TABLE OF CONTENTS. General Rules

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1 T41 1/ Interest and Taxes TABLE OF CONTENTS KEY ISSUE DESCRIPTION PAGE Introduction A Investment Interest Expense General Rules Reporting Deductible Investment Interest Electing to Treat Capital Gains and Qualified Dividends as Investment Income Disallowed Investment Interest B Qualified Residence Interest Expense General Rules Limitation on Qualified Residence Expense Decedent s Former Personal Residence Qualified Mortgage Insurance Premiums C Interest on Deferred Payment of Estate Tax Interest on Deferred Estate Tax Attributable to Closely Held Businesses or Farms Interest on Deferred Estate Tax Attributable to Reversionary or Remainder Interests D Trade or Business Interest Expense E Personal Interest Expense Not Deductible F Deductible and Nondeductible Taxes ILLUSTRATION Allowable Deductions Nondeductible Taxes Form 4952, Investment Interest Expense Deduction, Reporting the Computation of the Investment Interest Expense Deduction Schedule K-1 Reporting Beneficiary s Share of Net Investment Income Form 4952, Investment Interest Expense Deduction, Electing to Treat Net Capital Gain as Investment Income IRS Daily 4% Compound Rate Table Introduction Estates and trusts are generally entitled to claim deductions for interest and taxes, subject to the same limitations that apply to individual taxpayers. Introduction

2 10-2 T41 1/18 Interest deductions require a method of identifying the use of debt proceeds to classify the related interest expense. The regulations provide a system to trace the use of debt proceeds (Temp. Reg T). Once debt proceeds have been traced to a particular type of expenditure (i.e., investment, qualified residence, and personal), the related interest expense assumes the character of that expenditure and is treated under the appropriate set of rules. Investment interest expense is calculated on Form 4952 and deducted on Form 1041, with net investment income reported to the beneficiary on Schedule K-1 if income is distributed to the beneficiary. See Key Issue 10A. Although interest on the deferred payment of estate tax is not considered personal interest, the interest expense paid on the deferred estate tax is not deductible for estate or income tax purposes unless the estate was created prior to 1998 [IRC Sec. 2053(c)(1)(D)]. See Key Issue 10C. Trade or business interest is deductible by an estate or trust and is discussed in Key Issue 10D. Personal interest is not deductible, as discussed in Key Issue 10E. Certain taxes are deductible by an estate or trust. See Key Issue 10F. References Rev. Proc , CB 556. Schwan, Marvin M., Estate, 264 F. Supp. 2d 887, 91 AFTR 2d (DC SD 2003). KEY ISSUE 10A Investment Interest Expense. General Rules Investment interest is interest paid on debt proceeds used to purchase or carry property held for investment [IRC Sec. 163(d)(3)(A)]. It does not include any qualified residence interest or interest incurred in a passive activity [IRC Sec. 163(d)(3)(B)]. The limitation on the deductibility of investment interest expense that applies to individuals also applies to trusts and estates. The amount of deductible investment interest for any tax year cannot exceed net investment income [IRC Sec. 163(d)(1)]. Any excess can be carried forward to a succeeding tax year [IRC Sec. 163(d)(2)]. Form 4952 (Investment Interest Expense Deduction) is used to calculate the allowable investment interest deduction. However, there is no authority for allowing unused investment interest to pass through to the beneficiary on termination of an estate or trust. Investment income is defined as gross income from all property held for investment; net investment income is the excess of investment income over investment expenses [IRC Sec. 163(d)(4)]. Net capital gain attributable to the disposition of property held for investment is generally not investment income, but an election can be made to treat the capital gain as investment income. See Example 10A-3 and Election E306. Income classified as portfolio income (i.e., income not derived in the ordinary course of a trade or business) under the passive loss rules is investment income [IRC Secs. 163(d)(5)(A)(i) and 469(e)(1)(A)]. However, qualified dividends (i.e., dividends received from domestic corporations and qualified foreign corporations that are taxable at net capital gains rates) are not considered investment income for the investment interest expense deduction unless the fiduciary elects to include it [IRC Sec. 163(d)(4)(B)]. Income from an oil and gas working interest held in an entity that does not limit the taxpayer s liability [i.e., meets the exception that it is