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It is not uncommon for charitable remainder trusts to hold depreciable property or to hold an interest in a passthrough entity that holds depreciable property. In this article, Ted R. Batson, Jr., Vice President of Professional Services for Renaissance Inc., discusses the proper allocation of depreciation deductions between various forms of charitable remainder trusts and their income recipients.

by Ted R. Batson, Jr., MBA, CPA

Introduction

It is not uncommon for charitable remainder trusts (CRTs) to hold depreciable property or to hold an interest in a passthrough entity that holds depreciable property. The proper treatment of the depreciation deduction permitted under Internal Revenue Code (IRC) §167 is a question encountered by trustees of such CRTs. The Internal Revenue Service (IRS) determined that IRC §167(d), which requires the allocation of depreciation deductions between a trust and its income recipients in the same proportions as the trust's fiduciary accounting income, applies to CRTs.¹ In addition, the IRS ruled the governing instrument of a standard charitable remainder unitrust (SCRUT) does not have to require the creation of a depreciation reserve for the CRT to qualify as a charitable remainder trust under IRC §664(d)(2).² In contrast, the IRS ruled the trustee of an otherwise qualifying "income exception" charitable remainder unitrust³ that holds depreciable property must create a depreciation reserve and apply Treas. Reg. §1.167(h)-1(b) in determining the proper allocation of the depreciation deduction between the trust and its income recipients. ⁴

This article will explore the general rule described at IRC §167(d) and the regulations thereunder and discuss its application to CRTs in particular.

The General Rule for Trusts⁵

IRC §642(e) permits a trust to claim a deduction for depreciation to the extent that the deduction is not allowable to the trust's income recipients under IRC §167(d) which reads: 

LIFE TENANTS AND BENEFICIARIES OF TRUSTS AND ESTATES.--In the case of property held by one person for life with remainder to another person, the deduction shall be computed as if the life tenant were the absolute owner of the property and shall be allowed to the life tenant. In the case of property held in trust, the allowable deduction shall be apportioned between the income beneficiaries and the trustee in accordance with the pertinent provisions of the instrument creating the trust, or, in the absence of such provisions, on the basis of the trust income allocable to each. In the case of an estate, the allowable deduction shall be apportioned between the estate and the heirs, legatees, and devisees on the basis of the income of the estate allocable to each. (emphasis added)

The effect of this provision is the allocation of the allowable depreciation deduction⁶ between the trust and the income recipients in the same proportion as the trust's fiduciary accounting income⁷ is apportioned between the trust and its income recipients. The allocation percentages are computed without including the effect of the depreciation on fiduciary accounting income. ⁸

Example 1

The Miller Family Irrevocable Trust (a noncharitable trust) owns depreciable rental property from which it realizes $15,000 in rental income and a corresponding depreciation amount of $9,000 during tax year 20X1. Per the terms of the trust's governing instrument, $12,000 (or 80%) of fiduciary accounting income is distributed to the trust's income recipients during the year. In accordance with the rules described in IRC §167(d), $7,200 (80% or $9,000) of the depreciation is allocable to the income recipients. Their Schedule K-1 will report $12,000 in income and $7,200 in depreciation deductions for a net taxable amount of $4,800.

It is, however, possible for the depreciation deduction amount allocated to the trust's income recipients to exceed their pro-rata share of the trust's income. ⁹ This is illustrated in the following example:

Example 2

For the year 20X1, the Baker Trust has the following items:

The allowable depreciation deduction will be allocated between the trust and the income recipients as follows:

In this example the income recipients will report a net loss of $3,000 on their individual returns.  Note that the deductibility of this loss will be subject to the passive activity rules.

The Effect of a Depreciation Reserve

Where the governing instrument of a trust (or applicable local law) requires the trustee to maintain a depreciation reserve, the rule is modified. In this case, an amount of the allowable depreciation deduction equal to the amount of income set aside in the reserve is allocable solely to the trust. Any amount of allowable depreciation deduction that exceeds the reserve amount is then allocable between the trust and the income recipients under the normal rule. ¹⁰

Example 3

The Andrews Family Trust governing instrument states that the trustee must maintain a depreciation reserve whose annual additions are equal to an amount of depreciation determined under generally accepted accounting principles. For the year 20X1, the trust has the following items:

The allowable depreciation deduction will be allocated between the trust and the income recipients as follows:

Example 4

The Vining Legacy Trust governing instrument states that the trustee must maintain a depreciation reserve whose annual additions are equal to $5,000. For the year 20X1, the trust has the following items:

The allowable depreciation deduction will be allocated between the trust and the income recipients as follows:

Note that no additional deduction is allowed to the trust or the trust's income recipients for the amount ($1,500) by which the depreciation reserve set aside exceeds the allowable depreciation deduction.

