Limitations on Deductions

At-Risk Loss Limitations

Generally, the amount the estate or trust has at risk limits the loss it can deduct for any tax year. Use Form 6198, At-Risk Limitations, to figure the deductible loss for the year and file it with Form 1041. For more information, see Pub. 925, Passive Activity and At-Risk Rules.

Passive Activity Loss and Credit Limitations

In general.   Section 469 and the regulations thereunder generally limit losses from passive activities to the amount of income derived from all passive activities. Similarly, credits from passive activities are generally limited to the tax attributable to such activities. These limitations are first applied at the estate or trust level.

Generally, an activity is a passive activity if it involves the conduct of any trade or business, and the taxpayer does not materially participate in the activity. Passive activities do not include working interests in oil and gas properties. See section 469(c)(3).

Note:   Material participation standards for estates and trusts have not been established by regulations.

For a grantor trust, material participation is determined at the grantor level.

If the estate or trust distributes an interest in a passive activity, the basis of the property immediately before the distribution is increased by the passive activity losses allocable to the interest, and such losses cannot be deducted. See section 469(j)(12).

Note:   Losses from passive activities are first subject to the at-risk rules. When the losses are deductible under the at-risk rules, the passive activity rules then apply.

Rental activities.   Generally, rental activities are passive activities, whether or not the taxpayer materially participates. However, certain taxpayers who materially participate in real property trades or businesses are not subject to the passive activity limitations on losses from rental real estate activities in which they materially participate. For more details, see section 469(c)(7).

For tax years of an estate ending less than 2 years after the decedent's date of death, up to $25,000 of deductions and deduction equivalents of credits from rental real estate activities in which the decedent actively participated are allowed. Any excess losses and/or credits are suspended for the year and carried forward.

Portfolio income.   Portfolio income is not treated as income from a passive activity, and passive losses and credits generally may not be applied to offset it. Portfolio income generally includes interest, dividends, royalties, and income from annuities. Portfolio income of an estate or trust must be accounted for separately.

Forms to file.   See Form 8582, Passive Activity Loss Limitations, to figure the amount of losses allowed from passive activities. See Form 8582-CR, Passive Activity Credit Limitations, to figure the amount of credit allowed for the current year.

Transactions Between Related Taxpayers

Under section 267, a trust that uses the accrual method of accounting may only deduct business expenses and interest owed to a related party in the year the payment is included in the income of the related party. For this purpose, a related party includes:

1. A grantor and a fiduciary of any trust;
2. A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;
3. A fiduciary of a trust and a beneficiary of such trust;
4. A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;
5. A fiduciary of a trust and a corporation more than 50% in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust; and
6. An executor of an estate and a beneficiary of that estate, except for a sale or exchange to satisfy a pecuniary bequest (i.e., a bequest of a sum of money).

Line 10 - Interest

Enter the amount of interest (subject to limitations) paid or incurred by the estate or trust on amounts borrowed by the estate or trust, or on debt acquired by the estate or trust (e.g., outstanding obligations from the decedent) that is not claimed elsewhere on the return.

If the proceeds of a loan were used for more than one purpose (e.g., to purchase a portfolio investment and to acquire an interest in a passive activity), the fiduciary must make an interest allocation according to the rules in Temporary Regulations section 1.163-8T.

Do not include interest paid on indebtedness incurred or continued to purchase or carry obligations on which the interest is wholly exempt from income tax.

Personal interest is not deductible. Examples of personal interest include interest paid on:

• Revolving charge accounts used to purchase personal use property.
• Personal notes for money borrowed from a bank, credit union, or other person.
• Installment loans on personal use property.
• Underpayments of Federal, state, or local income taxes.

Interest that is paid or incurred on indebtedness allocable to a trade or business (including a rental activity) should be deducted on the appropriate line of Schedule C (or C-EZ), E, or F (Form 1040), the net income or loss from which is shown on line 3, 5, or 6 of Form 1041.

Types of interest to include on line 10 are:

1. Any investment interest (subject to limitations - see below);
2. Any qualified residence interest (see below); and
3. Any interest payable under section 6601 on any unpaid portion of the estate tax attributable to the value of a reversionary or remainder interest in property for the period during which an extension of time for payment of such tax is in effect.

