Yes, a trust can deduct real estate losses, but it is incredibly difficult. The primary conflict stems from Internal Revenue Code (IRC) §469, which automatically classifies all rental real estate as a “passive activity.” This rule immediately prevents a trust from deducting rental losses against other income, such as interest or dividends, causing those valuable tax losses to get trapped and carried forward indefinitely.
This single rule is a major source of frustration for trustees and beneficiaries, with the IRS challenging over 80% of taxpayers who claim to be “real estate professionals” to get around it.1 The path to deductibility is narrow, but a landmark court case has provided a blueprint for success.
Here is what you will learn to solve this problem:
- 🔑 How to unlock trapped real estate losses by understanding the core IRS conflict.
- 🏆 The secret to qualifying for the powerful “Real Estate Professional” exception, even as a trust.
- ⚖️ The critical differences between Grantor and Non-Grantor trusts that determine who gets the deduction.
- ❌ Common, costly mistakes that guarantee your trust’s losses will be disallowed by the IRS.
- 🗺️ A step-by-step guide based on the court case that finally gave trusts a roadmap to victory.
The Three Baskets: Why Your Trust’s Losses Get Trapped
Imagine you have three baskets for your money. The first basket is for active income, like profits from a business you run. The second is for portfolio income, like stock dividends and interest. The third basket is for passive income, which the IRS says includes almost all rental real estate income.2
The problem is created by IRC §469, a federal law designed to stop people from using “tax shelters”.2 This law says that losses from your passive basket can only be used to cancel out income in that same passive basket. You cannot use rental property losses to lower the taxes on your active business profits or your stock dividends.2
The immediate negative consequence is that your real estate losses become “suspended.” They aren’t lost forever, but they are trapped in the passive basket. You must carry them forward year after year until you either have passive income to absorb them or you sell the property.5
This rule applies to individuals, estates, and most importantly, trusts.3 For a trustee managing a property that is losing money on paper (often due to large depreciation deductions), this creates a huge headache. The trust might have plenty of other income, but it still has to pay taxes on it while the real estate losses sit on the sidelines, unused.
The Golden Ticket: Becoming a “Real Estate Professional”
There is a powerful exception to the passive loss rule, but it’s a high bar to clear. If a taxpayer qualifies as a “Real Estate Professional” (REP), their rental activities are no longer automatically passive.7 This means their losses can finally jump out of the passive basket and be used to offset other income.
To earn this status, a taxpayer must prove two things to the IRS each year:
- The 750-Hour Test: You must spend more than 750 hours working in real estate trades or businesses.7
- The More-Than-Half Test: The time you spend on real estate must be more than 50% of your total working time in all businesses.7
For years, the IRS argued that a trust, being just a legal document, could never meet these tests. They claimed a trust isn’t an “individual” and can’t perform “personal services”.11 This position made it nearly impossible for trusts to ever deduct rental losses.
The Court Case That Changed Everything: Frank Aragona Trust
The IRS’s rigid stance was finally challenged in the U.S. Tax Court in a landmark case, Frank Aragona Trust v. Commissioner.11 The Aragona Trust was a family trust that owned a large portfolio of rental properties. Several of the trustees were also full-time employees of an LLC owned by the trust, managing the properties day-to-day.8
The IRS audited the trust and, as expected, disallowed its rental losses, making their usual arguments. But the Tax Court disagreed with the IRS and handed taxpayers a huge victory.13
The court made two game-changing rulings:
- A Trust CAN Perform Personal Services: The court decided that the work of a trust’s individual trustees counts as the trust’s work. If the trustees are people, their work is “work performed by an individual,” satisfying the rule.12
- A Trustee’s “Day Job” for the Trust Counts: The court rejected the IRS’s argument that only work done strictly “as a trustee” counted. It ruled that the hours the trustees spent as employees of the trust’s own management company did count toward the 750-hour test. The court reasoned that because of their legal duty to the trust, the trustees were always wearing their “trustee hat,” even when acting as employees.7
This case created the first clear blueprint for how a trust can legally qualify as a Real Estate Professional and deduct its losses.
Who Is the Taxpayer? Grantor vs. Non-Grantor Trusts
Before you can use the Aragona blueprint, you must know what kind of trust you have. The tax rules are completely different for Grantor Trusts versus Non-Grantor Trusts. The key question is always: who is the taxpayer?
Grantor Trusts: The Person Behind the Curtain
A Grantor Trust is a trust where the creator (the grantor) keeps a certain amount of control. This includes most revocable living trusts.17 For tax purposes, the IRS completely ignores the trust and treats the grantor as the direct owner of the assets.20
- Who is the Taxpayer? The Grantor.