nonpassive under IRC Sec. 469(c)(3) and (4)] is investment income (and a net loss is considered investment expense) if the taxpayer does not materially participate in the activity [IRC Sec. 163(d)(5)(A)(ii)]. Passive activity losses do not reduce investment income. See Key Issue 7D for a discussion of passive activity loss limitations. Investment expenses include the deductions allowed, other than interest expense, that are directly connected with the production of investment income [IRC Sec. 163(d)(4)(C)]. Examples of investment expenses are depreciation on assets that produce investment income, flowthrough investment expenses from a partnership or S corporation, and investment advisor fees. An expense subject to the 2% adjusted gross income limitation (see Key Issue 13E) is considered only to the extent a deduction is allowed. Key Issue 10A

3 T41 1/ Planning Tip: If the estate or trusts holds real estate that generates nondeductible interest expense, the practitioner should advise the fiduciary to consider distributing the property to the appropriate beneficiaries as soon as possible. Preparation Pointer: Taxpayers claiming a deduction for qualified residence interest on any seller-financed mortgages must include on their tax return the name, address, and taxpayer identification number of the person (the seller) to whom the interest is paid or accrued. Furthermore, taxpayers receiving or accruing interest from seller-financed mortgages must include on their tax return the name, address, and taxpayer identification number of the person (the buyer) from whom the interest is received or accrued. This information is to be reported on the individual taxpayers Schedules A and B (Form 1040). Since trusts and estates do not file these schedules, the authors recommend a separate statement be attached to Form 1041 providing the required information. For a discussion of how to report other expenses associated with a personal residence used by a beneficiary, see the topic of Payments to Third Parties for Beneficiary s Personal Expenses in Key Issue 17H. Also, see PPC s 1040 Deskbook and Temp. Reg T for coverage of qualified residence interest and related limitations. Qualified Mortgage Insurance Premiums Premiums paid or accrued for qualified mortgage insurance by a trust or estate before January 1, 2018, in connection with acquisition indebtedness for a qualified residence are treated as qualified residence interest. Only premiums paid for mortgage insurance contracts issued on or after January 1, 2007 and allocable to periods before January 1, 2018, qualify for this provision [IRC Sec. 163(h)(3)(E)]. In effect, these amounts paid for qualified mortgage insurance premiums are treated as a separate category of qualified residence interest. Although the deduction for mortgage insurance premiums was scheduled to expire after 2016, it was retroactively extended for one year to December 31, 2017, by the Bipartisan Budget Act of Due to the phase-out rules of IRC Sec. 163(h)(3)(E)(ii), a trust or estate cannot deduct mortgage insurance premiums if its adjusted gross income (AGI) exceeds $109,000. If the trust or estate s AGI exceeds $100,000, the worksheet provided in the 2016 Form 1041 instructions can be used to calculate the allowable portion of the deduction. Caution: This worksheet was removed from the 2017 Form 1041 instructions. Practitioners should look for revised 2017 instructions to include this worksheet. KEY ISSUE 10C Interest on Deferred Payment of Estate Tax. Interest on Deferred Estate Tax Attributable to Closely Held Businesses or Farms A deferral and extension of time to pay estate tax is available under IRC Sec for estates consisting largely (minimum of 35%) of closely held businesses or farms. An estate meeting this requirement may elect to defer estate tax entirely for up to four years and then pay the tax in installments over 10 years. The estate must pay interest on the tax during the four-year deferral period and on the outstanding balance of estate tax during the 10-year period. The first installment of tax is due and payable with the fifth installment of interest. A 2% interest rate is applicable to the deferred tax on the first $1 million, adjusted for inflation (for 2017, this amount was $1.49 million) in taxable value of the closely held business (i.e., for 2017, the first $1.49 million in excess of the applicable exclusion amount) [IRC Sec. 6601(j)(1)(A)]. Thus, in 2017, when the applicable exclusion amount is $5.49 million, the estate tax attributable to the value of the closely held business between $5.49 million and $6.98 million would be eligible for the 2% rate [IRC Sec. 6601(j)(2)]. The excess over the $1.49 million (for 2017) of tax deferral has an interest rate of 45% of the underpayment rate, and the interest expense is not deductible for estate or income tax purposes. Section 6166 interest expense on the deferred tax attributed to a closely held business or farm is not deductible on Form 1041 because it is considered personal interest [IRC Sec. 163(k)]. However, the interest expense on a personal or commercial loan obtained for the payment of estate taxes is deductible on the estate tax return (Form 706) if it is necessary for the payment of estate taxes. Only interest expense on the deferred tax attributed to a reversionary or remainder interest under IRC Sec (discussed in this key issue) is deductible on either Form 706 or Form (See Key Issue 10E.) Key Issue 10C

4 10-8 T41 1/18 Interest on Deferred Estate Tax Attributable to Reversionary or Remainder Interests An estate may deduct any interest expense on the unpaid portion of estate tax attributable to the value of a reversionary or remainder interest in property [IRC Sec. 163(h)(2)(E)]. The deduction is reported on the interest expense line of Form 1041 or on Schedule J of Form 706. The interest rate is the regular rate used for tax underpayments under IRC Sec. 6621(b). (See Table T401 for a table of IRS interest rates on tax underpayments.) TheestatetaxmaybepostponedbytheIRSforuptothree years and six months after the termination of the precedent interest [IRC Sec and Reg (a)(2)]. A reversionary interest is any future interest of property that will return to the decedent, the decedent s estate, or be subject to the decedent s power of disposition. A remainder interest is a portion of an estate that can be enjoyed only after another interest is terminated. See PPC s 706/709 Deskbook for coverage of the deferral of estate tax attributable to a reversionary or remainder interest. Example 10C-1 Unpaid estate tax due to a reversionary interest. John Smith transfers the Flying J Ranch to his son, Tom Jones, for as long as Tom lives. If Tom predeceases John, the ranch will revert back to John. However, John died on June 30, 2016, during Tom s lifetime, leaving his entire estate to his favorite nephew, Harry Smith. The value of John s taxable estate was $6.5 million including the value of John s reversionary interest in the Flying J Ranch of $600,000. John s federal estate tax was $420,000. John s reversionary interest qualifies for extension of time to pay the estate tax under IRC Sec Thus, the payment of John s federal estate tax attributable to the reversionary interest may be postponed. The amount of the tax that may be postponed is $38,769, computed as follows: $600,000 $6,500,000 $420,000 = $38,769 The estate tax return was timely filed March 31, The estate properly elects to defer payment of $38,769 of estate tax for six months under IRC Sec Assume that the interest rate for underpayment of tax for the 2nd and 3rd quarters of 2017 is 4%. The daily compounding interest factor for the period of deferral (March 31, 2017 through September 30, 2017) is , computed using the 4% factor table from Rev. Proc for 183 days. Rev. Proc Table Number Compound Rate Days Factor 13 (See Illustration 10-4) 4 % The interest amount is the deferred estate tax multiplied by the interest factor: $38,769 = $785 The $785 is claimed as a deduction in the year paid. Thus, it is reported on the interest expense line of the 2017 Form KEY ISSUE 10D Trade or Business Interest Expense. There is no limitation on the deductibility of interest paid or accrued on indebtedness incurred in connection with the conduct of a trade or business. Interest expense in connection with a trade or business conducted by an estate or trust should be deducted on the appropriate line of Schedule C (Form 1040), Profit or Loss From Business, Schedule C-EZ (Form 1040), Net Profit From Business, or Schedule F (Form 1040), Profit or Loss From Farming. Example 10D-1 How to report business interest expense. A bookkeeping business is one of the assets of the Estate of Tom Dooley. The estate pays interest on debt used to finance the operations of the business. The business interest is reported on Schedule C or C-EZ (Form 1040). The net income or loss from the business then flows to page 1 of Form See Chapter 4 for coverage of issues related to business and farming activities. Key Issue 10D