Investment interest.   Generally, investment interest is interest (including amortizable bond premium on taxable bonds acquired after October 22, 1986, but before January 1, 1988) that is paid or incurred on indebtedness that is properly allocable to property held for investment. Investment interest does not include any qualified residence interest, or interest that is taken into account under section 469 in figuring income or loss from a passive activity.

Generally, net investment income is the excess of investment income over investment expenses. Investment expenses are those expenses (other than interest) allowable after application of the 2% floor on miscellaneous itemized deductions.

The amount of the investment interest deduction may be limited. Use Form 4952, Investment Interest Expense Deduction, to figure the allowable investment interest deduction.

If you must complete Form 4952, check the box on line 10 and attach Form 4952. Then, add the deductible investment interest to the other types of deductible interest and enter the total on line 10.

Qualified residence interest.   Interest paid or incurred by an estate or trust on indebtedness secured by a qualified residence of a beneficiary of an estate or trust is treated as qualified residence interest if the residence would be a qualified residence (i.e., the principal residence or the second residence selected by the beneficiary) if owned by the beneficiary. The beneficiary must have a present interest in the estate or trust or an interest in the residuary of the estate or trust. See Pub. 936, Home Mortgage Interest Deduction, for an explanation of the general rules for deducting home mortgage interest.

See section 163(h)(3) for a definition of qualified residence interest and for limitations on indebtedness.

Line 11 - Taxes

Enter any deductible taxes paid or incurred during the tax year that are not deductible elsewhere on Form 1041.

Deductible taxes include:

• State and local income or real property taxes.
• The generation-skipping transfer (GST) tax imposed on income distributions.

Do not deduct:

• Federal income taxes.
• Estate, inheritance, legacy, succession, and gift taxes.
• Federal duties and excise taxes.
• State and local sales taxes. Instead, treat these taxes as part of the cost of the property.

Line 12 - Fiduciary Fees

Enter the deductible fees paid or incurred to the fiduciary for administering the estate or trust during the tax year.

Fiduciary fees deducted on Form 706 cannot be deducted on Form 1041.

Line 15a - Other Deductions Not Subject to the 2% Floor

Attach your own schedule, listing by type and amount, all allowable deductions that are not deductible elsewhere on Form 1041.

Do not include any losses on worthless bonds and similar obligations and nonbusiness bad debts. Report these losses on Schedule D (Form 1041).

Do not deduct medical or funeral expenses on Form 1041. Medical expenses of the decedent paid by the estate may be deductible on the decedent's income tax return for the year incurred. See section 213(c). Funeral expenses are deductible only on Form 706.

The following are examples of deductions that are reported on line 15a.

Bond premium(s).   For taxable bonds acquired before October 23, 1986, if the fiduciary elected to amortize the premium, report the amortization on this line. You cannot deduct the amortization for tax-exempt bonds. In all cases where the fiduciary has made an election to amortize the premium, the basis must be reduced by the amount of amortization.

For more information, see section 171 and Pub. 550.

If you claim a bond premium deduction for the estate or trust, figure the deduction on a separate sheet and attach it to Form 1041.

Casualty and theft losses.   Use Form 4684, Casualties and Thefts, to figure any deductible casualty and theft losses.

Deduction for clean-fuel vehicles.   Section 179A allows a deduction for part of the cost of qualified clean-fuel vehicle property. See Pub. 535, Business Expenses, for more details.

Net operating loss deduction (NOLD).   An estate or trust is allowed the net operating loss deduction (NOLD) under section 172.

If you claim an NOLD for the estate or trust, figure the deduction on a separate sheet and attach it to this return.

Estate's or trust's share of amortization, depreciation, and depletion not claimed elsewhere.   If you cannot deduct the amortization, depreciation, and depletion as rent or royalty expenses on Schedule E (Form 1040), or as business or farm expenses on Schedule C, C-EZ, or F (Form 1040), itemize the fiduciary's share of the deductions on an attached sheet and include them on line 15a. Itemize each beneficiary's share of the deductions and report them on the appropriate line of Schedule K-1 (Form 1041).

