible without
passive income.
Portfolio income is
not passive and
should not be on
Form 8582. IRC §
469(e)(1)(A)
_____ Verify
Schedule F farm
losses have been
entered on Form 8582
line 3b unless
trustee materially
participates.
For farm losses to
be fully deductible
without considering
the passive loss
limitations, the
trustee must
materially
participate in the
farm. Material
participation does
not simply mean
making management
decisions. It means
working on a
regular, continuous
and substantial
basis in
operations. See IRC
§ 469(h).
_____ Verify that
NOLs (Form 1041
line 8 or 15) are
not, in fact,
passive losses
(rentals or passive
business losses)
- which should be
on Form 8582 line
3c (not on the face
of F1041 which will
offset portfolio and
other non-passive
income). Remember,
a passive loss
cannot offset
portfolio income.
An NOL will however,
offset portfolio
income or any other
kind of income on
the Form 1041.
_____ If a rental
property or passive
partnership interest
was gifted to a
charitable
organization or
individual, verify
current and
suspended losses
were not deducted.
The IRC § 469(j)(6)
requires passive
losses to be added
to donee's basis.
_____ If passive
losses have been
triggered due to a
disposition, ask if
the disposition was,
in fact a
distribution to
beneficiary? If
so, suspended losses
from the trust are
added to basis of
asset. They are not
a current
deduction. If
return reflects a
disposition or large
losses deducted, but
no Form 4797, it is
an indicator
property was
distributed to
beneficiary. Final
returns should be
carefully
scrutinized for this
issue. Review trust
Schedule K-1s and
beneficiary's Form
1040 Schedule E to
verify losses have
not been improperly
deducted. IRC §
469(j)(12) A
distribution does
not trigger losses
under IRC §
469(j)(12).
Furthermore, a
beneficiary often is
a related party.
See IRC §
469(g)(1)(B).
_____ If a rental
property or passive
partnership interest
is sold, ask
if sale was to a
beneficiary,
trustee, or other
related party.
If so, losses may
not be deducted.
They remain
suspended at the
trust level until
there is passive
income or the
property or interest
is acquired by an
unrelated party.
The IRC §
469(g)(1)(B) Losses
will, however, be
triggered to the
extent of net gain
reported on the
sale. Reg. §
1.469-2T(c).
Passive income will
always trigger
passive losses. See
IRC § 469(d).
_____ If you are
reviewing a return
for the year of an
individual’s death,
verify via review of
the final Form 1040
that suspended
passive losses are
allowed only to the
extent they exceed
the step-up in basis
(FMV) in the hands
of the beneficiary.
Frequently, the
step-up in basis to
fair market value
absorbs all passive
losses. Thus, none
are deductible. See
IRC § 469(g)(2).
Example in Pub. 925,
Passive Activity and
At-Risk Rules:
If the basis of a
passive activity in
the hands of a
transferee is
increased by $6,000,
and taxpayer had
unused passive
losses a date of
death of $8,000, the
decedent's deduction
is limited to $2,000
(8,000 less 6,000).
GRANTOR
TRUSTS: As a
grantor trust is not
an entity in the
eyes of tax law, for
purposes of the
passive loss
limitations, we
ignore the trust and
look directly to the
grantor (individual
taxpayer) to
determine whether
the active or
material
participation
standard has been
met. An examiner
will generally know
he is dealing with a
grantor trust as no
Schedule K-1 will be
filed (generally
taxpayer has only a
letter or a
statement) and
losses are generally
reflected on
Schedule C or the
front of Schedule
E. Often no F1041
is filed for a
grantor trust.
However, if a Form
1041 is filed, the
box in the upper
left hand side of
the F1041 will be
checked “Grantor
Type Trust”.
