Irrevocable Trust Capital Gains Tax: What You Need to Know

The benefits of an irrevocable trust in estate planning are multifold, everything from asset protection to tax advantages. Still, with regards to capital gains tax, confusion certainly abounds. In this article, we explore the key aspects of irrevocable trust capital gains tax and exclusions, the consequences of selling a home within an irrevocable trust from a tax perspective, and what tax rates apply.

Irrevocable Trust Capital Gains Tax

Irrevocable Trust and Capital Gains Tax: What You Need to Know

An irrevocable trust is usually taxed independently of its grantor. If an irrevocable trust sells any stocks, real estate, or other sorts of investments, it may be required to pay annual capital gains taxes. The specific tax liability related to irrevocable trust capital gains tax depends on how the trust has been structured:

• Grantor Trusts: When an irrevocable trust is a grantor trust, the capital gains are taxable to the grantor. In other words, the capital gains would be reflected on the personal tax return of the grantor, and the tax rates are computed based on the grantor's income. This type of structure often allows the grantor to manage capital gains tax liability more favorably.
• Non-Grantor Trusts: If the irrevocable trust is not a grantor trust, then, during the life of that trust, the trust pays the capital gains taxes. Non-grantor irrevocable trusts are taxed at much higher rates than individuals, especially once the income exceeds certain thresholds. Because of this, irrevocable trust capital gains tax is a huge concern when it relates to estate planning. What this structure underlines is how important it is to recognize, while setting up the trust, who shall bear the tax burden depending on the designation of the trust.

Properly planning an irrevocable trust's capital gains tax can make a huge difference in the financial efficiency of that same trust, both for the grantor and beneficiaries.

Irrevocable Trust Capital Gains Exclusion

Irrevocable Trust Capital Gains Exclusion Benefits and Rules

Sometimes, an irrevocable trust will not be required to pay capital gain taxes. The most common exclusion is the home sale exclusion, which permits an owner of a primary residence to exclude $250,000 ($500,000 for married couples) in gain from the sale of a primary residence.

An irrevocable trust may qualify for the capital gain exclusion from tax when selling a residence if the following are satisfied:

1. Ownership and Use: The beneficiary/grantor of the trust must have owned and used the home as their main or principal residence for at least two out of five years before its sale.
2. Grantor Trust: To the extent the trust is a grantor trust for purposes of the income tax, the grantor may be entitled to claim the exclusion for capital gains on the grantor's individual income tax return.

Where the trust is a non-grantor trust and where the home has been titled in the trust's name, no exclusion for capital gains is available since the trust as an entity does not meet the ownership and use requirements.

Taxes on Sale of Home in Irrevocable Trust

Understanding Taxes on the Sale of a Home in an Irrevocable Trust

Accordingly, when a primary residence is sold inside an irrevocable trust, taxes on the sale are dependent upon whether the trust is one considered to be a grantor or non-grantor trust and/or whether the capital gains exclusion applies:

1. Grantor trust: If the residence is held in a grantor trust, and if the grantor would qualify for the capital gains exclusion, a sale may be substantially tax free to the extent the gain is within the exclusion amount.
2. Non-Grantor Trust: If the trust is a non-grantor trust, the trust will pay the taxes on the capital gains from the sale of the home. The home sale exclusion is usually not applicable, and hence the trust will owe capital gains tax on full appreciation of the property.

If a house is held in an irrevocable trust, then its sale constitutes a taxable event. Capital gains will be based upon appreciation of the property value from the time it was originally purchased or transferred into the trust.

Capital Gains in Irrevocable Trust

The capital gains occurring in an irrevocable trust may be taxed at either the trust itself-non-grantor trust-or by the grantor-grantor trust. If there is a sale of any asset higher than its original purchase price, then such difference shall be liable to capital gains.

• Short-term capital gains: If a trust holds the asset for less than a year before selling, the gains are considered short-term and would be taxed at ordinary income tax rates.
• Long-term gains: are those realized when the trust has had the asset for more than a year prior to disposition, and are thereby generally taxed at the lower capital gains rates.

In a non-grantor trust, the entity's capital gains will be taxed using the trust tax rates, which have higher levels at much lower income thresholds than those for individual taxpayers.

Irrevocable Trust Capital Gains Tax Rate

Understanding the Capital Gains Tax Rate for Irrevocable Trusts

The capital gains tax rate for irrevocable trusts depends on the type of capital gain and the trust’s income level. The tax brackets for trusts are much more compressed than those for individuals, meaning trusts reach the highest tax rates at lower levels of income.

• Long-Term Capital Gains: In 2024, irrevocable trusts pay 0%, 15%, or 20% on long-term capital gains, depending on the trust’s income. The 20% rate applies to trust income over $14,450.
• Short-Term Capital Gains: Short-term capital gains are taxed as ordinary income, and the highest ordinary income tax rate for trusts is 37%. This rate applies to trust income over $14,450 in 2024.

Trusts are also subject to the Net Investment Income Tax (NIIT) of 3.8% on capital gains if the trust's income exceeds $13,450, further increasing the tax burden.

Conclusion

Capital gains management of an irrevocable trust involves taking careful consideration of the trust's structure, its associated tax rates, and exclusions from taxes that may apply. When dealing with irrevocable trust capital gains tax, it’s crucial to understand the specific tax implications based on how the trust is set up. While irrevocable trusts offer some benefits regarding estate planning and asset protection, they face a special set of rules with respect to taxation, particularly concerning irrevocable trust capital gains tax.

The key knowledge one should take away relates to the rates of taxation on capital gains for trusts, such as irrevocable trust capital gains tax, and what falls under exemptions, for example, upon the sale of a house. This understanding helps minimize the ongoing tax burden on trust assets and ensures that taxes are managed efficiently. At One Pacific Trust, we specialize in providing guidance on navigating these complex tax considerations, ensuring that your irrevocable trust is structured to optimize tax outcomes while preserving the trust’s value for future generations.