5 T41 1/ KEY ISSUE 10E Personal Interest Expense Not Deductible. Personal interest expense incurred by an estate or trust is not deductible [IRC Sec. 163(h)(1)]. Personal interest expense includes all interest other than: (1) interest on a trade or business debt (see Key Issue 10D); (2) investment interest (see Key Issue 10A); (3) passive activity interest (see Key Issue 7A); (4) qualified residence interest (see Key Issue 10B); and (5) interest paid on deferred estate tax payments (see Key Issue 10C) [IRC Sec. 163(h)(2)]. Examples of personal interest include interest paid on 1. installment loans on personal use property (e.g., an auto loan); 2. personal loans from a bank, credit union, or other person; 3. underpayments of federal, state, or local income taxes; or 4. estate tax deficiencies extended under IRC Sec (however, see the next Preparation Pointer). Interest paid by an estate on deferred estate tax under IRC Sec or is deductible on either Form 706 or Form 1041, but not both. However, interest paid by an estate on deferred estate tax under IRC Sec is not deductible on Form 1041 because it is considered personal interest. Only interest paid under a Section 6163 extension is deductible for income tax purposes by an estate (CCA ). See Key Issue 10C for additional discussion andexamplesonthesetypesofinterest. Preparation Pointer: Although interest on a loan to pay estate taxes cannot be deducted for income tax purposes on Form 1041, it may qualify for an estate tax deduction on Form 706 (Ltr. Ruls and ). See PPC s 706/709 Deskbook for a discussion of this deduction. KEY ISSUE 10F Deductible and Nondeductible Taxes. Allowable Deductions The following taxes generally are allowed as a deduction on page 1 (line 11) of Form 1041 for the tax year in which paid or accrued by the estate or trust (unless deducted elsewhere on Form 1041) [IRC Sec. 164(a)]: 1. State, local, and foreign real property taxes. 2. State and local personal property taxes. 3. Foreign or U.S. possession income taxes unless a credit for the tax is taken. 4. Generation-skipping transfer tax imposed on income distributions. 5. State and local income taxes. 6. General sales taxes (unless a deduction is taken for state and local income taxes). Taxes allowed as a deduction are generally claimed on the Taxes line of page 1 of Form However, if the taxes are a business expense or an expense incurred for the production of income, they are claimed on the appropriate line of Schedule C or C-EZ (Form 1040) or Schedule F (Form 1040). Taxes related to rental or royalty activities are reported on the appropriate line of Schedule E (Form 1040), Supplemental Income and Loss. Example 10F-1 Where to report taxes incurred in a trade or business. In August of 2015, Jim Dandee died and left his estate to his daughter, Julie. The estate has various assets including a vineyard operation in southern California. A general manager operates the vineyard. In 2017, the vineyard incurs the following taxes: 1. Local real estate taxes on the vineyard of $5, Personal property taxes on farm implements of $1,000. Key Issue 10F

6 10-10 T41 1/18 3. Payroll taxes on salaries paid to vineyard workers of $2,000. All of these taxes will be deductible on the Schedule C for the vineyard. The net income or loss from the vineyard s Schedule C then flows to page 1 of Form Personal Property Tax. Accrued state and local property taxes that were the decedent s obligations at the time of his or her death are deductible for both estate tax (Form 706) and income tax (Form 1041) purposes. As such, they represent deductions in respect of a decedent [IRC Sec. 691(b)]. See Key Issue 12B for information about deductions in respect of a decedent. However, a decedent s property taxes accrued after his or her death are not deductible on Form 706. If paid by the estate or trust, they can only be deducted on Form Example 10F-2 Decedent s property tax is deductible by estate. The executor of Harry James estate paid property taxes of $500 on September 1, 2017 for property taxes that were accrued at the date of Harry s death. The estate may claim a deduction of $500 on the Taxes line on page 1 of the 2017 Form If Form 706 is required to be filed, the estate may also deduct the accrued property tax as a claim against the estate on its estate tax return (Schedule K of Form 706). See PPC s 706/709 Deskbook. This is an example of a deduction in respect of a decedent (DRD), as discussed in Key Issue 12B. Variation: Assume the same facts except that the payment was for property taxes accrued after Harry s death. In this case, the taxes can only be claimed as an income tax deduction on Form A decedent s property taxes accrued after his or her death are not deductible as an administration expense and therefore are not deductible on Form 706. State and Local Income Tax. State and local income taxes may be claimed on Form 1041, line 11, unless an election is made to deduct state and local general sales tax paid or accrued by the estate or trust. See the following discussion on the general sales tax