Cost Basis of a House in an Irrevocable Trust Explained

Understanding the cost basis of a house in an irrevocable trust is essential for tax planning and estate management. The basis determines potential capital gains taxes when the property is sold, affecting both the trust and its beneficiaries. How the basis is calculated depends on how the property was acquired and whether it qualifies for a step-up in basis at death. Different rules apply depending on the type of transfer and ownership structure, making it important to understand these details to avoid unexpected tax liabilities.

Determining Original Basis

The original basis of a house in an irrevocable trust depends on how it was acquired. If the trust purchased the home, the basis is the purchase price plus allowable acquisition costs such as title fees, legal expenses, and recording charges. If the property was received as a gift before being placed in the trust, the basis generally carries over from the donor, meaning the trust assumes the same cost basis as the previous owner.

Capital improvements increase the basis. Renovations that extend the property’s useful life or enhance its value—such as adding a new roof, remodeling a kitchen, or building an addition—can be added to the original basis. Routine maintenance, like painting or minor repairs, does not qualify. Keeping detailed records of these expenditures is important, as they reduce taxable gains when the property is sold.

Depreciation affects the basis if the home was used as a rental property before or after being placed in the trust. Under IRS rules, residential rental property is depreciated over 27.5 years using the straight-line method. Each year of depreciation lowers the adjusted basis, increasing taxable gains upon sale. If the property was never rented, depreciation does not apply.

Transfers Into the Trust

When a house is transferred into an irrevocable trust, the tax implications depend on whether the transfer is classified as a gift or a sale. If the owner places the property into the trust without receiving payment, it is considered a gift and may trigger gift tax consequences. The IRS imposes a gift tax on transfers exceeding the annual exclusion amount, which is $18,000 per recipient in 2024. If the home’s value exceeds this threshold, the excess counts toward the grantor’s lifetime gift tax exemption, currently set at $13.61 million. While no immediate tax is owed unless the exemption is exhausted, IRS Form 709 must be filed to document the transfer.

If the transfer is structured as a sale, the trust must pay fair market value for the property. This approach is less common but may be used in estate planning to remove the asset from the grantor’s taxable estate while avoiding gift tax reporting. However, if the trust is a grantor trust, meaning the original owner retains certain powers over it, the IRS disregards the sale for income tax purposes, and no gain or loss is recognized.

The funding method also affects Medicaid eligibility and creditor protection. Medicaid’s five-year lookback period examines transfers into irrevocable trusts, potentially disqualifying the grantor from benefits if the transfer was intended to reduce countable assets. While irrevocable trusts can shield assets from creditors, fraudulent transfer laws prevent individuals from using them to evade existing debts.

Step-Ups for Beneficiaries

When a beneficiary inherits a house from an irrevocable trust, the cost basis they receive depends on whether the property was included in the deceased owner’s taxable estate. If the home was part of the grantor’s estate at death, the basis generally adjusts to its fair market value as of the date of death. This step-up in basis can reduce capital gains taxes if the beneficiary later sells the property, as only appreciation after inheritance would be taxable.

The step-up applies if the trust was structured so that the home remains within the grantor’s estate for tax purposes. This is often the case with revocable trusts that become irrevocable upon death or certain irrevocable trusts where the grantor retained interests like a life estate. If the property was completely removed from the grantor’s estate, such as in an irrevocable trust designed for asset protection or Medicaid planning, the step-up does not apply. Instead, the beneficiary inherits the original cost basis, which could result in significant capital gains tax if the property has appreciated substantially.

Executors can choose an alternate valuation date, six months after death, if it results in a lower estate tax liability. This can be beneficial if property values have declined, as it locks in a lower basis for beneficiaries while also reducing potential estate taxes. However, this option is only available if it lowers the overall estate tax burden.

Reporting Gains at the Trust Level

When an irrevocable trust sells a house, the gain is calculated by subtracting the property’s adjusted basis and any allowable selling expenses—such as real estate commissions, legal fees, and transfer taxes—from the sale price. Trusts are subject to compressed income tax brackets, meaning capital gains can quickly reach the highest federal rate of 20% once trust income exceeds $15,200 in 2024. Additionally, the 3.8% Net Investment Income Tax (NIIT) applies if the trust’s undistributed income surpasses this threshold.

Trusts file Form 1041, U.S. Income Tax Return for Estates and Trusts, to report gains. If the trust retains the proceeds, it pays tax at the trust level. If the trust distributes the gain to beneficiaries, it may pass the tax liability to them via a Schedule K-1. This decision depends on the trust’s terms and whether distributing income aligns with its objectives. Some trusts retain gains to manage distributions strategically, while others distribute proceeds to take advantage of beneficiaries’ potentially lower tax rates.

Distribution of Proceeds

Once a house held in an irrevocable trust is sold, the proceeds must be distributed according to the trust’s terms. How these funds are allocated depends on whether the trust retains the income or passes it to beneficiaries, with each option carrying distinct tax consequences.

Simple trusts must distribute all income to beneficiaries annually, meaning capital gains from the sale are typically retained as principal unless the trust document specifies otherwise. Complex trusts have more flexibility, allowing the trustee to either retain or distribute proceeds. If funds are distributed, beneficiaries receive a Schedule K-1 detailing their share of the taxable gain, which they must report on their personal tax returns. This can be beneficial if beneficiaries fall into lower tax brackets, reducing the overall tax burden.

If the trust retains the proceeds, reinvestment strategies may be considered to preserve or grow assets for future distributions. Some trusts reinvest in income-generating assets, such as dividend-paying stocks or rental properties, to provide ongoing financial support to beneficiaries. Others may use proceeds to fund specific obligations outlined in the trust, such as educational expenses or charitable donations. Trustees must balance these decisions with fiduciary responsibilities, ensuring that distributions align with the trust’s purpose while optimizing tax efficiency.