Estate Planning for Families With Rental Real Estate Businesses

Related Practice: Estate Planning & Administration

Successful estate planning for families with significant rental real estate business income involves coordinating complex income tax rules with dispositive planning.  Most critically, if any real estate business will be owned in a trust, it is important discuss with clients and their family members the choice of fiduciaries for the trust, the practical aspects of managing trust-owned real estate and the potential tax impacts of the resulting managerial structure.

Taxpayers generally prefer that business activities be characterized as non-passive or “active.”  Losses produced from “passive” activity can only be used to offset passive activity income.  If income that a trust derives from its real estate holdings is passive, it may be subject to the 3.8% Medicare surtax on net investment income in addition to taxation at ordinary income rates.  This combined rate can be as high as 43.4%.  Therefore, the best way to avoid the surtax is to have the trust income considered non-passive  or “active”.  Income from a business operated by a trust is non-passive if the Trustee “materially participates “ in the business, and the IRS reviews a Trustee’s activities very closely to determine whether “material participation” has occurred.

Rental real estate activities are considered passive unless the taxpayer can show it satisfies a three-part statutory “real estate operator exception” test, which requires the taxpayer to substantively show its material participation in the real estate business.  A recent Tax Court decision, Frank Aragona Trust v. CIR, 142 T.C. 165 (2014), significantly held that a trust can qualify for the “real estate operator exception” and that the activities of a trustee could be counted toward the trust’s material participation in the real estate business.  This is true even if the trustee also performs such activities as an employee or as a minority shareholder of an entity the trust uses to conducts its activities.

The key impact of this court case is that it makes clear that a trustee of a trust can also operate the trust’s rental real estate through an entity, like a limited liability company, and potentially qualify the trust’s managerial activities as “active” for income tax purposes.  This is helpful for planning purposes because there are various reasons why it may be prudent to manage a trust’s real estate activities via a wholly-owned LLC, and have the trustee act as an employee of such entity.  These items include, for example, employer liability protection, social security pay-in for the employee, and the possibility of providing employee benefits for the trustee-employee.  

This case unfortunately left unanswered important questions regarding managerial structure of rental real estate businesses.  For example, it is unclear whether a trust could count the activities of non-trustee employees who are part of the real estate management team towards the “real estate operator exception” test.  Therefore, when considering an estate plan involving real estate, it is important to contemplate the following items:

• Choice of Trustees.  The Trustee managing the real estate should be one who will regularly, continuously and substantially participate in the management of the rental real estate.  This legal standard requires that the trustee undertake specific activities and meet certain time commitments.  This may weigh against choosing a family member otherwise qualified to serve as a trustee.
• Modifications of Fiduciary Standards.  In many estate plans involving family businesses, it is advisable for the Settlor to modify some or all fiduciary duties of the trustee, specifically the duty of loyalty, when the Settlor’s desired fiduciaries have multiple roles in the business and estate plan.  For example, it can be a violation of the duty of loyalty for the trustee to unilaterally decide to pay himself a salary for managing trust real estate; therefore it is common to waive this potential violation where compensation is expected.  It is important to specifically address the types of desired activities of the future trustee and how those activities could conflict with objective fiduciary duties, to avoid blanket waivers or modifications of fiduciary standards.
• Recordkeeping.  The taxpayer bears the burden of proof in establishing that its activities were sufficient to satisfy the “real estate operator exception” test.  It is therefore critical that for all years, all parties participating in a trust’s real estate business, especially the trustee, maintain adequate records of their rental business activities including time spent, the types of work performed, and the capacity (i.e., as trustee or as employee) in which work is performed.
• Staff Appropriately and Practically.  If the trustee’s activities alone (either as trustee or employee) would not meet the requirements of the “real estate operator exception” test, then it is unlikely that the non-trustee employees’ activities will be considered by the IRS.  For example, it is common for trusts to engage an unrelated third-party property management entity to manage property day-to-day.  It is unlikely that use of a third-party property manager hired by the trustee would count towards the test.  However, if there is no family member or trusted third-party trustee who can manage the real estate appropriately and a third-party property manager is desired or needed, it is important to recognize what is needed to properly manage the real estate, even if that means that the surtax may apply to trust income.

Ultimately, when planning with rental real estate, planning proactively, with full knowledge of all of the details, will put a trust taxpayer in the best position possible to claim non-passive activities.  However, it remains necessary to balance the tax impacts against the practical structure of the trust and to design an estate plan that works best for the entire family in the long-term.  Contact a member of our Estate Planning group for questions on this article or any other estate planning matter.