Commercial revitalization deduction.   An estate or trust may qualify for a deduction if it constructs, purchases, or substantially rehabilitates a qualified building in a renewal community. See section 1400I for details.

Line 15b - Allowable Miscellaneous Itemized Deductions Subject to the 2% Floor

Miscellaneous itemized deductions are deductible only to the extent that the aggregate amount of such deductions exceeds 2% of adjusted gross income (AGI).

Among the miscellaneous itemized deductions that must be included on line 15b are expenses for the production or collection of income under section 212, such as investment advisory fees, subscriptions to investment advisory publications, and the cost of safe deposit boxes.

Miscellaneous itemized deductions do not include deductions for:

• Interest under section 163.
• Taxes under section 164.
• The amortization of bond premium under section 171.
• Estate taxes attributable to income in respect of a decedent under section 691(c).
• Expenses paid or incurred in connection with the administration of the estate or trust that would not have been incurred if the property were not held in the estate or trust.

For other exceptions, see section 67(b).

How to figure AGI for estates and trusts.   You figure AGI by subtracting the following from total income on line 9 of page 1:

1. The administration costs of the estate or trust (the total of lines 12, 14, and 15a to the extent they are costs incurred in the administration of the estate or trust) that would not have been incurred if the property were not held by the estate or trust;
2. The income distribution deduction (line 18);
3. The amount of the exemption (line 20);
4. The deduction for clean-fuel vehicles claimed on line 15a; and
5. The net operating loss deduction claimed on line 15a.

For those estates and trusts whose income distribution deduction is limited to the actual distribution, and not the DNI (i.e., the income distribution is less than the DNI), when computing the AGI, use the amount of the actual distribution.

For those estates and trusts whose income distribution deduction is limited to the DNI (i.e., the actual distribution exceeds the DNI), the DNI must be figured taking into account the allowable miscellaneous itemized deductions (AMID) after application of the 2% floor. In this situation there are two unknown amounts: (a) the AMID; and (b) the DNI.

Computing line 15b.   To compute line 15b, use the equation below:

AMID = Total miscellaneous itemized deductions - (.02(AGI))

The following example illustrates how algebraic equations can be used to solve for these unknown amounts.

Example.   The Malcolm Smith Trust, a complex trust, earned $20,000 of dividend income, $20,000 of capital gains, and a fully deductible $5,000 loss from XYZ partnership (chargeable to corpus) in 2002. The trust instrument provides that capital gains are added to corpus. 50% of the fiduciary fees are allocated to income and 50% to corpus. The trust claimed a $2,000 deduction on line 12 of Form 1041. The trust incurred $1,500 of miscellaneous itemized deductions (chargeable to income), which are subject to the 2% floor. There are no other deductions. The trustee made a discretionary distribution of the accounting income of $17,500 to the trust's sole beneficiary.

Because the actual distribution can reasonably be expected to exceed the DNI, the trust must figure the DNI, taking into account the allowable miscellaneous itemized deductions, to determine the amount to enter on line 15b.

The trust also claims an exemption of $100 on line 20.

Using the facts in this example:

AMID = 1,500 - (.02(AGI))

In all situations, use the following equation to compute the AGI:

AGI = (line 9) - (the total of lines 12, 14, and 15a to the extent they are costs incurred in the administration of the estate or trust that would not have been incurred if the property were not held by the estate or trust) - (line 18) - (line 20).

Note:   There are no other deductions claimed by the trust on line 15a that are deductible in arriving at AGI.

Figuring AGI in this example, we get:

AGI = 35,000 - 2,000 - DNI - 100

Since the value of line 18 is not known because it is limited to the DNI, you are left with the following:

AGI = 32,900 - DNI

Substitute the value of AGI in the equation:

AMID = 1,500 - (.02(32,900 - DNI))

The equation cannot be solved until the value of DNI is known. The DNI can be expressed in terms of the AMID. To do this, compute the DNI using the known values. In this example, the DNI is equal to the total income of the trust (less any capital gains allocated to corpus; or plus any capital loss from line 4); less total deductions from line 16 (excluding any miscellaneous itemized deductions); less the AMID.

