Investors use irrevocable trusts to protect their assets from creditors, lawsuits, and estate taxes. However, selling a home in an irrevocable trust can complicate your tax situation. This is a guide on how it works and whether you need to pay capital gains tax when selling a home in an irrevocable trust. You can work with one financial advisor who can help you plan ahead and avoid unnecessary taxes.

What is irrevocable trust?

On irrevocable trust is a special kind of to 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 an independent legal entity with its own tax identification number.

Essentially, the move is permanent until the trustee distributes assets to named beneficiaries or their heirs. Because the movement of assets is permanent, irrevocable trusts provide asset protection if someone sues the original owner or has other financial liabilities.

What are Capital Gains Taxes?

capital gains taxes are the tax liability that arises 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 capital gains taxes at lower rates than on ordinary income.

For example, the supreme ordinary federal income tax rate is 37% while the highest rate of return on investment is 20%. In comparison, an individual investor pays 0% on capital gains if their taxable income is $41,675 or less (2022 tax regulations). Married couples applying together enjoy the 0% capital gains rate if their taxable income is $83,350 or less.

In some cases, you can reduce your capital gains tax liability. Homeowners who have lived in a home for two of the past five years may apply for a $250,000 waiver ($500,000 for jointly filed married couples). And stock investors use realized capital losses to offset capital gains dollar for dollar to reduce or eliminate their taxes owed.

The story goes on

Do Irrevocable Trusts Pay Capital Gains Tax?

Because irrevocable trusts are the owners of assets until those assets are distributed beneficiaries, you would assume that the trust would have to pay all taxes on the earned income. However, this is not always the case. Irrevocable trusts must distribute all proceeds to the beneficiaries each year, making the trust a pass-through entity. These beneficiaries pay income tax.

However, capital gains are not considered income for irrevocable trusts. Instead, capital gains are treated as deposits in principle in the tax code. For this reason, when a trust sells an asset and realizes a gain, that gain is not distributed to beneficiaries. This means that irrevocable trusts will have to pay capital gains taxes.

Do irrevocable trusts qualify for the $250,000 exemption?

One of the biggest benefits of homeownership is the ability to avoid the former $250,000 capital gains gain when selling your home. For married couples applying together, the exemption is $500,000. To qualify, the home must have been your primary residence for two of the last 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? Because the irrevocable trust is not an individual, it is typically not permitted to claim the $250,000 tax exemption. So while that trust provides legal and financial protection, you’re missing out on tax benefits. You have to decide what is more important to you.

The final result

Irrevocable trusts can offer you and your assets legal and financial protection. However, if you sell your home, who pays for the capital gains from the sale of a home in an irrevocable trust? Although irrevocable trusts distribute income to beneficiaries, they are responsible for paying capital gains taxes. A financial advisor can be helpful in figuring out how to plan your finances for the future best tax situation.

Financial planning tips

• An investment strategy involves more than just choosing your investments. A good financial advisor can also help you minimize taxes by maximizing your tax-deferred accounts using capital gain strategies and other tools. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors operating in your area, and you can interview your advisor matches for free to decide which one is right for you. When you are ready to find an advisor who can help you achieve your financial goals, get started now.

• Capital gains taxes typically offer the lowest income tax rates, which can result in significant savings on your tax bill. Use our Income Tax Calculator to compare how much you’ll save if you pay capital gains taxes instead of income taxes on your profits.

©iStock.com/Myoy Studio, ©iStock.com/RichVintage, ©iStock.com/staticnak1983

The post Do Irrevocable Trusts Pay Capital Gains Tax? appeared first SmartAsset blog.