deduction. If the state and local income taxes were the decedent s obligation (i.e. accrued at the date of his or her death), they are deductible for both estate (Form 706) and income tax (Form 1041) purposes as they are deductions in respect of a decedent [IRC Sec. 691(b)]. See Key Issue 12B. State and Local General Sales Tax. State and local general sales taxes paid or accrued by the estate or trust may be deducted on Form 1041, line 11, if no deduction is taken for state and local income taxes. If deductible, sales taxes paid on items used in a trade or business are claimed on Schedule C, E, or F, depending upon the appropriate reporting. If the amount actually paid is at the same rate as the general sales tax, the deduction is the amount of state and local general sales tax paid. However, sales taxes on clothing, medical supplies, and motor vehicles are deductible as a general sales tax even if the tax rate paid was less than the general sales tax rate. Note that sales taxes on motor vehicles (including leased vehicles) are deductible if the tax rate was more than the general sales tax rate, but only up to the amount of the tax that would have been paid at the general sales tax rate. Caution: An estate or trust cannot use the optional sales tax tables that are available for individuals to compute the general sales tax deduction. Foreign Income Tax. Foreign taxes may be claimed either as a deduction on line 11 of Form 1041 or as a credit on Form 1116 (Foreign Tax Credit). (See Key Issue 21D for information on allocating tax credits between the fiduciary and beneficiaries.) Nondeductible Taxes The following taxes cannot be deducted on the Form 1041 by an estate or trust: 1. Federal income, duties, and excise taxes. 2. Federal estate and gift taxes. 3. Generation-skipping transfer taxes (unless imposed on income distributions). 4. State estate, inheritance, legacy, succession, or gift taxes. Key Issue 10F

7 T41 1/ Once the amount of the loss is established, the deductible portion is determined by subtracting the following amounts from the amount of the total loss: 1. $ % of adjusted gross income (AGI). 3. the amount of expected reimbursement (e.g., insurance). AGI for this purpose is computed by subtracting the administration expenses of the estate or trust from the total income line of the Form 1041 [IRC Sec. 165(h)(5)(C)]. Example 13C-1 Claiming a casualty loss for personal use property. The Estate of David Jones owned a condominium that was completely destroyed by a fire soon after David s death in January At the time, his daughter, who was the sole heir, was residing there rent-free pending the distribution of the condominium to her. The unit had an adjusted basis of $350,000 before the fire, but the estate received only $230,000 in proceeds from the insurance policy. The estate s AGI for the fiscal year ending November 30, 2017, was $300,000. The amount of the deductible casualty loss is $89,900 [($350,000 $230,000 insurance proceeds) (10% $300,000) $100] as computed in Section A of Form (The 10% of AGI and $100 limitations apply.) The $89,900 deduction is reported on the Other deductions not subject to the 2% floor line on page 1 of Form Illustration 13-1 shows the estate s completed Form 4684 Section A. The estate must also file a statement with Form 1041 [or with the Department of the Treasury, Cincinnati, OH 45999] waiving the right to deduct the loss on the estate tax return (Form 706). Illustration 13-2 contains a sample waiver statement using these facts. Law Change Alert: The Disaster Tax Relief and Airport and Airway Extension Act of 2017 (Disaster Act) and the Bipartisan Budget Act of 2018 provide temporary relief for taxpayers who incurred net disaster losses as a result of Hurricanes Harvey, Irma, or Maria or the California wildfires. Both acts define a net disaster loss as the excess of qualified disaster-related personal casualty losses over personal casualty gains as defined in IRC Sec. 165(h)(3)(A). For qualifying taxpayers, the 10% of adjusted gross income (AGI) limitation has been removed. The net disaster loss deduction is not included in the alternative minimum tax (AMT) calculation. In addition, the Disaster Act increases the $100 per-casualty floor to $500 for disaster-related personal casualty losses. Qualified disaster-related personal casualty losses are personal casualty losses that are attributable to the following: Hurricane Harvey and occurred in the Hurricane Harvey disaster area after 8/22/17. Hurricane Irma and occurred in the Hurricane Irma disaster area after 9/3/17. Hurricane Maria and occurred in the Hurricane Maria disaster area after 9/15/17. California wildfire and occurred in the disaster