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Allowable Deductions for Trusts

Allowable Deductions for Trusts

“I don’t always ask questions about trusts or estates, but when I do, I ask the Tax School…”

We’re coming to you today as a follow up to our Summer 2020 in-depth online seminar, Expand Your Tax Practice: Capitalize on the Trust Explosion!

In particular, we want to address some of the most frequently asked questions.

Question 1: What deductions are allowed for a trust or estate? The answer revolves around another question; are the deductions specific to the administration of the trust or estate, or are the expenses miscellaneous itemized deductions?

Fortunately, we have recently released IRS regulations that address the deductibility of trust or estate administrative expenses and excess deductions on the termination of a trust or estate.

On May 11, the IRS issued proposed regulations (REG-113295-18) for IRC §§ 67(g) AND 642(H)(2).

The proposed regulations seek to clarify that certain deductions are allowed by an estate or trust because they are not miscellaneous itemized deductions. The regulations also address how deductions are allocated and treated by a beneficiary after a trust or estate terminates (excess deductions).

Before we explain the impact of these regulations, we need to do a little background work.

IRC §67(g): No miscellaneous itemized deductions allowed under TCJA

This regulation was part of the Tax Cuts and Jobs Act (TCJA). It explicitly disallowed miscellaneous itemized deductions by individuals and, therefore, by inference, estates, and trusts (filing 1041 income tax returns) for the TCJA years 2018 through 2025.

After the enactment of TCJA, the IRS issued Notice 2018-61 in July 2018, which announced that proposed regulations would be coming regarding the effect of §67(g) on estates and trusts to deduct certain expenses.

Here’s the key point:

The notice stated that regulations would provide clarity regarding the deductions for expenses which are administrative expenses of an estate or trust and more importantly, would not have been incurred if the estate or trust did not exist, are still deductible for an estate or trust.

In other words, expenses incurred only because there is a trust or estate are deductible and are not miscellaneous itemized deductions, rendered nondeductible by TCJA.

Excess Deductions on Termination

If there are excess deductions when a trust or estate is terminated, those deductions are passed through to the beneficiary. Typically, the beneficiary treats excess deductions as miscellaneous itemized deductions. However, now thanks to TCJA, these are not deductible for tax years 2018 through 2025. Notice 2018-61 expressed the intent of the IRS to address the treatment of these deductions as well.

Proposed Regulation 1.67-4

The proposed regulations put into motion the “promise” of Notice 2018-61’s treatment and makes the following clarifications as to trust and estate expenses which are not miscellaneous expenses under IRC §67(e) and are therefore deductible:

  • The administrative expenses of an estate or trust that would not have been incurred if the trust or estate didn’t exist. Examples include the following.
    • Tax preparation fees for estate and trust tax returns (1041)
    • Attorney fees
    • Trustee fees
    • Management and maintenance of property expenses (discussed below)
    • Investment advisory fees specific to the estate or trust
    • Fees paid and expenses reimbursed (such as travel) for a personal representative or fiduciary who is administering the trust or estate
  • The personal exemption of an estate or trust
  • The distribution deduction for trusts which distribute income, and
  • The distribution deduction for estates or trusts which accumulate income

Proposed Regulation 1.642(H)-2

The proposed regulations also give guidance on determining how beneficiaries treat excess deductions.

The deductions in the hands of the beneficiary are treated the same as they were by the trust or estate (Example: a long term capital loss of a trust remains a long term capital loss to the beneficiary). When a Schedule K-1 is issued to a beneficiary, it indicates the type and nature of the excess deduction being passed through so the beneficiary can treat the excess deduction in the same manner.

Once final, the proposed regulations will apply to tax years beginning after the date they are published as final (as of July 24, 2020, they are not yet final although the comment period ended on June 25).

However, estates, trusts, and beneficiaries may rely on the proposed regulations for tax years 2018 and later before the date the regulations are published as final. Therefore, practitioners may want to revisit returns filed for the most recent TCJA years (2018 and 2019 at this point) to determine if taxpayers could benefit from amending those returns.

Question 2: What expenses can be deducted for real property held by a trust or estate?

With this question, we will concentrate our answer on real property held by a trust or estate which is not part of a business or investment activity such as a rental property, farm property, or other business property. There is no question that these types of real property which are held for the production of income or investment can have reasonable and necessary expenses for upkeep or maintenance deducted against the income generated.

What about Mom’s house, which is now being held by the trust or estate? For the answer here, we are going to assume that Mom has passed away.

The first item to become familiar with is that the “home” is not a personal residence to the trust or estate (we’re not addressing personal residence trusts here). The second item then is given the previous statement, what, if any, expenses can be deducted for the care and upkeep of this property by the trust or estate?

Under §20.2053-3(d)(1), deductions for expenses of administering an estate:

Expenses necessarily incurred in preserving and distributing the estate, including the cost of storing or maintaining the estate property if it is impossible to effect immediate distribution to the beneficiaries, are deductible to the extent permitted by § 20.2053-1 Deductions for expenses, indebtedness, and taxes; in general.

However, the same is not true regarding improvements to the property, which would not be depreciable and should be added to the property’s corpus (principal) basis:

Expenses for preserving and caring for the property may not include outlays for additions or improvements, nor will such expenses be allowed for a longer period than the executor is reasonably required to retain the property.

As tax professionals, we ask the question, “Where do we deduct the repairs and maintenance on Mom’s house while it’s in the trust or estate?”

We go back to the guidance of the proposed regulations illustrated earlier. Are these not expenses that would not have been incurred if the trust or estate didn’t exist? One could argue that repairs and maintenance would be required no matter who (or what) controls it. Still, I believe it is reasonable to conclude that the expenses to maintain the property are “reasonable and necessary administrative expenses of a trust or estate” and are therefore deductible.

Stay thirsty for knowledge, my friends…

by Tom O’Saben, EA

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