In cases where there is no rental income, but there exists an allowable depreciation deduction, the deduction can still pass out to the trust's income recipients based upon the allocation of other items of fiduciary accounting income. ¹¹

It is unclear what treatment would apply in the case where there exists an allowable depreciation deduction, but there is no fiduciary accounting income for distribution to the income recipients. The question may be further complicated where a required distribution to income recipients is made from principal when income is insufficient. This can arise when an annuity amount or unitrust amount is used to determine the payment to income recipients rather than referring to income. Because the statute and regulations require apportionment on the basis of trust income, the author believes the absence of trust income will preclude apportionment of the depreciation deduction to the trust's income recipients.

If the trustee creates a depreciation reserve, but is not authorized or required to do so, the depreciation reserve is then ignored. However, the income set aside is treated as an item of undistributed income and will affect the percentages used to allocate the allowable depreciation deduction. ¹²

The Special Exception for Partnership and LLC Interests

In Rev. Rul. 61-211 the Service addressed the treatment of depreciation accrued by a partnership of which a trust was a partner.  In that ruling the Service held that if the partnership agreement permitted the special allocation of depreciation to a partner, then the trust could look through the partnership and claim its allocable share of the depreciation "as if it were realized directly from the depreciable ... partnership property." ¹³ In Rev. Rul. 74-71 the Service modified Rev. Rul. 61-211 to remove the requirement that the partnership agreement permit or require a special allocation of the depreciation to its partners.

Example 5

The Carter Irrevocable Trust governing instrument states that the trustee must maintain a depreciation reserve whose annual additions are equal to $5,000.  For the year 20X1, the trust has the following items:

The allowable depreciation deduction will be allocated between the trust and the income recipients as follows:

LLCs that elect to be taxed as partnerships will be treated in the same manner as described above.

The Practical Problem of Partnership/LLC Interests

As a practical matter, a partner of a partnership may experience problems in obtaining the information necessary to determine its share of the partnership's allowable depreciation deduction. While partnerships are required to disclose many allocable items of income, deduction, and credit to their partners, the amount of the allowable depreciation deduction is not a required disclosure. While some general partners may respond to a trustee's request for this information, compliance with the request is not compulsory. In addition, the compressed time frame for filing the fiduciary return vis-xc3xa0-vis the statutory deadline for supplying partners with their Schedule K-1 may make reduce the viability of this option.

Charitable Remainder Trusts In Particular

Standard Charitable Remainder Unitrusts.  In a series of private letter rulings issued in 1986 and 1989 the Internal Revenue Service laid out its position with respect to the treatment of depreciation by trustees of SCRUTs. ¹⁴ The Service concluded, "the recipient of the unitrust amount [is] entitled to deduct a portion of the depreciation deductions allocable to ... property transferred to a [charitable remainder trust]." ¹⁵ The significance of this ruling lies in its exclusion of the income recipients' portion of the depreciation deduction from inclusion in the "four-tier" accounting scheme of Treas. Reg. 1.664-1(d).

While not specifically addressed in the ruling, it is reasonable to assume that the trustee will still have to determine the amount of fiduciary accounting income received by the trust in order to properly determine the allocation of the depreciation deduction between the trust and its income recipients. This seems to be necessary despite the fact that the actual amount distributed is not determined by reference to the trust's fiduciary accounting income, but rather by reference to the unitrust amount. While not specifically addressed in the rulings, in years where the unitrust amount is less than the fiduciary accounting income of the trust, a portion of the allowable depreciation deduction should be allocable to the trust.

Example 6

The Dunham Charitable Remainder Unitrust is a qualifying CRT under IRC §664(d)(2). The governing instrument does not require that the trustee maintain a depreciation reserve.  For the year 20X1, the trust has the following items:

The allowable depreciation deduction will be allocated between the trust and the income recipients as follows:

None of the allowable depreciation deduction will be included in Tier 1 (ordinary income).  As a result the full amount of the rental income would pass out on the income recipients' Schedule K-1 for inclusion on their individual income tax return.  However, the $3,000 depreciation deduction would also pass out resulting in a net taxable amount from rental sources of $5,000. The tax character of the remaining $2,000 ($10,000 unitrust amount less $8,000 rental income) is not determinable from the facts given.