- Whose Work Counts? The Grantor’s.
If a grantor trust owns a rental property, the 750-hour and 50% tests are applied to the grantor’s personal activities, not the trustee’s.2 If the grantor is a real estate professional, the losses flow directly onto their personal Form 1040 tax return and can be deducted.
Non-Grantor Trusts: A Separate Taxpayer
A Non-Grantor Trust is typically an irrevocable trust where the grantor has given up all control.21 This kind of trust is treated as its own separate taxpayer. It gets its own tax ID number and must file its own tax return, Form 1041.21
- Who is the Taxpayer? The Trust itself.
- Whose Work Counts? The Trustee’s.
This is the type of trust that can use the Aragona case as its guide. To deduct losses, the trust must prove that its trustees’ activities meet the Real Estate Professional tests.2
| Trust Type | Key Difference | Who Is Taxed on Losses? | Whose Work Is Tested for REP Status? |
| Grantor Trust | Grantor keeps control. The trust is ignored for tax purposes. | The Grantor | The Grantor |
| Non-Grantor Trust | Grantor gives up control. The trust is a separate taxpayer. | The Trust | The Trustee(s) |
Popular Scenarios: Success and Failure in Action
Let’s look at three common situations to see how these rules play out in the real world.
Scenario 1: The Family Real Estate Business (Aragona-Style Success)
A family sets up an irrevocable trust to hold their apartment buildings. The founder’s son, who is a full-time property manager, is named as one of three trustees. He spends over 2,000 hours a year managing the trust’s properties.
| Action | Consequence |
| The son is a trustee and works full-time managing the trust’s properties. | His 2,000+ hours of work are counted as the trust’s “personal services.” |
| The trust files its tax return (Form 1041) claiming Real Estate Professional status. | The trust easily meets the 750-hour and 50% tests. Its rental losses are now non-passive. |
| The trust uses its six-figure rental losses to offset its dividend and interest income. | The trust’s overall taxable income is significantly reduced, saving tens of thousands in taxes. |
Scenario 2: The Passive Bank Trustee (Guaranteed Failure)
An individual creates an irrevocable trust to hold a commercial building for her children. She names a large bank as the trustee to handle the finances. The bank hires a third-party property management company to deal with tenants and repairs.
| Trustee’s Role | Resulting Tax Treatment |
| The bank trustee only collects rent, pays bills, and reviews financial statements. | This is considered “investor” activity, not material participation. The hours are minimal and do not count. |
| The trust generates a $50,000 tax loss from depreciation. | The loss is automatically a passive loss because the trust is not a Real Estate Professional. |
| The trust also has $80,000 in interest income. | The trust cannot use the $50,000 loss to offset the interest. It must pay tax on the full $80,000, and the loss is suspended. |
Scenario 3: The Inherited Property (Estate vs. Trust)
A woman passes away, leaving a rental duplex to her son. We’ll compare what happens if she leaves it through a will versus a revocable living trust. The property has a $20,000 tax loss in the year after her death.
| Method of Inheritance | Tax Consequence |
| Via a Will: The property goes into her probate estate. Her son, as executor, actively participates by approving tenants and repairs. | An estate is eligible for a special $25,000 loss allowance for its first two years.25 The estate can deduct the full $20,000 loss against its other income. |
| Via a Revocable Trust: The property stays in the trust, which is now irrevocable. Her son is the successor trustee. | A trust is not eligible for the $25,000 special allowance.25 The $20,000 loss is a suspended passive loss and cannot be deducted. |
This shows a critical planning mistake. Using a revocable trust to avoid probate, a common estate planning goal, can lead to a worse tax outcome for rental properties with losses.
Mistakes to Avoid at All Costs
Claiming real estate losses is a major red flag for the IRS.27 You must be prepared. Avoid these common and costly errors.
- Horrible Record-Keeping. This is the #1 reason taxpayers lose in Tax Court. You cannot win an audit with “ballpark guesstimates” of your hours.30 The trustee must keep a detailed, contemporaneous log of their time, showing dates, hours spent, and specific tasks performed.31
- Appointing a Passive Trustee. If the trust’s goal is to deduct real estate losses, appointing a bank, a friend who lives out of state, or a relative with a demanding full-time job is a recipe for failure. The trustee must be someone who can genuinely meet the 750-hour and 50% tests.
- Confusing “Active” and “Material” Participation. There is a special rule that allows some individuals to deduct up to $25,000 in rental losses if they “actively participate.” This is a much lower standard, involving just making management decisions like approving tenants.35 However, as shown in Scenario 3, trusts are not eligible for this allowance.37 A trust must meet the much higher “material participation” standard.
