Setting Aside Income for Wear and Tear
Physical assets lose value over time. Buildings age, equipment wears out, and machinery becomes obsolete. When a trust holds these kinds of assets, the income they produce gradually consumes the underlying principal. Arizona law gives trustees the discretion to account for this by transferring a reasonable amount from income to principal as a depreciation reserve.
A trustee may transfer to principal a reasonable amount of the net cash receipts from a principal asset that is subject to depreciation but may not transfer any amount for depreciation of that portion of real property used or available for use by a beneficiary as a residence or of tangible personal property held or made available for the personal use or enjoyment of a beneficiary.
A.R.S. § 14-7427(A)The word "may" is important here. This is a discretionary power, not a requirement. A trustee can choose to set aside funds for depreciation or choose not to, depending on the circumstances. The amount must be reasonable, which means it should reflect actual wear and decline in value rather than an aggressive deduction that starves income beneficiaries.
When Depreciation Transfers Are Not Allowed
The statute carves out three situations where depreciation transfers cannot be made. First, property used or available as a beneficiary's residence is exempt. If a trust owns a home where a beneficiary lives, the trustee cannot reduce income distributions to build a depreciation reserve on that home. The same goes for tangible personal property held for a beneficiary's personal use.
Second, depreciation transfers are not allowed during the administration of a decedent's estate. And third, if the trustee is already accounting for the asset under a business or farming activity governed by section 14-7412, the depreciation rules in that section apply instead.
Any amount transferred to principal for depreciation does not need to be held in a separate fund. It simply becomes part of the trust's principal, available for investment alongside other principal assets. Arizona defines depreciation for this purpose as a reduction in value due to wear, tear, decay, corrosion, or gradual obsolescence of a fixed asset with a useful life of more than one year.