Example 7

The Walter & Maxine Phillips Charitable Remainder Unitrust is a qualifying CRT under IRC §664(d)(2). The governing instrument does not require that the trustee maintain a depreciation reserve.  For the year 20X1, the trust has the following items:

The allowable depreciation deduction will be allocated between the trust and the income recipients as follows:

$1,333 of the allowable depreciation deduction will be included in Tier 1 (ordinary income).  As a result the net rental income included in Tier 1 will be $8,667.  The character of the unitrust amount in the hands of the income recipients would be as follows:

Combining this result with the $2,667 depreciation deduction flowing separately to the income recipients results in net taxable rental income of $3,833 and other ordinary income of $1,500.

Example 8

The Brady Charitable Trust is a qualifying CRT under IRC §664(d)(2).  The governing instrument does require the trustee to maintain a depreciation reserve.  For the year 20X1, the trust has the following items:

The allowable depreciation deduction will be allocated between the trust and the income recipients as follows:

The full $4,000 of the allowable depreciation deduction will be included in Tier 1 (ordinary income).  As a result the net rental income included in Tier 1 will be $6,000.  The character of the unitrust amount in the hands of the income recipients would be as follows:

Example 9

The Cox Charitable Remainder Trust is a qualifying CRT under IRC §664(d)(2).  The governing instrument requires that the trustee maintain a depreciation reserve.  For the year 20X1, the trust has the following items:

The allowable depreciation deduction will be allocated between the trust and the income recipients as follows:

$3,333 of the allowable depreciation deduction will be included in Tier 1 (ordinary income).  As a result the net rental income included in Tier 1 will be $6,000.  The character of the unitrust amount in the hands of the income recipients would be as follows:

Combining this result with the $667 depreciation deduction flowing separately to the income recipients results in net taxable rental income of $5,487 and other ordinary income of $1,846.

Net Income Charitable Remainder Unitrusts.  In Ltr. Rul. 8931023 the IRS laid the groundwork for a different conclusion for income exception unitrusts by stating "[The standard charitable remainder unitrust case] is distinguishable from the situation presented in the case of a unitrust satisfying the requirement of section 664(d)(3) of the Code, where the trust distribution is dependent, in part, on trust income, as defined in section 643(b)." ¹⁶ In a separate ruling involving a net-income only charitable remainder unitrust, the IRS stated:

[T]he cost of depreciation, or using up, of income producing assets must be taken into account, in a systematic and rational manner, in determining the amount of net income.  This is necessary in order to ensure that the current expenses of producing income will be borne by the income beneficiaries, and to preserve the value of the trust assets for the charitable remainderman.  Therefore, under the terms of the governing instrument, if the trustee of [the net-income only charitable remainder unitrust] accepts or invests in depreciable property, it is required to establish a depreciation reserve in accordance with generally accepted accounting principles.(emphasis added) ¹⁷

As illustrated in the previous examples, maintaining a depreciation reserve will reduce the amount of depreciation available for pass-through treatment by an amount equal to the reserve.  In addition, where the trustee is required or elects to maintain a depreciation reserve, the amount retained is typically treated as a charge against fiduciary accounting income.  This has the very real effect of reducing the income available for distribution from the trust.

Example 10

The Harper Charitable Remainder Trust is a qualifying CRT under IRC §664(d)(3).  The governing instrument requires that the trustee maintain a depreciation reserve.  For the year 20X1, the trust has the following items:

The allowable depreciation deduction will be allocated between the trust and the income recipients as follows:

$3,111 of the allowable depreciation deduction will be included in Tier 1 (ordinary income).  As a result the net rental income included in Tier 1 will be $3,889.  In addition, the net income available for distribution will be the $9,000 less the $3,000 charge for the depreciation reserve.  Since the trust is a net-income type charitable remainder trust, the distribution will be the lesser of the fiduciary accounting income and the unitrust amount or $6,000. The character of the unitrust amount in the hands of the income recipients would be as follows:

Combining this result with the $999 depreciation deduction flowing separately to the income recipients results in net taxable rental income of $2,890 and other ordinary income of $2,000. The character of the additional $111 is undeterminable from the facts given.

