Individual Seeks Changes to Proposed Regs on Estate Deductions

May 30, 2020

CC:PA:LPD:PR (REG-113295-18)
Room 5203
Internal Revenue Service
PO Box 7604
Ben Franklin Station
Washington, D.C. 20044

Re: Comments on Regulations about Effect of Section 67(g) on Trusts and Estates

Dear Sir or Madam,

This letter comments on the proposed regulations under section 642(h), Effect of Section 67(g) on Trusts and Estates, REG-113295-18, 83 Fed. Reg. 27693 (May 11, 2020), which updates the regulations to reflect changes made by Public Law No. 115-97, the law formerly known as the Tax Cuts and Jobs Act of 2017.

This letter is submitted in my personal capacity.

1. Excess Deduction from Rental Property's Real Estate Taxes

Prop. Treas. Reg. § 1.642(h)-5(b) contains an example of an estate with $2,000 of rental income, $4,500 of investment income, $3,500 of real estate taxes on rental property, and $14,000 of section 67(e) deductions. The estate allocates $2,000 of real estate taxes to the $2,000 of rental income and allocates $4,500 of the section 67(e) deductions to all $4,500 of investment income, so that the estate's termination causes the beneficiary to receive the remaining $1,500 of real estate tax deductions (an itemized deduction) and $9,500 of section 67(e) deductions.

The estate is not subject to the passive activity loss rules and section 469(j)(12) in the example, presumably due to either active participation or material participation by the estate in the rental activity. The estate's manner of participation should be clarified in the example, including whether the estate is a real estate professional under section 469(c)(7) or is using the active participation rule for estates in section 469(i)(4).¹

The example seems to not take advantage of the end of Treas. Reg. § 1.652(b)-3(d), which provides that “if the trust has rents, taxable interest, dividends, and tax-exempt interest, and the deductions directly attributable to the rents exceed the rental income, the excess may be allocated to the taxable interest or dividends in such proportion as the fiduciary may elect.”² The estate should allocate the remaining $1,500 of real estate taxes to the investment income and $3,000 of the section 67(e) deductions to the remaining $3,000 of investment income, so that the estate's termination causes the beneficiary to receive the remaining $11,000 of section 67(e) deductions under section 642(h)(2). All of the beneficiary's deductions would be above-the-line section 67(e) deductions, instead of $1,500 being a real estate tax deduction.

Furthermore, even if the estate does not allocate any real estate tax deductions to the investment income and causes the beneficiary to receive $1,500 of real estate tax deductions upon the estate's termination, the deductions are above-the-line deductions of the estate under section 62(a)(4) as deductions attributable to property held for the production of rents (or under section 62(a)(1) as a business deduction) and therefore potentially section 642(h)(1) excess deductions. The real estate tax deductions at the beneficiary level would be above-the-line deductions and would not be subject to section 164(b)(6), given that they are allocable to a rental property.

2. NOL Carryback from Section 642(h)(1) Deductions

Prop. Treas. Reg. § 1.642(h)-5(a) contains an example where an estate terminates in 2020 and allocates $1,000 of net operating loss (NOLs) generated in 2020 to each of its two beneficiaries, an individual and a trust, under section 642(h)(1). The example states that neither the individual beneficiary nor the trust beneficiary can carry back any of the estate's NOL made available to them under section 642(h)(1).

The example should provide instead that the individual and the estate may carry back the NOL for five taxable years under section 172(d)(1)(D), which was enacted by Pub. L. No. 116-136 (Coronavirus Aid, Relief, and Economic Security Act, or CARES Act) section 2303(b) on March 27, 2020. The NOL carryback provisions in the CARES Act should apply to beneficiaries of trusts and estates in the same manner as all other taxpayers, in order to provide economic stimulus and relief during the Covid-19 pandemic.

A further example can confirm that the five year carryback in section 172(d)(1)(D) applies even if the estate's NOL is generated in a taxable year beginning in 2017 or earlier, and carried forward until the estate terminates between 2018 and 2020.

3. Deduction Carryovers

Prop. Treas. Reg. § 1.642(h)-2(c) provides that the section 642(h)(2) excess deductions allowed for a beneficiary cannot be carried over to any other taxable year of the beneficiary. An exception should be made for investment interest under section 163(d), which should be allowed to be carried forward under section 163(d)(2) to the beneficiary's subsequent taxable years if unused. There is no clear reason why investment interest should be entirely disallowed if not used by the beneficiary in the same taxable year, which would be contrary to the general intent of the regulations to discourage trusts from prolonging their existence solely in order to use more tax deductions.³

The current Treas. Reg. § 1.642(h)-2(a) does not allow any unused section 642(h)(2) excess deductions to be carried over to the beneficiary's subsequent taxable years, which makes sense when all the section 642(h)(2) excess deductions are miscellaneous itemized deductions that cannot be carried over under general tax rules. When some of the section 642(h)(2) excess deductions are no longer miscellaneous itemized deductions, carryover should be permitted to the extent otherwise possible under general tax rules.

For the remaining section 642(h)(2) excess deductions that cannot be carried over, ordering rules should clarify whether the excess deductions are applied before, after, or ratably with the beneficiary's other deductions. If the beneficiary has section 642(h)(2) excess deductions and other deductions that add up in excess of the beneficiary's gross income, it may not be apparent whether the excess is due to the section 642(h)(2) excess deductions or other deductions. Furthermore, the amount of the beneficiary's NOL carryover to a later taxable year under section 172 should take into account all of the beneficiary's section 642(h)(2) excess deductions that are section 67(e) deductions, as deductions that are attributable to the beneficiary's trade or business and not subject to section 172(d)(4).

I would be glad to discuss my comments if that would be helpful.

Sincerely,

Libin Zhang
New York, NY