Does a revocable living trust avoid capital gains tax? Understanding trusts and taxation

A revocable living trust is a flexible estate planning tool that allows you to maintain control over your assets during your lifetime while providing for their management and distribution after your death. The term "revocable" means that the creator of the trust, also known as the grantor, can modify or dissolve the trust at any time, providing a level of flexibility not found in irrevocable trusts.

A distinguishing feature of a revocable living trust is that it takes effect during the lifetime of the creator, who typically serves the initial trustee and names a successor trustee to take over management and distribution of the trust's assets after the grantor's death or in the event of incapacity. During their lifetime, the grantor can buy, sell or transfer assets in and out of the trust as they see fit.

On the other hand, an irrevocable trust cannot be easily changed or revoked. While this might seem like a disadvantage, irrevocable trusts can offer enhanced benefits in the realm of tax planning and asset protection.

The capital gains tax is a levy on the profit realized from the sale of a non-inventory asset. Common examples of assets subject to capital gains taxes include stocks, bonds, precious metals and real estate. In the United States, both individuals and corporations are required to pay income tax on the net total of all their capital gains.

For tax purposes, a revocable living trust is considered “grantor trust” and a "disregarded entity" by the Internal Revenue Service. This means that the trust and the grantor are treated as the same entity for income tax purposes. The concept of a disregarded entity is significant because it determines how the trust's income and assets are taxed.

As a disregarded entity, the assets in a revocable living trust are considered to be owned by you, the grantor. This has several important tax implications:

• Income reporting. Any income generated by trust assets is reported on the grantor’s personal tax return (Form 1040) using your Social Security number. The trust does not file a separate tax return and doesn't need its own tax identification number (EIN) as long as the grantor is alive and serving as trustee.
• Capital gains. Upon sale of appreciated assets within the trust, the grantor is responsible for any capital gains taxes, just as if you owned the assets outside of the trust. The trust itself doesn't pay these taxes separately.
• Tax basis. The tax basis of assets in the trust remains the same as it was before the assets were transferred into the trust. This means that putting assets into a revocable living trust doesn't provide a step-up in basis during your lifetime.
• Estate taxes. Because you retain control over the assets in a revocable living trust, they are included in your taxable estate upon your death for estate tax purposes.

The disregarded entity status continues as long as the trust remains revocable and you're alive. After your death, the trust typically becomes irrevocable, and the successor trustee takes over management and distribution of the assets according to your instructions. At this point, the trust is no longer a disregarded entity and may be subject to different tax rules depending on how it's structured and how the assets are distributed.

While revocable living trusts don't provide a direct route to avoiding capital gains tax, they can influence how and when this tax is paid in specific situations. One of the most significant ways this occurs is through the "step-up in basis" rule. When a person dies, their beneficiaries may receive a "step-up" in basis on inherited assets. This means the asset's tax basis is increased to its fair market value at the date of death. If the beneficiary decides to sell the asset soon after inheriting it, they may owe little or no capital gains tax due to this step-up. Importantly, both assets in a revocable living trust and assets passed through a will are eligible for this step-up in basis.

Capital gains tax rates vary depending on your income level, how long you've held the asset and the nature of the asset. Assets held for one year or less are taxed as ordinary income, which means they're taxed at your regular federal income tax rate (10-37% as of 2024). Assets held for more than one year are subject to more favorable long-term capital gains tax rates that range from zero to 20% based on the filer’s taxable income. Long-term capital gains from the sale of collectibles (such as art, antiques and precious metals) and certain small business stocks are taxed at a maximum rate of 28%. Meanwhile, the portion of a gain from selling real estate that's attributable to depreciation is usually taxed at a maximum rate of 25%.

Despite not offering direct capital gains tax benefits, revocable living trusts remain valuable estate planning tools in many situations. They're worth considering if you want to avoid probate, desire privacy in the distribution of your assets, own property in multiple states, want to plan for potential incapacity or have minor children and wish to establish long-term asset management.

Given the complexities involved in trusts, taxes and estate planning, it's crucial to seek professional advice. An experienced estate planning attorney can help draft and implement trust documents and develop an overall estate plan. A financial professional can assist with financial planning and tax strategies. These professionals can work in concert to create a comprehensive plan tailored to your specific needs and goals.

While a basic living trust does not avoid capital gains tax, it remains a valuable component of comprehensive estate planning. The primary benefits of a living trust include probate avoidance, privacy and ease of asset management. When it comes to tax planning, more sophisticated trust structures and alternative strategies may be necessary to minimize capital gains tax effectively. Remember that effective estate and tax planning is not a one-size-fits-all proposition. Your individual circumstances, including the size of your estate, your beneficiaries and your long-term goals, will determine the most appropriate strategies for you.