Do Irrevocable Trusts Pay the Capital Gains Tax?

Investors use irrevocable trusts to protect their assets from creditors, lawsuits and estate taxes. However, when you sell a home in an irrevocable trust, that can complicate your tax situation. This is a guide to how it works and whether you’ll have to pay capital gains tax on the sale of a home 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.

In essence, the move is permanent until the trustee distributes assets to named beneficiaries or their heirs. Because asset moves are permanent, irrevocable trusts provide asset protection when someone sues the original owner or they have other financial liabilities.

What Are Capital Gains Taxes?

Capital gains taxes are the tax liability created when you sell an asset. Examples of assets subject to capital gains taxes include homes, stocks, collectibles, businesses and other similar assets. Most investors pay capital gains taxes at lower tax rates than they would 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 liability. Homeowners who lived in a house 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.

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Do Irrevocable Trusts Pay the Capital Gains Tax?

Because irrevocable trusts are the owners of assets until those assets are distributed to beneficiaries, you would assume that the trust must pay all taxes on earned income. However, that’s not always the case. Irrevocable trusts must distribute all income to beneficiaries each year, which makes the trust a pass-through entity. Those beneficiaries pay the taxes on income.

However, capital gains are not considered income to irrevocable trusts. Instead, capital gains count as contributions to principle in the tax code. Because of that, when a trust sells an asset and realizes a gain, that gain is not distributed to the beneficiaries. This means that irrevocable trusts must pay capital gains taxes.

Do Irrevocable Trusts Qualify for the $250,000 Exemption?

One of the major benefits of home ownership is the ability to avoid the first $250,000 in capital gains profit when selling your home. For married couples filing jointly, the exemption is $500,000. To qualify, the home must be your primary residence for two of the last five years.

But what happens when you transfer your home to an irrevocable trust? Who pays the capital gains tax on the sale of a home in an irrevocable trust? Because the irrevocable trust is not a natural person, it is typically not allowed to use the $250,000 exemption. So, while this trust provides legal and financial protection, you lose out on tax benefits. You’ll have to decide which is more important to you.

The Bottom Line

Irrevocable trusts can provide legal and financial protection for you and your assets. However, when you sell your home, who pays the capital gains on the sale of a home in an irrevocable trust? Although irrevocable trusts distribute income to beneficiaries, it is responsible for paying capital gains taxes. A financial advisor can be helpful in figuring out how you can put your finances in the best tax situation.

Tips for Financial Planning

• Investment strategy involves more than choosing your investments. A good financial advisor can also help you minimize taxes by maximizing your tax-advantaged accounts, using capital gains strategies and other tools. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now. 

• Capital gains taxes usually offer the lowest income tax rates, which can provide meaningful savings on your tax bill. Use our income tax calculator to compare how much you’ll save by paying capital gains taxes instead of income taxes on your profits.

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