Limitations on Deductions

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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).

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 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 (that is, 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 (for example, 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 (for example, 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; and

  • 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 later); 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 of Form 1041 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 (that is, the principal residence or the secondary 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.

Qualified mortgage insurance premiums. Enter (on the worksheet later) the qualified mortgage insurance premiums paid under a mortgage insurance contract issued after December 31, 2006, in connection with qualified residence acquisition debt that was secured by a principal or secondary residence. See Prepaid mortgage insurance below if the estate or trust paid any premiums allocable after 2012. If at least one other person was liable for and paid the premiums in connection with the loan, and the premiums were reported on Form 1098, Mortgage Interest Statement, include the estate's or trust's share of the 2012 premiums on the worksheet later.

Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, or the Rural Housing Service, and private mortgage insurance (as defined in section 2 of the Homeowners Protection Act of 1998 as in effect on December 20, 2006).

Mortgage insurance provided by the Department of Veterans Affairs and the Rural Housing Service is commonly known as a funding fee and guarantee fee, respectively. These fees can be deducted fully in 2012 if the mortgage insurance contract was issued in 2012. Contact the mortgage insurance issuer to determine the deductible amount if it is not included in box 4 of Form 1098.

Qualified Mortgage Insurance Premiums Deduction Worksheet

1. Enter the total premiums the estate or trust paid in 2012 for qualified mortgage insurance for a contract issued after December 31, 2006 1.
2. Enter the estate's or trust's AGI 2.
3. Enter $100,000 3.
4. Is the amount on line 2 more than the amount on line 3?
No.
The deduction is not limited. Include the amount from line 1 above on Form 1041, line 10. Do not complete the rest of this worksheet.
Yes.
Subtract line 3 from line 2. If the result is not a multiple of $1,000, increase it to the next multiple of $1,000. For example, increase $425 to $1,000, increase $2,025 to $3,000, etc. 4.
5. Divide line 4 by $10,000. Enter the result as a decimal. If the result is 1.0 or more, enter 1.0 5. .
6. Multiply line 1 by line 5 6.
7. Qualified mortgage insurance premiums deduction. Subtract line 6 from line 1. Enter the result here and include the amount on Form 1041, line 10 7.

Prepaid mortgage insurance.

If the estate or trust paid mortgage insurance premiums allocable to periods after the end of its tax year, such premiums must be allocated over the shorter of:

  • The stated term of the mortgage, or

  • 84 months, beginning with the month the insurance was obtained.

The premiums are treated as paid in the year to which they are allocated. If the mortgage is satisfied before its term, no deduction is allowed for the unamortized balance. See Pub. 936 for details. These allocation rules do not apply to qualified mortgage insurance provided by the Department of Veterans Affairs or the Rural Housing Service.

Limit on the amount that is deductible.

The estate or trust cannot deduct mortgage insurance premiums if the estate's or trust's AGI is more than $109,000. If the estate's or trust's AGI is more than $100,000, its deduction is limited and you must use the worksheet below to figure the deduction. See How to figure AGI for estates and trusts, later, for information on figuring AGI.

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 the following:

  • State and local income taxes. You can deduct state and local income taxes unless you elect to deduct state and local general sales taxes. You cannot deduct both.

  • State and local general sales taxes. You can elect to deduct state and local general sales taxes instead of state and local income taxes. Generally, you can elect to deduct the actual state and local general sales taxes (including compensating use taxes) you paid in 2012 if the tax rate was the same as the general sales tax rate. However, sales taxes on food, clothing, medical supplies, and motor vehicles are deductible as a general sales tax even if the tax rate was less than the general sales tax rate. Sales taxes on motor vehicles are also deductible as a general sales tax if the tax rate was more than the general sales tax rate, but the tax is deductible only up to the amount of tax that would have been imposed at the general sales tax rate. Motor vehicles include cars, motorcycles, motor homes, recreational vehicles, sport utility vehicles, trucks, vans, and off-road vehicles. Also include any state and local general sales taxes paid for a leased motor vehicle.

