Tax Implications of Selling a House in a Trust Before Death
Selling a house from a trust before the owner's death creates distinct tax considerations. Learn how trust structure and sale timing impact tax liability.
When a house held within a trust is sold while the person who created the trust is still living, the tax implications are distinct. This scenario differs from inheriting a property, where tax rules upon death can change the financial outcome. The sale of a home from a trust before the grantor’s death triggers a specific set of tax considerations, and the resulting liability depends on the structure of the trust.
The Role of Trust Type
The primary factor in determining the tax outcome of a home sale is the type of trust holding the property. Trusts fall into two main categories, revocable and irrevocable, and the Internal Revenue Service (IRS) views them very differently for tax purposes.
A revocable living trust allows the grantor—the person who created the trust—to change its terms, add or remove assets, or dissolve it entirely. For federal income tax purposes, the IRS disregards the revocable trust as a separate entity. It is considered a “grantor trust,” meaning all income and deductions from the assets flow directly to the grantor’s personal tax return.
An irrevocable trust is more rigid; once created and funded, the grantor cannot make changes or reclaim the assets. While this type of trust can be a separate tax-paying entity, many are intentionally designed to be “grantor trusts” for income tax purposes. This design allows assets to be removed from the grantor’s control for estate planning while keeping the tax treatment simple.
If an irrevocable trust is a “non-grantor” trust, it is recognized as a distinct taxpayer. In this case, the trust itself is responsible for reporting the income from the sale and paying any taxes due.
Calculating the Capital Gain on the Sale
Before determining the tax owed, one must first calculate the profit, or capital gain, from the sale. The formula is the final selling price of the home, minus any selling costs, and then minus the property’s adjusted basis. The result is the capital gain subject to taxation.
The selling price is the final amount paid by the buyer for the home. Selling costs are direct expenses associated with the sale, such as real estate commissions, attorney fees, and other closing costs. These expenses are subtracted from the selling price.
The adjusted basis starts with the original purchase price of the property. This initial basis is then increased by the cost of any capital improvements made over the years, such as a new roof or a kitchen remodel. Routine repairs and maintenance do not increase the basis.
A property sold from a trust before the grantor’s death does not receive a “step-up” in basis. This benefit, where the basis is adjusted to the fair market value at the date of death, is only available for inherited property. For a pre-death sale, the trust uses the grantor’s original “carryover basis.”
For example, a grantor purchased a home for $100,000 and made $50,000 in improvements, for an adjusted basis of $150,000. If the home is sold before death for $600,000, the capital gain is $450,000. If beneficiaries inherited that same home when it was worth $600,000, their stepped-up basis would be $600,000, resulting in zero capital gain.
Applying the Principal Residence Exclusion
After calculating the capital gain, the next step is to determine if any of it can be excluded from taxation. The Section 121 exclusion allows an individual to exclude up to $250,000 of gain from the sale of their primary home. Married couples filing a joint return can exclude up to $500,000.
To qualify, the taxpayer must meet both an ownership test and a use test. This requires the individual to have owned the home and used it as their principal residence for at least two of the five years immediately preceding the sale. The application of this exclusion in the context of a trust depends on its tax status.
For a revocable trust, claiming the exclusion is straightforward. Because the IRS treats the grantor as the owner for tax purposes, the exclusion is available if the grantor personally meets the two-year use test. The trust’s ownership period is counted as the grantor’s ownership period.
The situation is similar for an irrevocable trust structured as a “grantor trust.” The grantor can still claim the Section 121 exclusion if they meet the use test. However, if the trust is a “non-grantor” trust, it is a separate taxpayer and cannot claim the exclusion, as the trust itself cannot “use” the property as a principal residence.
Tax Reporting and Payment Responsibility
The responsibility for reporting the sale to the IRS and paying any tax due depends on whether the trust is a grantor or non-grantor trust.
In the case of a revocable or irrevocable grantor trust, the tax responsibility falls on the grantor. The transaction is reported on the grantor’s personal Form 1040. The details of the sale are entered on Form 8949, “Sales and Other Dispositions of Capital Assets,” and the resulting capital gain is summarized on Schedule D.
For an irrevocable non-grantor trust, the trust itself is the taxpayer. The trustee is responsible for filing Form 1041, the “U.S. Income Tax Return for Estates and Trusts,” to report the sale. The tax on the capital gain is paid directly from the trust’s assets, and the income tax brackets for trusts are more compressed than for individuals.
A planning opportunity exists for non-grantor trusts through Distributable Net Income (DNI). If the trust distributes the sale proceeds to the beneficiaries in the same tax year, the trust may take a distribution deduction. This action can pass the tax liability for the capital gain from the trust to the beneficiaries, who would then report the income on their personal tax returns, potentially at a lower tax rate. This decision rests with the trustee and must align with the terms of the trust document.