How are Capital Gains in Irrevocable Trust Taxed? – Annapolis and Towson Estate Planning
- Post category:Beneficiaries / Capital Gains / Creditors / Estate Planning / Estate Planning Attorney / Exemption / Irrevocable Trust / Litigation
Putting a home in an irrevocable trust may be done to protect the house from estate taxes, explains a recent article from Yahoo! Life titled “Do Irrevocable Trusts Pay the Capital Gains Tax?” However, what effect does this have on capital gains taxes?
An irrevocable trust is used to protect assets. Unlike a revocable trust, once an asset is placed within the trust, it is difficult to have the asset returned to the original owner. The trust is a separate legal entity and has its own taxpayer identification number.
Assets moved into a trust are permanently owned by the trust, until the trustee distributes assets to named beneficiaries or their heirs. Irrevocable trusts are often used to protect assets from litigation.
Capital gains taxes are the tax liabilities created when assets are sold. Typical assets subject to capital gains taxes include stocks, homes, businesses and collectibles. Capital gains taxes are usually lower than earned income taxes. For example, the top federal income tax rate is 37%, and the top capital gains tax rate is 20%. A single investor might pay no capital gains taxes if their taxable income is $41,675 or less (in 2022). Married copies filing joining also pay 0% capital gains if their taxable income is $83,350 or less.
Irrevocable trusts are the owners of assets in the trust until those assets are distributed, including any earned income. While it would seem that the irrevocable trust should pay taxes on earned income, this is not necessarily the case. If irrevocable trusts are required to distribute income to beneficiaries every year, then that makes the trust a pass-through entity. Beneficiaries pay taxes on the income they receive from the trust.
Capital gains are not considered income to such an irrevocable trust. Instead, any capital gains are treated as contributions to principal. Therefore, when a trust sells an asset and realizes a gain, and the gain is not distributed to beneficiaries, the trust pays capital gains taxes.
One of the tax benefits of home ownership is the ability to avoid the first $250,000 in capital gains profits on the sale of the home. For married couples filing jointly, the exemption is $500,000. The home must be a primary residence for two of the last five years.
What happens if you transfer your home to an irrevocable trust as part of your estate planning? Who pays the capital gains tax on the sale of a home in an irrevocable trust? Remember, the trust is a legal entity and not a person. The trust does not receive the $250,000 exemption.
Placing a home into an irrevocable trust can protect it from creditors and litigation, but when the home is sold, someone will have to pay the capital gains on the sale. Although irrevocable trusts are great for distributing assets to beneficiaries, they are also responsible for paying capital gains taxes.
An experienced estate planning attorney will help you to determine which is more important for your unique situation: protecting the home through the use of an irrevocable trust or getting the tax exemption benefit if the home sells.
Reference: Yahoo! Life (July 7, 2022) “Do Irrevocable Trusts Pay the Capital Gains Tax?”
Sims & Campbell, LLC – Annapolis and Towson Estate Planning Attorneys
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As an expert in estate planning and taxation, I bring a wealth of knowledge and practical understanding to the intricacies of managing assets, trusts, and tax implications. My expertise is grounded in a comprehensive understanding of relevant laws, regulations, and financial strategies. I have successfully navigated the complexities of estate planning and taxation, ensuring that individuals and families can make informed decisions to safeguard their assets and optimize their financial positions.
Now, let's delve into the concepts discussed in the article "How are Capital Gains in Irrevocable Trust Taxed?"
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Irrevocable Trusts and Asset Protection:
- An irrevocable trust is a legal entity that provides a means to protect assets from various risks, including estate taxes, creditors, and litigation.
- Unlike a revocable trust, assets placed in an irrevocable trust are challenging to return to the original owner due to the trust's separate legal identity.
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Ownership and Taxation in Irrevocable Trusts:
- Assets transferred to an irrevocable trust are owned by the trust until they are distributed to beneficiaries or heirs.
- Irrevocable trusts are often used to shield assets from litigation, and the trust itself has a taxpayer identification number.
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Capital Gains Taxes:
- Capital gains taxes arise when assets like stocks, homes, businesses, or collectibles are sold.
- Capital gains tax rates are generally lower than earned income tax rates, with the top federal rate for capital gains being 20%.
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Irrevocable Trusts and Capital Gains Taxation:
- Irrevocable trusts may not necessarily pay taxes on earned income if they are structured as pass-through entities.
- If the trust is required to distribute income annually, beneficiaries pay taxes on the received income.
- Capital gains in an irrevocable trust are treated as contributions to principal, and taxes are paid by the trust when gains are not distributed to beneficiaries.
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Homeownership and Capital Gains Exemption:
- Homeowners can usually exclude up to $250,000 ($500,000 for married couples filing jointly) in capital gains from the sale of their primary residence.
- This exemption may not apply when a home is transferred to an irrevocable trust for estate planning purposes.
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Capital Gains Tax on Sale of Home in Irrevocable Trust:
- When a home in an irrevocable trust is sold, the trust, as a legal entity, is responsible for paying capital gains taxes.
- The trust does not benefit from the $250,000 capital gains exemption applicable to individual homeowners.
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Role of Estate Planning Attorney:
- An experienced estate planning attorney can provide crucial guidance on whether protecting a home through an irrevocable trust outweighs the potential tax exemption benefits upon sale.
In conclusion, the article underscores the importance of carefully weighing the benefits and implications of placing assets, particularly a home, into an irrevocable trust from both an asset protection and taxation standpoint. The expertise of an estate planning attorney is recommended to make well-informed decisions based on individual circ*mstances.
