One of the most common additions to a well thought out estate plan is a trust because a trust can accomplish such a wide range of estate planning goals. To know whether a trust could be a beneficial addition to your estate plan, you need to better understand your trust options and the role taxes play when trust assets are sold by different types of trusts. An Indianapolis trust attorney at Frank & Kraft explains how capital gains taxes are treated when you create an irrevocable trust.
Revocable vs. Irrevocable Trusts
Trusts all fall into one of two categories – testamentary or living trusts. A testamentary trust is activated by a provision in the Settlor’s Will at the time of death whereas a living trust activates once all formalities of creation are in place and the trust is funded. Living trusts can be further divided into revocable and irrevocable living trusts. Because a testamentary trust is activated by a provision in the Settlor’s Will, and a Will can always be revoked up to the time of the Testator’s death, a testamentary trust is also revocable up to that point.
Capital Gains Tax Basics
Capital gains taxes are paid when you realize a gain on the sale of an asset. For example, if you purchased real property for $400,000 and sold it ten years later for $500,000, you would realize a gain of $100,000. Determining when capital gains taxes are due, how to calculate the gain upon which the tax is paid, and how much tax is due can be quite complicated because of the numerous and varied factors involved and the complexity of the tax laws.
Irrevocable Trusts and Capital Gains Taxes
Whether or not capital gains taxes are due after the sale of a trust asset will depend on several factors, starting with the type of trust involved. If the trust is a revocable trust, the trust is not usually a separate tax entity during the lifetime of the Settlor. As such, the Settlor retains incidents of ownership over the property held by the trust. If a trust asset is sold, and a gain is realized, capital gains tax obligation is triggered. That gain must be reported on the Settlor’s personal tax return.
Conversely, an irrevocable trust is typically a separate tax entity because when you transfer ownership of property into it, you give up control and any opportunity to take the assets back. For this reason, gains or losses are not reported on the Settlor’s personal tax return. Unfortunately, however, that is not the end of the capital gains tax analysis. You must still consider what type of irrevocable trust is involved to know if capital gains taxes apply to the sale of assets.
A simple irrevocable trust is required to disburse all income made by the trust every tax year. Those disbursements are then taxable to the beneficiaries as income. Some irrevocable trusts, however, are more complex and are permitted by law to retain income. This type of irrevocable trust may only distribute some of the income to the trust beneficiaries. Capital gains, however, are not considered to be income to irrevocable trusts. Instead, capital gains are viewed as contributions to the principal. Consequently, if the trust sells an asset and realizes a gain, that gain would not be distributed, meaning the trust would have to pay taxes on the gain as profit to the trust.
Transfer to a Beneficiary
If an irrevocable trust distributes, or transfers, an asset to a beneficiary, instead of selling the assets and distributing the gain, then the beneficiary becomes responsible for any taxes due. Although the initial distribution may not be taxable, capital gains taxes may become due if the beneficiary sells the asset down the road. In that case, the amount of capital gains tax due will typically be calculated using the value of the assets at the time it was distributed to the beneficiary as the basis, not the value of the asset at the time it was originally purchased.
Contact an Indianapolis Trust Attorney
For more information, please join us for an upcoming FREE seminar. If you have additional questions or concerns about trusts, contact an experienced Indianapolis trust attorney at Frank & Kraft by calling (317) 684-1100 to schedule an appointment.
Mr. Kraft assists clients primarily in the areas of estate planning and administration, Medicaid planning, federal and state taxation, real estate and corporate law, bringing the added perspective of an accounting background to his work.
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