Reporting Rules for Depreciation Deductions by Trusts: Part 1
From Tim Harden, CPA, J.D., LL.M. (Taxation)
ABOUT THE AUTHOR: Tim Harden is a CPA with Brady Martz, who works with estates, trusts, and individuals to provide tax saving strategies and compliance services. He has an extensive background in the field of trust, estate, and gift tax, including the areas of probate, asset protect, and complex trust and estate planning with tax compliance, including roughly 16 years as an attorney in this area prior to changing his focus to public accounting.
Introduction
At first glance, the rules for reporting depreciation for trusts and estates might not seem that important because a lot of trusts only own investment assets. However, there are two reasons why these rules are both relevant and, indeed, important. First, an increasing number of nongrantor trusts own interests in business entities that are taxed as S corporations or partnerships, from which the depreciation will flow through to the trust owner. This is due to the increasing frequency of estate planning techniques that have resulted in many transfers or sales of business interests to trusts to freeze their value at the time of the transfer for estate tax purposes. Many of these were structured as sales to grantor trusts, but as the population ages, the grantors die, and the trusts will become nongrantor trusts. In addition, in certain parts of the country, oil and gas trusts are popular and common, which opens the potential for depletion deductions.
Further, the use of revocable living trusts has become more common in recent decades, with grantors transferring most if not all their assets to the trusts to avoid probate and provide for a more secure succession of ownership and management of businesses. The deaths of these grantors will also turn these into nongrantor trusts at some point soon, with a potential step-up in basis that generates new depreciation deductions. Thus, there could be depreciation deductions both for businesses and rental properties that were transferred to these revocable living trusts that must be analyzed and reported correctly. Second, the rules are specialized and do not necessarily give the results that would be assumed by the practitioner generally familiar with trusts.
Having established that it is important to understand the rules for depreciation deductions taken by trusts, we can begin to look at the framework for how the rules specifically apply. First, it is necessary to note that under Section 179(d)(4), nongrantor trusts and estates are not eligible for the Section 179 deduction, which otherwise would allow the deduction of the full amount of qualifying assets when they are placed in service. There is a possible workaround in this area for trusts and estates that own partnership (although not S corporation) interests, however, that we will discuss in Part Two of this article.
In terms of regular depreciation deductions, it is well established that under the Internal Revenue Code, trusts are entitled to take a deduction for depreciation. However, depreciation is not apportioned between the trust and the beneficiaries in the same manner as for items of income and expense. Instead, the beneficiary gets to take to the deduction based on a comparison between the distribution, if any, to the beneficiary and the accounting income of the trust. This can create surprising results, especially if the tax practitioner had been operating under the assumption that the depreciation would be allocated in the same manner as items of income and expense.
This two-part article will explain how the apportionment works, with examples, cover the application of Section 179, and then it will also explore the less frequently used “reserve” exception to this rule.
