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With interest rates at historic lows and a gyrating stock market, many trustees have turned to real estate as an investment vehicle. While the potential for appreciation and steady income may be appealing, there are certain traps that a trust faces in owning depreciable assets such as rental real estate. This article discusses one of those traps facing a trust which invests in a partnership or limited liability company which owns rental real estate — the treatment of the deduction for depreciation and the requirement that the partnership separately state this expense apart from rental income.
In general, partnerships and S Corporations are required to separately state all income and expense items on the K-1 form if the tax treatment relies on the situation of the of the owner/partner. It is due to this rule, for instance, that the deduction arising from the IRC Sec 179 expensing election is required to be shown separately — the ability to take advantage of the deduction depends on the partner’s tax situation and net income, not that of the partnership. For individuals which are partners in a partnership which owns rental real estate, there is usually no difference in how rental income and the direct expenses such as depreciation are treated on their tax returns — therefore, rental income is usually shown net of depreciation expense on line 2 of form K-1.
However, in the case of trusts and estates, depreciation itself can change the taxable income of a trust. This is due to the way the Internal Revenue Code requires depreciation to be allocated between a trust and its beneficiaries. As a result, a partnership is required to separately state, apart from the rental income, any depreciation expense on any K-1 for a trust or estate partner.
For example, take Trust T. Trust T is a limited partner in a partnership which owns rental real estate. The trust has one beneficiary. The partnership passes through to Trust T $5,000 of rental income and $1,000 of depreciation expense. The trust has distributed $3,000 to the beneficiary. For purposes of this example the partnership has distributed $5,000 to Trust T, and the accounting income of the trust equals that amount.
On the face of it, it would appear that Trust T has $4,000 of net income, with $3,000 being reported on form K-1 and taxable to the beneficiary (as reflected by total distributions) while the remaining $1,000 would be taxable to the trust. However, due to the application of the rules related to the calculation of trust income, this would be incorrect. The trust is required to allocate the depreciation expense to both the trust and the beneficiary. In this example, the $1,000 of depreciation expense should be allocated 60% to the beneficiary ($3,000 distribution received by the beneficiary, divided by the $5,000 of trust income before depreciation) and 40% to Trust T. As a result, the Trust T K-1 will show $3,000 of income taxable to the beneficiary, $600 of depreciation expense passed out separately to the beneficiary (60% of the $1,000 depreciation expense) resulting in net taxable income to the beneficiary of $2,400. The taxable income of the trust would be $1,600 ($5,000 rental income less $3,000 distribution less $400 depreciation).
This potential problem could lead to possible unforeseen tax burdens for trusts. In practice, most partnerships do not separately state depreciation for their estate or trust partners. In the case of large partnerships, the partnership itself may not even be aware that their partners include any trusts. And trusts, given their accounting rules which differ significantly from those of business entities, it may be near impossible for a real estate partnership to determine the tax effect of separately stating depreciation expense.
This is a very nuanced and tricky area of tax law. With more and more trusts acquiring depreciable assets, either through direct ownership or via investment in partnerships and other business entities, there must be careful consideration of the possible tax consequences. The tax professionals at RINA are here to help guide you through these decisions and to find the ownership structure most beneficial to your unique situation.