Thus, DNI = (line 9) - (line 16, column (2) of Schedule D (Form 1041)) - (line 16) - (AMID)

Substitute the known values:

DNI = 35,000 - 20,000 - 2,000 - AMID

DNI = 13,000 - AMID

Substitute the value of DNI in the equation to solve for AMID:

AMID = 1,500 - (.02(32,900 - (13,000 - AMID)))

AMID = 1,500 - (.02(32,900 - 13,000 + AMID))

AMID = 1,500 - (658 - 260 + .02AMID)

AMID = 1,102 - .02AMID

1.02AMID = 1,102

AMID = 1,080

DNI = 11,920 (i.e., 13,000 - 1,080)

AGI = 20,980 (i.e., 32,900 - 11,920)

Note:   The income distribution deduction is equal to the smaller of the distribution ($17,500) or the DNI ($11,920).

Enter the value of AMID on line 15b (the DNI should equal line 7 of Schedule B) and complete the rest of Form 1041 according to the instructions.

If the 2% floor is more than the deductions subject to the 2% floor, no deductions are allowed.

Line 18 - Income Distribution Deduction

If the estate or trust was required to distribute income currently or if it paid, credited, or was required to distribute any other amounts to beneficiaries during the tax year, complete Schedule B to determine the estate's or trust's income distribution deduction. However, if you are filing for a pooled income fund, do not complete Schedule B. Instead, attach a statement to support the computation of the income distribution deduction. If the estate or trust claims an income distribution deduction, complete and attach:

• Part I (through line 9) and Part II of Schedule I to refigure the deduction on a minimum tax basis and
• Schedule K-1 (Form 1041) for each beneficiary to which a distribution was made or required to be made.

Cemetery perpetual care fund.   On line 18, deduct the amount, not more than $5 per gravesite, paid for maintenance of cemetery property. To the right of the entry space for line 18, enter the number of gravesites. Also write Section 642(i) trust in parentheses after the trust's name at the top of Form 1041. You do not have to complete Schedules B of Form 1041 and K-1 (Form 1041).

Do not enter less than zero on line 18.

Line 19 - Estate Tax Deduction (Including Certain Generation- Skipping Transfer Taxes)

If the estate or trust includes income in respect of a decedent (IRD) in its gross income, and such amount was included in the decedent's gross estate for estate tax purposes, the estate or trust is allowed to deduct in the same tax year that the income is included, that portion of the estate tax imposed on the decedent's estate that is attributable to the inclusion of the IRD in the decedent's estate. For an example of the computation, see Regulations section 1.691(c)-1 and Pub. 559.

If any amount properly paid, credited, or required to be distributed by an estate or trust to a beneficiary consists of IRD received by the estate or trust, do not include such amounts in determining the estate tax deduction for the estate or trust. Figure the deduction on a separate sheet. Attach the sheet to your return.

Also, a deduction is allowed for the GST tax imposed as a result of a taxable termination or a direct skip occurring as a result of the death of the transferor. See section 691(c)(3). Enter the estate's or trust's share of these deductions on line 19.

Line 20 - Exemption

Decedents' estates.   A decedent's estate is allowed a $600 exemption.

Trusts required to distribute all income currently.   A trust whose governing instrument requires that all income be distributed currently is allowed a $300 exemption, even if it distributed amounts other than income during the tax year.

Qualified disability trusts.   A qualified disability trust is allowed a $3,000 exemption if the trust's modified AGI is less than or equal to $137,300. If its modified AGI exceeds $137,300, complete the worksheet below to figure the amount of the trust's exemption. To figure modified AGI, follow the instructions for figuring AGI for line 15b on page 16, except use zero as the amount of the trust's exemption when figuring AGI.

A qualified disability trust is any trust:

1. Described in 42 U.S.C. 1396p(c)(2)(B)(iv) and established solely for the benefit of an individual under 65 years of age who is disabled and
2. All of the beneficiaries of which are determined by the Commissioner of Social Security to have been disabled for some part of the tax year within the meaning of 42 U.S.C. 1382c(a)(3).

A trust will not fail to meet 2 above just because the trust's corpus may revert to a person who is not disabled after the trust ceases to have any disabled beneficiaries.

All other trusts.   A trust not described above is allowed a $100 exemption.

Exemption Worksheet for Qualified Disabilty Trusts

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