Taxing trust income, including rental income, begins with recognizing that the tax is assessed on the beneficiaries and not the trust itself. The financial activity for the year is divided among the beneficiaries and included in their income. However, just because the income comes from a trust does not mean that the character of the income changes. As rental income is considered passive, the beneficiaries must treat the rental income received from the trust as passive on their personal returns.
Trusts in General
Trusts are separate taxable entities created for the benefit of beneficiaries. A donor provides the trust with property, such as rental real estate, which is to be used for the beneficiaries' benefit. The trust is maintained by a trustee, who manages the trust’s property for the beneficiaries’ benefit. A family trust is a trust organized to benefit family members who are related by blood or law. Trusts that have any taxable income for the year or a beneficiary who is a non-resident alien must file a Form 1041. The return must be filed by the trustee by the 15th day of the fourth month after the end of the trust’s tax year. For most trusts, this date is April 15th. Trusts are not taxed directly on the income they generate; the beneficiaries are taxed. So in addition to filing a 1041, the trustee must also provide the beneficiaries with K-1s. These documents detail the beneficiaries' “share” of the trust activities, including how much taxable income the beneficiaries must include on their personal returns.
Taxing Rental Property
Rental income can be in the form of cash or property received for the use of property. Rental income can be offset by expenses incurred in renting a property. These expenses include depreciation on the underlying property and repairs made to keep the property in working order. Both the revenue and expenses related to the rental property are considered “passive.” Passive activities are businesses in which the party receiving the benefit does not materially participate. Examples of material participation include managing a business's workforce or producing the business's product for multiple hours of the work day over a long period of time. Generally all rental activities are considered passive. The key consideration for passive activities is that net passive losses can generally only be used to offset passive gains. If your passive losses exceed your passive gains, you may “carry forward” your excess losses to offset future passive gains.
Rental Property in Family Trust
While rental income will ultimately be reported on line 5 of the trust income tax return, or Form 1041, the trustee also needs to complete to summarize the trust's rental income on a separate schedule. Instead of creating a new form for this purpose, the IRS requires that trusts use a Schedule E from a Form 1040. The trust's rental income and expenses are reported in Section I of Schedule E. In that section, the trustee must record the location of the properties and the total income received for each. After that, the expenses associated with each property are recorded based on type. Expenses listed include mortgage payments, taxes, utilities, advertising used to promote the property for rent, and insurance. Beneficiaries will also use Schedule E to report their share of the trust’s rental income when completing their person returns. This is done by recording the amount listed on the beneficiary’s K-1, in Part III of Schedule E.
Tax Tips and Disclaimer
When creating a trust, consult with an attorney to ensure that all state filing requirements are appropriately fulfilled. For complex trust tax returns, consult with a tax professional, such as a certified public accountant (CPA) or licensed attorney. Keep your tax records for at least seven years to protect against the possibility of future audits. Every effort has been made to ensure this article’s accuracy, but it is not intended to be legal advice.
- USlegal.com: Trusts.
- USlegal.com: Family Trust Law & Legal Definition.
- IRS.gov; Instructions for Form 1041 an Schedules A, B, G, J and K-1; 2010.
- IRS.gov; Tax Topics – Topic 414 Rental Income and Expenses; 2011.
- IRS.gov; Tax Topics – Topic 425 Passive Activities – Losses and Credits; 2011.
- IRS.gov: Form 1041.
- Internal Revenue Service. "Instructions for Schedule K-1 (Form 1041) for a Beneficiary Filing Form 1040," Page 2. Accessed Oct. 25, 2019.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.