The Tax Implications Of Selling A House In A Trust: What You Need To Know
A trust is often used to simplify estate planning and may include a home. However, if loved ones want to sell the home, they may need to deal with various types of taxes – all at an emotional time that’s filled with change. Knowing how to handle the tax implications of selling a house in a trust can help make the process less cumbersome than it needs to be.
What Is A Trust?
A trust is a structure you can put your assets in which is typically managed by a third party. The distribution of the assets takes place through a trust fund, which is often just a bank account with some unique access rules. There are various types of trusts including living trusts, special needs trusts and charitable trusts, just to name a few.
Revocable Vs. Irrevocable Trusts
The two major types of trust are revocable and irrevocable. Although they can serve the same essential purpose, there are major differences that come down to flexibility.
In a revocable trust, changes can be made up until the death of the person or people who set up the trust. In an irrevocable trust, no changes can be made after the trust is set up. It’s important to understand this because you can’t get a new mortgage to get the home out of a trust, for example. The exception is if you’re trying to refinance a property and the trust is revocable.
The person who set up the trust has to go through the qualification process individually to show they can make payments on the loan. Additionally, the third party controlling the trust has to be authorized to sign off on the transaction on behalf of the individual or group who set up the trust. This isn’t possible with an irrevocable trust. Consult a Home Loan Expert for additional guidelines.
Who Is Included In A Trust?
There are three parties to any trust. However, each of these categories may be made up of multiple people. Here’s the breakdown:
- Settlor: This is the person or group responsible for setting up the trust. You may also see this referred to as grantor, donor, trustor or trust maker.
- Trustee: The trustee is the person or group responsible for administering the trust, often a third party.
- Beneficiary: Also sometimes referred to as the grantee, this is the person or persons who get distributions from the trust.
Tax Implications Of Selling A House In A Trust
Before we get deeply into the implications of selling a house in a trust, it’s worth noting the different types of taxes that come into play.
- Capital gains tax: Capital gains taxes are paid on profits from the sale of assets, including homes. It’s worth noting that there is an exemption on taxes for a certain amount of profit if you meet the qualifications. This could come into play if a living grantor is selling out of a revocable trust.
- Estate taxes: Estate taxes are paid out of the accounts of the deceased. If the heirs decided to sell the family home, the profits would go into the estate, which would also be responsible for the taxes.
- Inheritance tax: Some states charge what’s referred to as an inheritance tax. Instead of or in addition to taxes being paid by the estate, the individual or group inheriting the property pays a tax on the value.
- Stepped-up basis: Stepped-up basis is a tax advantage you can sometimes allow yourself after inheriting property. The idea is that when you sell the property after taking a step up in basis, the value of that property is based on what it was worth when you inherited it rather than what it was worth when the person you inherited from bought the property. This can decrease your tax liability.
While there are all these tax items to think about, who pays the taxes and when can depend on how the trust is set up. Let’s run through a couple scenarios.
If the home is in a revocable trust when sold, tax liability is pretty easy. When selling a home that’s within a trust, the grantor (seller) is taxed on the capital gains (profits) they make on the house sold. The theory here is that because the trust was revocable, the grantor never relinquished the asset and would owe the tax liability.
On the other hand, what happens if the trust is already being paid out based on either the passing of the grantor or the appropriate amount of time passing under the terms of the trust? Who is taxed on the sale of the home? The answer to this can depend upon how the trust is set up.
If the documentation underlying the trust permits the trustee to reinvest the profits from the sale of any assets back into the principal and they choose to do so, the tax on that capital gain is charged to the trust itself. Income tax on estates and trusts is reported on Form 1041.
On the other hand, if the trustee is regularly passing all gains to the beneficiary, the beneficiary gets taxed on those gains. If you’re unsure how the tax should be handled in your situation, be sure to speak to an estate planning attorney and/or tax professional. With that, let’s dig in a little deeper on each of the tax considerations listed earlier.
Capital Gains Tax
The basics of capital gains tax are easy to explain, but the application is a little more complicated. At its most basic level, capital gains tax works like this:
If you bought a home for $500,000 and sold that later for $700,000, you would owe capital gains tax on your $200,000 profit. The tax rate you can expect to pay will vary based on how long you held the property as well as your income.
However, there’s an exemption for those who have used a property as their primary residence and owned it for 2 out of the last 5 years. Although you have to own the home and live in it as your main residence, those can be separate 2-year periods. The amount of the exclusion can be up to $250,000 filing as an individual or $500,000 if married filing jointly.
As mentioned above, when the proceeds of the sale of a home after the grantor’s death are reinvested in the trust rather than being passed through as income, the estate pays the tax. It’s worth noting that the threshold rates for the different capital gains tax brackets are different for estates and trusts than they are for individuals.
The capital gains tax is still paid, but it’s out of the proceeds of the trust so that beneficiaries don’t have to deal with it.
Some states charge an inheritance tax. This may be along with or instead of an estate tax. Whereas an estate tax is charged against the remaining assets of the deceased, an inheritance tax is charged to the heirs or beneficiaries. Tax rates and exemptions vary quite a bit from state to state. Consult a tax advisor regarding your situation.
