When a trust owns real estate – directly or through a partnership – fiduciary tax accounting becomes more complex. Trustees and beneficiaries who are not tax professionals can easily make mistakes that lead to incorrect distributions, unexpected tax liabilities, or disputes among beneficiaries. Understanding the pitfalls helps you manage trust assets effectively and honor the grantor’s intent.
Mistake 1: Misclassifying Principal and Income
Failing to distinguish between principal (corpus) and income (earnings) is a common error. For real estate, rental receipts are usually income, while proceeds from the sale of the property are principal. Mortgage principal payments are charges to principal, not income, even if the trust instrument purports to say otherwise.
Misclassifying these items distorts Fiduciary Accounting Income (FAI) and can lead to over- or under-distributions to income beneficiaries. It may also cause a mismatch between what is treated as income for fiduciary purposes and what is deductible or taxable for federal income tax purposes.
Example: The Mortgage Miscalculation
- Scenario: A trust receives $140,000 of rental income and pays $100,000 of mortgage interest plus $30,000 of mortgage principal. Under local law, interest is charged to income and principal to principal.
- The Mistake: The trustee incorrectly charges the entire $130,000 mortgage payment to income.
- The Result: FAI is understated and the income beneficiary receives less than intended. For tax purposes, only the $100,000 interest is deductible; the principal payment is not, regardless of how the trust instrument describes it.
Mistake 2: Confusing Taxable Income with Fiduciary Accounting Income
Trustees often wrongly assume tax-deductible items affect FAI the same way. Depreciation, for example, reduces taxable income, but it reduces FAI only if the governing instrument or state law authorizes a depreciation reserve and the trustee maintains one.
Example: The “Phantom Income” Trap
- Scenario: A trust generating $20,000 of interest income also owns rental property generating $6,000 of gross rents with $5,000 of rental expenses and $4,000 of tax depreciation.
- Accounting Logic: If the trust maintains a depreciation reserve equal to the tax depreciation, FAI is $17,000 ($20,000 + $6,000 – $5,000 – $4,000). If all FAI must be distributed, the trustee pays out $17,000.
- The Tax Conflict: Passive activity rules may suspend the rental loss for tax purposes, making taxable income $20,000 (interest only). This results in $3,000 of “phantom income” taxed to the trust that is not matched by cash available for distribution.
The key point is that FAI is determined by the governing instrument and state law, while DNI and taxable income are determined by tax rules. Conflating them leads to distribution and reporting errors.
Mistake 3: Not Following the Trust Document or State Law
The governing instrument is the primary authority for classifying receipts and disbursements between income and principal. For testamentary trusts, this is usually the decedent’s will. If the document does not provide clear guidance, the trustee must turn to applicable state law.
In many jurisdictions, this will be a version of the Uniform Principal and Income Act or similar statute. For real estate, the law of the jurisdiction where the property is located may also be relevant.
Even when a governing instrument grants discretion, a trustee’s discretion is constrained by fiduciary duties, particularly the duty of impartiality. The trustee must consider the interests of both income and remainder beneficiaries and may not favor one class at the unjustified expense of the other unless the instrument explicitly authorizes such favoritism.
Moreover, tax rules do not always respect provisions in the governing instrument that depart fundamentally from the local law concept of income. For tax purposes, such provisions can be disregarded when determining FAI, even though the trustee remains bound by them as a matter of fiduciary administration.
Example: The Document vs. Tax Law
- Scenario: A will creates a trust requiring all income be distributed to a spouse, but defines interest and dividends as principal. State law classifies them as income.
- The Conflict: For tax purposes, this is a fundamental departure from local law, so interest and dividends are treated as FAI.
- The Result: Because the instrument labels them principal, they are not required to be distributed. Consequently, the trust is not treated as distributing all of its income currently for purposes of the distribution deduction.
Mistake 4: Incorrect Allocation of Expenses
Real estate expenses must be allocated appropriately between income and principal. Ordinary expenses that maintain property (routine repairs, property management fees, and similar costs) are generally charged to income. Capital improvements that increase the property’s value or extend its useful life are typically charged to principal.