Alternate Points of View

There are practitioners who believe that the IRS has incorrectly ruled in the published rulings.  They point to the specific provisions of Treas. Reg. 1.664-1(d)(2) which describe how deductions are to be allocated in a charitable remainder trust. Those provisions can be interpreted to require that, with limited exceptions, all items of income and deduction must pass through the unique four-tier system described in Treas. Reg. 1.664-1(d)(1).  Because IRC §642(e) is not specifically excepted from the provisions of Treas. Reg. 1.664-1(d)(2), they argue that all of the depreciation deduction must flow into Tier 1.  If the result of this is a net loss, then under the four-tier rules the loss carries back to prior years until all accumulated income is offset and then forward indefinitely. ¹⁸

Ruling Desirable

The treatment of depreciation in a charitable remainder trust is far from settled.  There have been no authoritative pronouncements. If you are considering a charitable remainder trust where depreciation will be a significant element of the trust's activity, then it is recommended that a ruling be sought.

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1. Ltr. Rul. 8610067; See also Pusey, J. Michael, Charitable Remainder Trusts, 2^nd Edition, 1997, Vol. 1, pp. 554-556 especially footnote 1236;  "Depreciation Pass-Through in the CRT", Charitable Gift Planning News; Vol. 7, No. 9, September 1989, pp. 2-3;  "Depreciation in a Charitable Remainder Trust", Charitable Gift Planning News; Vol. 10, No. 7, August 1992, pp. 5-8;  Teitell, Conrad, Deferred Giving, 1997, Vol. 1, ¶1.07[H]^back

2. Ltr. Ruls. 8922019, 8922022, and 8931023.  See also Ltr. Ruls. 8922020 and 8922021 for a similar ruling with respect to charitable remainder annuity trusts^back

3. Defined at IRC §664(d)(3).^back

4. Ltr. Ruls. 8931019, 8931020^back

5. See Keene, David, "Understanding How Depreciation of Trust Property Can Affect Beneficiaries", Estate Planning, Vol. 26, July 1999, p. 260^back

6. The allowable depreciation deduction is the amount computed under the applicable tax depreciation method.^back

7. Fiduciary accounting income is an amount separately determined under the terms of a trust's governing instrument and the applicable principal and income laws of the state in which the trust is sited.  It is distinct from tax definitions of income and frequently will differ from taxable income in both its makeup and amount.  Fiduciary accounting income is specifically used in most trust applications by authority of IRC §643(b).^back

8. Treas. Reg. §1.167(h)-1(b)(1)^back

9. Rev. Rul. 74-530^back

10. Treas. Reg. 1.167(h)-1(b) If property is held in trust, the allowable deduction is to be apportioned between the income beneficiaries and the trustee on the basis of the trust income allocable to each, unless the governing instrument (or local law) requires or permits the trustee to maintain a reserve for depreciation in any amount. In the latter case, the deduction is first allocated to the trustee to the extent that income is set aside for a depreciation reserve, and any part of the deduction in excess of the income set aside for the reserve shall be apportioned between the income beneficiaries and the trustee on the basis of the trust income (in excess of the income set aside for the reserve) allocable to each. For example:
    
    

    (1) If under the trust instrument or local law the income of a trust computed without regard to depreciation is to be distributed to a named beneficiary, the beneficiary is entitled to the deduction to the exclusion of the trustee.

    (2) If under the trust instrument or local law the income of a trust is to be distributed to a named beneficiary, but the trustee is directed to maintain a reserve for depreciation in any amount, the deduction is allowed to the trustee (except to the extent that income set aside for the reserve is less than the allowable deduction). The same result would follow if the trustee sets aside income for a depreciation reserve pursuant to discretionary authority to do so in the governing instrument.

    No effect shall be given to any allocation of the depreciation deduction which gives any beneficiary or the trustee a share of such deduction greater than his pro rata share of the trust income, irrespective of any provisions in the trust instrument, except as otherwise provided in this paragraph when the trust instrument or local law requires or permits the trustee to maintain a reserve for depreciation.

