Trusts are widely used in estate planning across Washington State, in large part because a trust a properly structured and drafted trust can provide control, flexibility, and tax efficiency. Moreover, a trust can hold a variety of assets such as real estate, investments, and business interests. Because a trust is often considered a separate legal entity, questions commonly arise regarding how capital gains taxes apply when assets within the trust are sold, making a thorough understanding of how capital gains interact with different trust structures critical to effective estate planning. With that in mind, the attorneys at Legacy Estate Planning, LLC explain how capital gains taxes can impact assets held in a Washington State trust.
Trust Basics
Trusts are generally categorized as either living trusts or testamentary trusts. A testamentary trust is created through a Will and does not take effect until the death of the Testator. Since the Will can be changed during the Testator’s lifetime, the trust itself is revocable until death. In contrast, a living trust is established and funded during the Grantor’s lifetime. Living trusts fall into two categories: revocable and irrevocable. This distinction significantly affects how capital gains are taxed when trust-held assets are sold.
Understanding Capital Gains Tax
Capital gains taxes apply when an asset is sold for more than its original purchase price. The taxable gain is calculated by subtracting the asset’s cost basis from the sale price. For instance, if a piece of property in Washington was bought for $300,000 and later sold for $500,000, the capital gain would be $200,000, meaning you would potentially pay taxes on the $200,000 gain. The rate of tax liability for this gain depends on how long the asset was held and the tax status of the owner. Whether the asset is held by an individual or a trust will impact how those taxes are applied and who is responsible for paying them.
Capital Gains in Revocable Trusts
Revocable living trusts are frequently used in Washington estate plans, particularly for avoiding probate and retaining privacy. In a revocable trust, the Grantor keeps full authority and control over the trust assets while alive. Because the trust itself is not considered a separate “taxpayer,” any gains resulting from the sale of assets held in the trust are reported on the Grantor’s personal income tax return. The IRS views the trust and the Grantor as one entity, so there is no change in how capital gains are calculated or taxed compared to assets held individually.
Tax Treatment of Irrevocable Trusts
Irrevocable trusts differ in that the Grantor generally relinquishes control of the assets and cannot revoke the trust once it has been established. Because the trust is considered a separate legal entity, the IRS usually treats an irrevocable trust as a distinct taxpayer. When the trust sells an asset, any capital gains typically remain within the trust and are taxed at the trust level, rather than being passed on to beneficiaries. Trusts reach the highest federal income tax bracket at a much lower threshold than individuals, meaning they often face higher tax rates on capital gains.
Transferring Assets Instead of Selling
When a trust distributes assets directly to beneficiaries rather than selling them, there is usually no immediate capital gains tax. The beneficiary becomes the new owner of the asset and assumes a tax basis that may be adjusted, depending on how the trust was set up. If the asset qualifies for a “step-up” in basis at the time of distribution, the new basis will be the asset’s market value at the time of transfer. For example, that same property that was purchased for $300,000 and is worth $500,000 at the time it is transferred to a trust beneficiary, will get a step-up in basis giving the beneficiary a basis of $500,000. If the beneficiary later sells the property, capital gains would only be due on any gain above the $500,000 basis.
The Importance of Planning for Capital Gains
The way a trust is drafted and administered can significantly affect the tax consequences, making it important to plan for the potential tax implications within your estate plan. Working with an experienced estate planning attorney to create an estate plan that includes consideration of whether assets will be sold or transferred, and whether a revocable or irrevocable trust is used, can minimize the impact of capital gains taxes and preserve more wealth for heirs.
Do You Have Additional Questions about How Capital Gains Taxes Impact a Washington State Trust?
If you have additional questions about how capital gains taxes impact a Washington State trust, contact the experienced Bellevue estate planning attorneys at Legacy Estate Planning, LLC by calling (425) 455-6788 to schedule an appointment.
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