Misallocating a large, unusual, or long-term expense to income can materially depress FAI in the current year and cause unfair results for income beneficiaries. Conversely, allocating what should be an income charge to principal may erode the interests of remainder beneficiaries.
Example: The Mixed-Use Leasing Commission
- The Scenario: A trustee uses the same broker to lease residential apartments and a long-term retail space in a mixed-use building. For years, one-half month’s rent for each apartment lease has appropriately been charged to income as an ordinary leasing cost. However, the ground-floor retail space is then leased for a 10-year term, incurring a much larger commission (e.g., 6% of the total lease payments).
- The Mistake: Treating the entire 10-year retail commission as a current income charge. This unfairly burdens income beneficiaries.
- The Fix: A more appropriate approach is to treat the cost as a principal charge and, if consistent with local law and the governing instrument, amortize it over the lease term, aligning the cost with the income stream it helps generate.
Mistake 5: Mishandling Depreciation
Depreciation allows the trust to recover the cost of improvements to real estate (other than land) over time for tax purposes. For fiduciary accounting, depreciation is deducted from income only if:
- The governing instrument or applicable state law authorizes or requires a depreciation reserve, and
- The trustee actually maintains such a reserve.
Otherwise, depreciation does not reduce FAI, even though it reduces taxable income.
Example: The Partnership Over-Distribution
- The Scenario: A partnership in which a trust is a partner allocates $6,000 of net rental income to the trust, including $5,000 of depreciation. The trust instrument requires a depreciation reserve equal to tax depreciation.
- The Math: Fiduciary accounting income from this source is only $1,000.
- The Risk: If the trustee distributes the full $6,000 as income, the trustee has effectively invaded principal and over-distributed to the income beneficiary at the expense of the remainder beneficiaries.
Note: Depreciation is generally allocated between the trust and beneficiaries based on how FAI is split if a depreciation reserve is not maintained.
Mistake 6: Not Planning for Taxes on “Phantom Income” from Partnerships
When a trust owns a partnership interest in a real estate venture, the partnership’s taxable income allocated to the trust may exceed the cash distributions the trust receives. For FAI, only cash or property actually received is ordinarily treated as income, unless the trust instrument gives the trustee a right to compel distributions.
Example: The Cashless Tax Bill
- The Scenario: A trust is a limited partner in a real estate partnership. The partnership allocates $100,000 of taxable income to the trust but makes no distribution during the year.
- The Result: The trust must pay income tax on the $100,000 but has no corresponding accounting income and perhaps insufficient liquid assets to pay the tax.
- The Risk: This “phantom income” can strain liquidity and generate confusion or frustration among beneficiaries who see no additional distributions.
Prudent trustees anticipate these scenarios by monitoring partnership agreements, projected taxable income versus expected distributions, and the trust’s liquidity. They may seek to negotiate distribution policies or maintain adequate reserves to cover anticipated tax liabilities.
Mistake 7: Failing to Adjust for Taxes Paid on Undistributed Income
When the trust pays income tax on undistributed income, particularly from partnerships or other pass-through entities, the tax burden often falls economically on principal. If the trust is also distributing FAI to income beneficiaries, failure to consider an appropriate adjustment between income and principal can unfairly burden one class of beneficiaries.
Many modern trust statutes, including versions of the Uniform Principal and Income Act, provide a “power to adjust” that allows a trustee, in limited circumstances, to reallocate amounts between income and principal to achieve fairness and better reflect total return.
Trustees who ignore this tool, where available, may inadvertently favor income beneficiaries (who receive current cash flows without bearing a proportionate share of tax paid from principal) or remainder beneficiaries (if adjustments are made without regard to the settlor’s intent).
Careful trustees review the governing document and applicable state law to determine whether a power to adjust exists, under what conditions it may be used, and how any such adjustments should be documented.
Ensuring Fairness and Compliance in Trust Administration
Trusts that own real estate present special fiduciary accounting and tax challenges. Trustees and advisors who understand these rules are better positioned to administer in a way that meets legal requirements, reflects the grantor’s intent, and treats all beneficiaries fairly. Avoid costly trust tax mistakes—reach out to our team today.