    Do not include sales taxes paid on items used in a trade or business. An estate or trust cannot use the Optional Sales Tax Tables for individuals in the Instructions for Schedule A (Form 1040), Itemized Deductions, to figure its deduction.

  • State, local, and foreign real property taxes.

  • State and local personal property taxes.

  • Foreign or U.S. possession income taxes. You may want to take a credit for the tax instead of a deduction. See the instructions for Schedule G, line 2a, later, for more details.

  • The generation-skipping transfer (GST) tax imposed on income distributions.

Do not deduct:

  • Federal income taxes;

  • Estate, inheritance, legacy, succession, and gift taxes; or

  • Federal duties and excise taxes.

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. If you made the election to amortize the premium, the basis in the taxable bond must be reduced by the amount of amortization.

For tax-exempt bonds, you cannot deduct the premium that is amortized. Although the premium cannot be deducted, you must amortize the premium and reduce the estate's or trust's basis in the tax-exempt bond by the amount of premium amortized. In the case of a premium on a tax-exempt bond, or if the fiduciary has made an election to amortize the premium on a taxable bond, the basis in the bond 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.

Domestic production activities deduction. The estate or trust may be able to deduct up to 9% of its share of qualified production activities income (QPAI) from the following activities.
  1. Construction performed in the United States.

  2. Engineering or architectural services performed in the United States for construction projects in the United States.

  3. Any lease, rental, license, sale, exchange, or other disposition of:

    1. Tangible personal property, computer software, and sound recordings that the estate or trust manufactured, produced, grew, or extracted in whole or in significant part within the United States;

    2. Any qualified film the estate or trust produced; or

    3. Electricity, natural gas, or potable water the estate or trust produced in the United States.

In certain cases, the United States includes the Commonwealth of Puerto Rico.

The deduction does not apply to income derived from:

  • The sale of food and beverages the estate or trust prepared at a retail establishment;

  • Property the estate or trust leased, licensed, or rented for use by any related person; or

  • The transmission or distribution of electricity, natural gas, or potable water.

The deduction cannot exceed 9% of modified AGI or 50% of certain Form W-2 wages. QPAI, as well as Form W-2 wages, must be apportioned between the trust or estate and its beneficiaries. For more details, see Form 8903, Domestic Production Activities Deduction, and its separate instructions.

Special rule for oil-related QPAI.

If the estate or trust has oil-related QPAI, the domestic production activities deduction is reduced by 3% of the smallest of:

  • Oil-related QPAI,

  • QPAI, or

  • Modified AGI.

See Form 8903 for details.

Net operating loss deduction (NOLD). An estate or trust is allowed the 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 estate's or trust's apportioned share of 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 estate's or trust's apportioned share of the deductions on an attached sheet and include them on line 15a.

Note.

Do not report the beneficiary's apportioned share of depreciation, depletion, and amortization on line 15a. Report the beneficiary's apportioned share of deductions on Schedule K-1 (Form 1041), box 9.

Itemize each beneficiary's apportioned share of the deductions and report them in the appropriate box of Schedule K-1 (Form 1041).

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 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 IRD under section 691(c), or

  • 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 domestic production activities deduction claimed on line 15a; and

  5. The NOLD claimed on line 15a.

For those estates and trusts whose income distribution deduction is limited to the actual distribution, and not the DNI (that is, 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 (that is, 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 2012. The trust instrument provides that capital gains are added to corpus. Fifty percent 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 15, 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. For more information, see Pooled Income Funds, earlier.

If the estate or trust claims an income distribution deduction, complete and attach:

  • Part I (through line 26) and Part II of Schedule I (Form 1041) 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 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.

If you claim a deduction for estate tax attributable to qualified dividends or capital gains, you may have to adjust the amount on Form 1041, page 1, line 2b(2), or Schedule D (Form 1041), line 18.

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 $3,800 exemption. The exemption is not phased out for the 2012 tax year, regardless of adjusted gross income.

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 item 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.