A trust is a legal entity created to hold assets separate from the person that actually buys them. Trusts that are set up as living or revocable trusts have no tax-planning benefits -- they're typically just used as tools to facilitate easier asset transfers. Irrevocable trusts, on the other hand, can be used to transfer assets and avoid estate tax.
Before calculating the tax due on inherited trusts, the property in the trust has to be valued. When the property is in a revocable living trust, it's in a legal limbo zone. For the purposes of probate law, it's the trust's, but for tax law, it's treated as if the decedent owned it. As such, the property gets revalued as of the date of death. The tax code requires the person that inherits the property to use that value when it comes time to calculate estate or capital gains taxes.
Estate and Gift Tax
Properties in a living trust are subject to estate and gift tax. However, before you have to start paying estate taxes on inherited property, you get to subtract an exclusion. As of 2013, the exclusion is $5.25 million, which applies both to taxable gifts given during life as well as well as to what gets left behind after death. If a person gave his child a $500,000 house and then died, for instance, the first $4.75 million of his asset would be tax-free after subtracting the large taxable gift. Any amount over that is subject to a 40 percent estate tax. Married people effectively get to double their exemptions. As of 2013, when a spouse passes away and his assets transfer to his spouse tax-free, his exemption does, as well. Continuing the above example. If that individual gave a $500,000 gift and then died, his wife would inherit his property and his $4.75 million exemption. When she dies, assuming she gives no additional taxable gifts, she'll be able to add her late husband's $4.75 million exemption to her $5.25 million exemption to transfer $10 million in assets to her heirs without estate tax.
Tax on Future Profits
Once the contents of the trust get inherited, they're just like any other asset. Income from the inherited investments is subject to the same tax rates as any other income of that type. When you sell assets that you inherit and you make profit, you'll pay capital gains taxes as well. However, the capital gains taxes get calculated relative to the profit between the selling price and the value at which you inherited the property.
Irrevocable Trust Taxes
When you inherit from an irrevocable trust, the rules are different. The IRS treats property in an irrevocable trust as being completely separate from the estate of the decedent. As such, anything you inherit from the trust won't be subject to estate or gift taxes. You will have to pay income tax or capital gains tax on your profits from the assets you receive once you get them, though.
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