area after 10/7/17. Note: For a list of federally declared disaster areas, see the Federal Emergency Management Agency s website at When to Report Personal Casualty and Disaster Losses Generally, casualty losses are deductible in the year incurred (it does not matter when the property is replaced or repaired) [Reg (a)(1)]. If the casualty loss occurs in a federally declared disaster area and is attributable to a federally declared disaster (see for designated areas), the taxpayer may elect to deduct the loss on the return for the immediately preceding year [IRC Sec. 165(i)]. If that return has been filed, it may be amended for a refund of taxes already paid. This decision is based on a number of factors, the two most important of which are the loss s maximum deduction based on AGI level and the taxpayer s cash flow situation (if the refund is needed immediately to offset the economic loss). Election E212 is a sample election for casualty losses incurred in a federal disaster area. Business and Income-producing Property Losses A deduction is also allowed for losses resulting from a casualty, or a theft of business or income-producing property [IRC Sec. 165(c)]. The method of determining the deductible portion of the loss is the same as discussed for personal-use property, except the deduction is not reduced by the $100 or 10% of AGI. The amount of the loss is computed in Section B of Form Key Issue 13C

8 13-8 T41 1/18 Example 13C-2 Claiming a casualty loss for investment property Assume the same facts as in Example 13C-1. If David s daughter had not been residing in the condominium rent-free at the time of the fire pending its distribution to her, the condominium would likely (depending on the intended use) have been income-producing property in the hands of the estate instead of personal use property. In this situation, the entire $120,000 loss ($350,000 $230,000) would have been deductible on Form 4684, Section B. KEY ISSUE 13D Other Deductions Not Subject to the 2% of AGI Floor. Expenses Other than Casualty and Theft Losses In addition to casualty and theft losses discussed in Key Issue 13C, the following items are examples of expenses that should be reported on the Other deductions not subject to the 2% floor line on page 1 of Form 1041: 1. Amortization of bond premiums for taxable bonds acquired before October 23, (See Key Issue 3E for additional information concerning bond premiums.) 2. Net operating loss deduction. (See Key Issue 14A for more information on NOLs.) 3. Fiduciary s share of amortization, depreciation, and depletion not related to investments and not claimed elsewhere on the return (i.e., on Schedules C, C-EZ, E, or F). The fiduciary s share of these deductions should be reported on an attached sheet and included on line 15(a). The beneficiary s share of such deductions should be reported in the appropriate box of Schedule K-1 (Form 1041). (See Chapter 8 for more information on depreciation and depletion.) 4. Domestic production activities deduction, as discussed in this key issue. 5. Interest expenses, taxes, and estate taxes attributable to income in respect of a decedent (IRD). See Key Issue 9A for a discussion of IRD. 6. Fiduciary, attorney, accountant, and return-preparer fees are deductible in arriving at adjusted gross income and are not subject to the 2% of AGI floor if the expenses would not have been incurred if the property was held outside the estate or trust [IRC Sec. 67(e)(1)]. (See Key Issues 13A and 13B for additional coverage of administration expenses and their deductibility.) Observation: After the grantor s death, certain trusts may incur expenses normally associated with estate administration. Examples include storage fees for personal effects to be distributed according to the trust agreement or appraisal fees. These expenses are fully deductible by an estate because they are unique to the estate s administration and incurred only because of the taxpayer s death. Similar costs incurred by a trust are also deductible without regard to the 2% limitation (Reg ). Qualified Production Activities Income Deduction The fiduciary s share of qualified production activities income deduction (QPAI) is not subject to the 2% of AGI floor and should be reported on the Other deductions not subject to the 2% floor line on page 1 of Form The deduction must be attributable to the following activities [IRC Sec. 199(a)(1), (c)(4), and (d)(1)]: 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: Key Issue 13D a. 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; b. any qualified film the estate or trust produced; or c. electricity, natural gas, or potable water the estate or trust produced in the United States.