Selling A House In A Trust: Tax Implications And How It Works

A trust can be a method for transferring property and other assets to beneficiaries before or after your passing while avoiding having to deal with probate later on. However, there are many times when a trust can complicate the bill you owe Uncle Sam. Let’s look at the tax implications of selling a home in a trust. Before taking any action, consult a tax preparer or financial advisor.

What Is A Trust?

A trust involves the transfer of assets into a legal entity controlled by a third-party until those assets are distributed to one or more beneficiaries at a later date. Property can be put into a trust to be distributed upon death or on a defined date. However, they’re commonly used in estate planning to avoid probate. There are also advantages and disadvantages tax wise.

Who Is Included In A Trust?

There are generally three parties (as individuals or as a group) who are part of a trust arrangement:

• Settlor or grantor: This is the person putting assets or property into the trust for later distribution.
• Trustee: This is the party in a trust arrangement who’s responsible for managing the assets in care of the trust until the point they’re distributed to beneficiaries. For example, they might be placed in care of a stock portfolio or rental properties which generate income that flows back to the trust.
• Beneficiary: This is the person or group who benefits from the assets in the trust at some point down the line, either on an ongoing basis or by having the assets distributed all at once.

Revocable Vs. Irrevocable Trusts

There are numerous types of trusts, but two of the biggest classes of trusts are revocable and irrevocable trusts.

• A revocable trust (or living trust) is one in which the grantor can put assets in and pull them back out of the trust at will. This gives them the opportunity to dissolve the trust at any time before they pass. Because such an arrangement means that your assets are under the control of the grantor, any tax liability based on those assets is the responsibility of the donor.
• An irrevocable trust is one that can’t be changed once it’s set up. You can’t pull anything in or out. The assets aren’t under the control of the grantor. Because of this, the long-term tax liability doesn’t lie with the grantor, although there may be gift tax issues to deal with.

How A Trust Can Benefit You

There are several potential benefits to putting your house in a trust. Let’s run through a few of them:

• Defined control: You can specify not only who receives what part of your assets but when they get it. For example, you might choose to give the proceeds from the sale of the home to your grandchildren, but only after they reach 25.
• Wealth protection: Depending on how the estate is set up, it may be useful in protecting assets that you would be passing down from creditors who might be after assets under the control of your beneficiaries.
• Avoid probate: Probate takes place in public, and by transferring things in a trust, you may be able to avoid that. Additionally, you may be able to sidestep certain fees and estate taxes.

Tax Implications Of Selling A House In A Trust

The tax implications of selling a house depend heavily on how the trust is set up and whether your beneficiaries are receiving what’s being considered recognized income from the sale. In terms of liability specific to a home sale, the biggest thing to think about is capital gains tax.

Capital gains tax is profit you get from selling an asset for more than what you originally paid for it. This example is a little simplistic for reasons we’ll get into below, but if you buy your house for $200,000 and sell it down the line for $250,000, you owe capital gains tax on your $50,000 profit.

If you’re selling in a trust, how the taxes are paid depends on whether the trust is revocable or irrevocable. Revocable trusts place tax responsibility on the grantor because the property is under the grantor’s control until it’s finally given to the beneficiary.

Many irrevocable trusts are required to disburse all income made by the trust every tax year, which becomes taxable income for its beneficiaries. However, for irrevocable trusts, capital gains may not be considered income. They are often regarded as contributions to the principal. Instead of income taxes paid by the beneficiary, capital gains taxes are paid by the trust.

Selling A House In A Revocable Trust Vs. An Irrevocable Trust

We’ve touched on this a bit, but now might be a good time to simplify what can come down to a lot of legalese when selling your home in a revocable versus irrevocable trust.

If you’re selling a home out of a revocable trust, you are responsible for the taxes resulting from that sale because while it’s in the trust, the property never left your control. Creditors may also be able to come after that asset if you owe them based on your having control as well.

When selling out of an irrevocable trust, the property is no longer yours from the instant you finalize the trust. So, you individually may have to pay a gift tax when it’s put in the trust.

When the property is sold, how the capital gains taxes are handled depends on whether the income from the sale is immediately distributed to beneficiaries or reinvested in the principal of the trust. If the proceeds are reinvested, the tax would be paid by the trust. If they are immediately distributed as income, each beneficiary would pay their share of the taxes.

To make sure you’re doing the right thing, be sure to consult a tax advisor and/or a real estate attorney.

Taxes That Cover Inheritance

Whether you’re looking to bequeath property or you’re on the inheriting end, you should be sure to understand the taxes that may apply.

• Capital gains tax: Whether you sell property in a trust or you end up just inheriting it and then selling it, you’ll have to pay capital gains tax on the profit over when you bought or inherited it.
• Inheritance tax: Although there’s no inheritance tax at the federal level, some states charge tax on inheritances to the beneficiaries.
• Estate tax: There is a federal estate tax, but as a practical matter, you have to have a fairly large estate before you should begin to worry about taxes on what you pass down. The lifetime exclusion on gifts and estate transfers in 2023 for one person is $92 million.

Who Qualifies For The $250,000 Or $500,000 Home Sale Exclusion?

If you sell your home out of a trust, this doesn’t work because a trust is a legal entity and not a person. However, there is a capital gains tax break if you sell your primary home yourself.

If you are selling your primary home, you can exclude up to $250,000 worth of value that you would otherwise have to pay capital gains tax on. If you’re married and file jointly, this home sale exclusion doubles to $500,000. There are just two rules:

• You have to own your home for 2 years out of the last 5.
• You must use the home as your main home for 2 years out of the last 5.

These can be separate 2-year periods.

Stepped-Up Basis Tax Rules For Those Who’ve Inherited Property

Another break if someone inherited property from you is that when they sell the property, for the purpose of capital gains tax, the fair market value is whatever it was on the day you passed. This means they only have to account for the gains since that date rather than when you bought the property. This is referred to as step-up in basis.

Tips For Financial Planning When Selling A House In A Trust

There are a couple of tips you should consider if you’re looking to sell a home currently in a trust:

• Calculate savings: This may not always be the case, but speaking generally, having the trust pay capital gains tax if it’s irrevocable or the grantor do so in a revocable trust will be cheaper than having the beneficiaries pay income tax. In order to do the math, you’ll need a rough home sale calculation.
• Work with a financial advisor: In case you haven’t noticed, estate planning and the tax implications can be quite complicated. It can be worth working with a financial advisor to guide you along the way.

The Bottom Line

Both a revocable and an irrevocable trust are ways to pass property and other assets to others while avoiding probate. Particularly with an irrevocable trust, you can protect your property as you pass it down and, done correctly, there could be tax advantages for your beneficiaries. However, there are exclusions and tax basis rules that you can look to outside of a trust as well.

Some of the rules are quite complex and every situation is different. Before making any moves, we recommend speaking with an estate planning professional. If you’re ready to sell your house, you can get started by connecting with an agent today.