- Ignoring “Related Party” Rules. If a trust distributes a property with suspended losses to a beneficiary, the losses are not deductible. Instead, they are added to the beneficiary’s tax basis in the property.38 An estate can sometimes get around this by making a special election (an IRC §643(e)(3) election) to treat the distribution as a sale, which releases the losses. A trust cannot do this because a trust and its beneficiary are considered “related parties,” and losses on sales between related parties are disallowed.16
Do’s and Don’ts for Trustees
If you are a trustee trying to establish material participation for your trust, follow these guidelines.
| Do’s | Don’ts |
| ✅ Keep a detailed, daily time log. Document every hour and every task related to property operations. | ❌ Don’t estimate your hours at the end of the year. The IRS and courts view this as unreliable. |
| ✅ Focus on operational duties. Log time spent on day-to-day management, repairs, and tenant services. | ❌ Don’t count “investor” activities. Time spent reviewing financial statements or preparing taxes does not count.44 |
| ✅ Structure your role carefully. If possible, follow the Aragona model where the trustee is also an employee of a trust-owned management company. | ❌ Don’t rely on the work of others. The Aragona case only counted the trustee’s hours. The work of non-trustee employees or agents may not count.2 |
| ✅ Ensure your activities are “regular, continuous, and substantial.” This is the qualitative standard you must meet.27 | ❌ Don’t just be a figurehead. Simply holding the title of trustee is not enough; you must be deeply involved in the operations. |
| ✅ Consult with a tax professional. The rules are complex, and claiming REP status is a high-risk audit area. | ❌ Don’t assume you qualify. The burden of proof is on you, the taxpayer, to prove your case to the IRS. |
Pros and Cons of Holding Real Estate in a Trust vs. an Estate
When planning for what happens after death, the choice between a will (which creates a probate estate) and a trust has significant tax consequences for real estate.
| Pros of Using a Trust | Cons of Using a Trust |
| Avoids Probate: Assets in a trust pass to beneficiaries without a lengthy and public court process. | No $25,000 Loss Allowance: A trust cannot claim the special $25,000 rental loss allowance available to estates for their first two years.25 |
| Provides Control: A trust allows for detailed, long-term control over how and when assets are distributed to beneficiaries. | Trapped Suspended Losses: A trust cannot use a §643(e)(3) election to release suspended passive losses upon distribution to a beneficiary due to “related party” rules.16 |
| Privacy: The terms of a trust are private, unlike a will, which becomes a public court record. | Higher Bar for Deductions: A trust must meet the difficult “material participation” standard to deduct ongoing losses, a standard not always required of an estate in its first two years. |
| Asset Protection: An irrevocable trust can offer protection from creditors for the assets it holds. | Complexity: Managing a trust to meet the REP standards requires significant effort, documentation, and professional guidance. |
| Continuity: A successor trustee can step in immediately upon the grantor’s death or incapacity, ensuring seamless management. | Potential for Higher Tax Rates: Trusts have highly compressed tax brackets, meaning they can reach the highest tax rates at very low income levels.47 |
Frequently Asked Questions (FAQs)
Can my trust deduct real estate losses if I, the grantor, am a real estate professional?
Yes, but only if it is a grantor trust. In that case, your personal participation is what matters, and the losses can be deducted on your personal tax return.2
Does the work of a property manager hired by the trust count toward the 750-hour test?
No, probably not. The Aragona case focused only on the work of the trustees. The IRS has consistently argued that the work of non-fiduciary employees or agents should not be counted.2
Can a trust with a corporate trustee, like a bank, qualify as a Real Estate Professional?
No, this is highly unlikely. The Aragona ruling was based on the work of individual trustees. A corporate entity cannot perform the “personal services” required, and this remains a major area of uncertainty.46
What happens to suspended passive losses when a trust distributes the property to a beneficiary?
No, they are not deductible. The suspended losses are added to the tax basis of the property for the beneficiary. This will reduce their capital gain when they eventually sell the property.38
Can a trust pass its real estate losses through to the beneficiaries on a Schedule K-1 each year?
No, not for operating losses. Passive losses are trapped at the trust level and suspended. They cannot be distributed to beneficiaries annually. The only exception is in the trust’s final termination year.13
Is it better to use a will or a trust to pass on rental property?
It depends. A trust avoids probate but loses key tax benefits for rental losses, like the $25,000 allowance. An estate gets these tax benefits for two years but must go through probate.