Stepped-Up Basis Tax Rules
When you inherit property, it’s generally eligible for a step up in basis. This means that if your parents bought a property for $150,000 and it was worth $300,000 when you inherited it, the capital gains taxes you paid when you sold the property would be based on the $300,000 value at the time of the passing rather than when they bought the property.
However, when you inherit it as part of a trust, it depends on whether the trust was revocable or irrevocable at the time of the person’s passing. If it was revocable, there is a step up in basis because they retained control and could’ve pulled that out of the trust at any time.
If the property was transferred to an irrevocable trust prior to death, there’s no step up in basis because it’s not part of the estate for tax purposes. This is true even though the grantor is responsible for the taxes on the property until it’s passed to the beneficiary under the terms of the trust, even if that only happens after the death of the grantor.
Selling A House In A Revocable Trust Vs. An Irrevocable Trust
There are similarities and differences when selling a house in a revocable trust vs. irrevocable trust. Let’s take them in turn.
If a house is in a revocable trust, you don’t need anyone’s permission to sell the property because you can freely move assets in and out of the trust up until your passing. Because you can just take the property out of the trust to sell it, there are no special considerations.
If you’re selling a house in an irrevocable trust, there are a couple of separate issues to think about: The first is whether there is a step up in basis based on the property being inherited. The second involves your actual permission to sell.
As to the fair market value question, it helps to know that all revocable trusts become irrevocable on the death of the last grantor. However, because the property was under the control of the grantor up until their death, it’s considered part of the estate. A step up in basis would allow the capital gains tax owed by beneficiaries to be based on the difference between the sale price and the value of the home at the time of inheritance.
It works differently if the trust was set up as irrevocable from the start. If that was the case, the property is treated as a gift the second it’s put in the trust. Once in the trust, because it’s no longer under the grantor’s control for estate purposes, you don’t get a step up in basis on inheriting property.
Capital gains taxes would be based on the sale price minus the value of the property when the grantor originally bought it. Who pays the capital gains taxes depends on whether the profits from the sale are reinvested in the trust or passed through to the beneficiaries as part of regular payments. If they are reinvested, taxes are paid by the trust. Otherwise, it falls to the grantees.
Permission is really a function of two separate considerations. To start, the trustee has to have the authority to sell the property. Second, the trustee has to agree to sell the property on behalf of the grantor.
While we’ve gone over several general points here, what happens can vary greatly depending on the way your trust is set up. We recommend consulting an attorney. If you choose not to sell, but rather have one person take over the home, here’s more information on how to refinance an inherited property to buy out heirs.
Tips For Selling A House In A Trust
If you’re looking to sell a house in a trust, there are several steps we would recommend:
- Consult an estate planning attorney. If you have any questions regarding your rights and responsibilities under the trust, an attorney will be able to help you determine whether and how best to move forward with the sale.
- Interview real estate agents. If your trust documents allow you to sell the home, you could choose to sell without a real estate agent. But an agent may be helpful, particularly if there’s some debate among the heirs as to the list price and whether to accept offers. They can be helpful in negotiation and dealing with much of the paperwork.
- Collect documentation. Title companies will want to know, for example, that the property is in the name of the trust and that the trust documents allow for them to sell. With that in mind, you’ll want the title, deed and trust info readily available.
- Get a property appraisal. This has two purposes: If you inherited the property from a previously revocable trust after the death of the grantor, an appraisal would establish the fair market value of the property for the purposes of your step up in basis. Getting an appraisal before putting the property on the market could also help you establish a list price.
FAQs About The Tax Implications Of Selling A House In A Trust
Now that we’ve touched on a variety of the ins and outs, let’s run through some frequently asked questions.
Is property inherited from a trust taxable?
Yes. The real question is who pays the taxes. That depends upon whether the property was in a revocable or irrevocable trust at the time of the grantor’s passing. States may also treat this differently depending on how they handle estate and/or inheritance taxes.
What is the cost basis of a house in an irrevocable trust?
In most cases, the cost basis of an asset is its cost to the owner. It’s important to know your cost basis because capital gains tax is calculated on the difference between the sale price of your home and the cost basis. The IRS has ruled that assets placed in an irrevocable trust have the cost basis that they had immediately before being placed in the trust.
What happens to an irrevocable trust when the grantor dies?
If the trust was set up as irrevocable from the start, the grantor’s possession of assets ceases when they’re put in the trust. Because of this, when the grantor dies, the trust is administered according to the trust documentation. Depending on what the guidelines are in the original documents, there may be a successor trustee or the trust may dissolve.
Can I avoid paying capital gains tax with a trust?
No. When you sell a home, someone is responsible for any capital gains taxes that must be paid. Whether those taxes are owed by the grantor, trust or beneficiaries depends on several factors including the type of trust, timing and applicable federal, state and local law. It can also be impacted by how trust proceeds are distributed.
The Bottom Line
Any time you sell a home, capital gains taxes may be owed. Selling your home in a trust doesn’t change that. The cost basis of the property may depend on whether the home was placed in a revocable or irrevocable trust. The type of trust and the timing of the sale as well as applicable laws all determine who pays the taxes.
In addition to tax considerations, you will need to be sure that the trust documentation is clear that you have the right to sell the property in your current circumstances. We recommend consulting an estate planning attorney about your situation. If selling is right for you, you’ll want to find a real estate agent experienced in dealing with trust sales.