Investors use irrevocable trusts to protect their assets from creditors, lawsuits and estate taxes. However, when you sell a property in an irrevocable trust, it can complicate your tax situation. This is a guide to how it works and whether you need to pay capital gains tax when selling a house in an irrevocable trust. You can work with a financial advisor who can help you plan ahead and avoid unnecessary taxes.
What is an irrevocable trust?
An irrevocable trust is a special type of trust used to protect assets. Unlike other trusts, once you move assets into the irrevocable trust, you cannot return them to the original owner. It is a separate legal entity with its own taxpayer identification number.
Essentially, the move is permanent until the trustee distributes assets to named beneficiaries or their heirs. Because asset transfers are permanent, irrevocable trusts provide asset protection when someone sues the original owner or has other financial obligations.
What are Capital Gains Taxes?
Capital gains taxes are the tax liabilities that arise when you sell an asset. Examples of assets subject to capital gains tax include homes, stocks, collectibles, businesses, and other similar assets. Most investors pay capital gains taxes at lower tax rates than for ordinary income.
For example, the top ordinary federal income tax rate is 37%, while the top capital gains rate is 20%. By comparison, a single investor pays 0% on capital gains if their taxable income is $41,675 or less (2022 tax rules). Married couples filing jointly enjoy the 0% capital gains rate when their taxable income is $83,350 or less.
In some cases, you can reduce your capital gains tax. Homeowners who have lived in a home for two of the previous five years can claim a $250,000 exemption ($500,000 for married couples filing jointly). And stock investors use realized capital losses to offset capital gains dollar-for-dollar to reduce or eliminate their taxes owed.
Do Irrevocable Trusts Pay Capital Gains Tax?
Since irrevocable trusts are the owners of assets until those assets are distributed to the beneficiaries, you would assume that the trust must pay all taxes on the income earned. However, that is not always the case. Irrevocable trusts must distribute all income to the beneficiaries each year, making the trust a pass-through entity. Those beneficiaries pay the taxes on the income.
However, capital gains are not considered income for irrevocable trusts. Instead, capital gains count as contributions to principle in the tax code. Therefore, when a trust sells an asset and realizes a profit, that profit is not distributed to the beneficiaries. This means irrevocable trusts must pay capital gains tax.
Are Irrevocable Trusts Eligible for the $250,000 Waiver?
One of the main benefits of homeownership is the ability to avoid the first $250,000 in capital gains when selling your home. For married couples filing jointly, the exemption is $500,000. To qualify, the home must have been your primary residence for two of the last five years.
But what happens if you transfer your property to an irrevocable trust fund? Who pays the capital gains tax on the sale of a property in an irrevocable trust? Because the irrevocable trust is not a natural person, it is generally not allowed to use the $250,000 waiver. So while this trust offers legal and financial protection, you miss out on tax benefits. You will have to decide what is more important to you.
It comes down to
Irrevocable trusts can provide legal and financial protection for you and your assets. But if you sell your home, who pays for the capital gain on the sale of a home in an irrevocable trust? While irrevocable trust distributes income to beneficiaries, it is responsible for paying capital gains taxes. A financial advisor can be helpful in figuring out how to put your finances in the best tax position.
Financial planning tips
Investment strategy involves more than choosing your investments. A good financial advisor can also help you minimize taxes by maximizing your tax break accounts, using capital gains strategies and other tools. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisor matches for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
Capital gains taxes usually offer the lowest income tax rates, which can add up to significant savings on your tax bill. Use our income tax calculator to compare how much you save by paying capital gains tax instead of income tax on your profits.
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