A family trust is a living trust you set up to pass your property to your family outside probate. If you appoint yourself as trustee, you can manage your assets -- rental houses, bank accounts, personal home -- just as if you were still the legal owner. At your death, your hand-picked successor trustee takes over to manage the trust, its income and the payments to your heirs.
A family trust doesn't affect your taxes while you're alive. Even though your trust holds the title to your rental property, you still pay the taxes. You report the rent checks as income on your tax return, and subtract such expenses as repairs, property taxes and mortgage interest. If your rental runs in the red, you can deduct up to $25,000 in losses from your other income. After that, you have to carry losses forward to deduct in future years.
After your death, your trust becomes an independent taxpayer. Your successor trustee has to file a tax return reporting the trust's income until all the assets are distributed to the beneficiaries. The bad news is that the trust pays higher tax rates on rental and other income than a human being earning the same amount. As of 2013, the tax rate on undistributed income above $11,950 is 39.6 percent. Even with lots of rental expenses to write off, that's going to hurt.
If, say, you set up the trust to manage property for minors, or an adult who can't control his spending, the trust may continue paying taxes for years. One way your trustee can reduce the bill is to distribute more income to the beneficiaries. When the trust gives money out, it can write off the distribution against its income. The beneficiary pays tax at her own rates, as if she'd earned the income herself. Rental income is taxed at her regular rate, for instance, while profits from selling the house would be taxed as capital gains.
Dodging the Bullet
If your primary goal for the trust is bypassing probate, consider whether it's worth the higher taxes the trust may have to pay compared to someone inheriting the rental directly. If the goal is for the trust to manage property for the long-term, your trustee will have to decide how much rental income to distribute each year and how much to hold on to for possible repairs or other emergencies. He should also think about the beneficiaries' tax rates. If a big distribution pushes your heirs into a higher tax bracket, they may not be pleased.