    ^back

11. Abbin, Byrle M., Income Taxation of Fiduciaries and Beneficiaries, 2001 Edition, Volume 1, ¶ 311.1.^back

12. Abbin, ¶ 311.1^back

13. Rev. Rul. 61-211^back

14. Ltr. Ruls. 8610067, 8922019, 8922020, 8922021, 8922022, 8931023^back

15. Ltr. Rul. 8610067^back

16. Ltr. Rul. 8931023^back

17. Ltr. Ruls. 8931019, 8931020, ^back

18. Presumably this carryback and carryforward is subject to the application of the passive activity rules.^back

Charitable Remainder Trusts, 2^nd Edition, 1997, Vol. 1, pp. 554-556 especially footnote 1236;  "Depreciation Pass-Through in the CRT", Charitable Gift Planning News; Vol. 7, No. 9, September 1989, pp. 2-3;  "Depreciation in a Charitable Remainder Trust", Charitable Gift Planning News; Vol. 10, No. 7, August 1992, pp. 5-8;  Teitell, Conrad, Deferred Giving, 1997, Vol. 1, ¶1.07[H]x1e[delim]x1efn2;;;bfn2;;;Ltr. Ruls. 8922019, 8922022, and 8931023.  See also Ltr. Ruls. 8922020 and 8922021 for a similar ruling with respect to charitable remainder annuity trustsx1e[delim]x1efn3;;;bfn3;;;Defined at IRC §664(d)(3).x1e[delim]x1efn4;;;bfn4;;;Ltr. Ruls. 8931019, 8931020x1e[delim]x1efn5;;;bfn5;;;See Keene, David, "Understanding How Depreciation of Trust Property Can Affect Beneficiaries", Estate Planning, Vol. 26, July 1999, p. 260x1e[delim]x1efn6;;;bfn6;;;The allowable depreciation deduction is the amount computed under the applicable tax depreciation method.x1e[delim]x1efn7;;;bfn7;;;Fiduciary accounting income is an amount separately determined under the terms of a trust's governing instrument and the applicable principal and income laws of the state in which the trust is sited.  It is distinct from tax definitions of income and frequently will differ from taxable income in both its makeup and amount.  Fiduciary accounting income is specifically used in most trust applications by authority of IRC §643(b).x1e[delim]x1efn8;;;bfn8;;;Treas. Reg. §1.167(h)-1(b)(1)x1e[delim]x1efn9;;;bfn9;;;Rev. Rul. 74-530x1e[delim]x1efn10;;;bfn10;;; Treas. Reg. 1.167(h)-1(b) If property is held in trust, the allowable deduction is to be apportioned between the income beneficiaries and the trustee on the basis of the trust income allocable to each, unless the governing instrument (or local law) requires or permits the trustee to maintain a reserve for depreciation in any amount. In the latter case, the deduction is first allocated to the trustee to the extent that income is set aside for a depreciation reserve, and any part of the deduction in excess of the income set aside for the reserve shall be apportioned between the income beneficiaries and the trustee on the basis of the trust income (in excess of the income set aside for the reserve) allocable to each. For example:

(1) If under the trust instrument or local law the income of a trust computed without regard to depreciation is to be distributed to a named beneficiary, the beneficiary is entitled to the deduction to the exclusion of the trustee.

(2) If under the trust instrument or local law the income of a trust is to be distributed to a named beneficiary, but the trustee is directed to maintain a reserve for depreciation in any amount, the deduction is allowed to the trustee (except to the extent that income set aside for the reserve is less than the allowable deduction). The same result would follow if the trustee sets aside income for a depreciation reserve pursuant to discretionary authority to do so in the governing instrument.

No effect shall be given to any allocation of the depreciation deduction which gives any beneficiary or the trustee a share of such deduction greater than his pro rata share of the trust income, irrespective of any provisions in the trust instrument, except as otherwise provided in this paragraph when the trust instrument or local law requires or permits the trustee to maintain a reserve for depreciation.

x1e[delim]x1efn11;;;bfn11;;;Abbin, Byrle M., Income Taxation of Fiduciaries and Beneficiaries, 2001 Edition, Volume 1, ¶ 311.1.x1e[delim]x1efn12;;;bfn12;;;Abbin, ¶ 311.1x1e[delim]x1efn13;;;bfn13;;;Rev. Rul. 61-211x1e[delim]x1efn14;;;bfn14;;;Ltr. Ruls. 8610067, 8922019, 8922020, 8922021, 8922022, 8931023x1e[delim]x1efn15;;;bfn15;;;Ltr. Rul. 8610067x1e[delim]x1efn16;;;bfn16;;;Ltr. Rul. 8931023x1e[delim]x1efn17;;;bfn17;;;Ltr. Ruls. 8931019, 8931020, x1e[delim]x1efn18;;;bfn18;;;Presumably this carryback and carryforward is subject to the application of the passive activity rules.-->