Investors use irrevocable trusts to protect their assets from creditors, lawsuits, and estate taxes. However, when you sell a home in an irrevocable trust, it can complicate your tax situation. This is a guide explaining how it works and whether you will have to pay capital gains tax when selling a home in an irrevocable trust. You can work with a financial adviser 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 transfer assets into the irrevocable trust, you cannot return them to the original owner. It is a separate legal entity with its own tax identification number.
Essentially, the move is permanent until the trustee distributes the 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 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 tax include homes, stocks, collectibles, businesses, and other similar assets. Most investors pay taxes on capital gains at lower tax rates than they would on ordinary income.
For example, the highest ordinary federal tax rate is 37%, while the highest capital gains rate is 20%. For comparison, a single investor pays 0% on capital gains if their taxable income is $41,675 or less (2022 tax rules). Married couples who file jointly benefit from 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 equity 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 the assets until those assets are distributed to the beneficiaries, you would assume that the trust must pay all taxes on the income earned. However, this is not always the case. Irrevocable trusts must distribute all income to beneficiaries each year, making the trust a flow-through entity. These beneficiaries pay income taxes.
However, capital gains are not considered income for irrevocable trusts. Instead, capital gains are considered principle contributions in the tax code. For this reason, when a trust sells an asset and realizes a gain, that gain is not distributed to the beneficiaries. This means irrevocable trusts must pay capital gains taxes.
Are irrevocable trusts eligible for the $250,000 exemption?
One of the biggest benefits of home ownership 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 house must have been your principal residence for two of the past five years.
But what happens when you transfer your home to an irrevocable trust? Who Pays Capital Gains Tax When Selling a Home in an Irrevocable Trust? Since the irrevocable trust is not an individual, it is generally not permitted to use the $250,000 exemption. So while this trust provides legal and financial protection, you lose tax benefits. You will need to decide which is more important to you.
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 irrevocable trust? Although irrevocable trusts distribute income to beneficiaries, they are responsible for paying capital gains taxes. A financial advisor can help you determine how you can put your finances in the best tax position.
Financial Planning Tips
The investment strategy is not limited to the choice of your investments. A good financial advisor can also help you minimize taxes by maximizing your tax-efficient accounts, using capital gains strategies and other tools. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your advisors at no cost to decide which one is best for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
Capital gains taxes generally offer the lowest tax rates, which can result in significant savings on your tax bill. Use our income tax calculator to compare how much you’ll save by paying capital gains taxes instead of taxes on your profits.
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Do irrevocable trusts pay capital gains tax? appeared first on SmartAsset Blog.