When it comes to trusts, it's not so much a question of whether taxes will come due on the assets they hold, but who is responsible for paying them. This depends a great deal on whether the trust is revocable or irrevocable, and if the grantor – the creator of the trust – is still living. Income tax usually does not come into play when a trust sells real estate. The issue is capital gains.
A revocable trust isn't usually a separate tax entity during the grantor's lifetime. If you create such a trust, you still retain incidents of ownership over the property you fund it with. As trustee, you manage the trust and its assets yourself. You can buy or sell its property, or make any other changes you like. If your trust holds a home and you sell the property, and if you realize capital gains, you must report the gains on your personal tax return. Your gain is the sales price less what you paid for the property and the cost of any improvements you made. (Reference 5) Because you still have incidents of ownership, however, and provided you live there, you remain eligible for the federal $250,000 capital gains exclusion – $500,000 if you're married and file a joint return – even if the house was held by the trust. Therefore, you would have to recognize a relatively hefty profit before any capital gains tax would come due.
Simple Irrevocable Trusts
Irrevocable trusts are a whole different matter. When you fund such a trust by transferring ownership of property into it, you give up control and any opportunity to take the assets back. For this reason, after the transfer, you would no longer report gains on your personal tax return. This type of trust is a separate tax entity and requires a tax identification number. If you create a simple irrevocable trust, this means it's required to disburse all its income every tax year and the disbursements are taxable to the beneficiaries as income. Capital gains are not income to irrevocable trusts. They're contributions to corpus – the initial assets that funded the trust. Therefore, if your simple irrevocable trust sells a home you transferred into it, the capital gains would not be distributed and the trust would have to pay taxes on the profit.
Complex Irrevocable Trusts
Complex irrevocable trusts are permitted by law to retain income, distributing only a portion to their beneficiaries. Although technically you can be a beneficiary of your irrevocable trust or even act as the trustee, you'll lose valuable estate tax advantages if you do so. Most grantors do not act as trustees or receive any benefit from their irrevocable trusts for this reason. If you are a beneficiary during your lifetime, any proceeds or distributions you take are reportable on your personal tax return and the trust can take a tax deduction for anything it pays you. Capital gains would still be considered additions to corpus, however, and are therefore not distributable. Your complex trust would pay any capital gains tax due from your house sale.
If, after your death, your trust transfers your home to a beneficiary, that individual becomes responsible for any taxes due. The real estate inheritance is not taxable; the Internal Revenue Service does not consider it income. If your beneficiary sells it, however, he becomes personally responsible for capital gains tax on the proceeds. His tax basis is not what you initially paid for the property, but what it is worth at the time of your death, so he may not realize any significant capital gains. This is particularly true if he sells relatively soon after he inherits.
- KLR Wealth Management: Title Matters Part 2 – Who Pays the Income Taxes?
- J. Mark Fisher: Living Revocable Trusts
- Law Offices of Linda M. Toga: Selling a House Held by an Irrevocable Trust
- Michael D. Flynn & Associates: Capital Gains Vs. Inheritance Tax and Probate
- Fox Business: Capital Gains and Your Home Sale
- The Rushforth Firm: Irrevocable Trusts
- TurboTax: Estates and Trusts
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.