There are many tax considerations when selling a primary residence. But one concern that often comes up is the sale of a principal residence by an irrevocable trust.
There are pros and cons of the legal ownership of your main residence. But normally it is not that tax efficient to have your personal residence in an irrevocable trust. Let’s review some of the reasons why putting your principal residence in an irrevocable trust (that is not a QPRT) would be a bad idea.
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Loss of deductions
An irrevocable trust will typically not have any grantor provisions. As such, any income and deductions are retained in the trust and will not flow through to the grantor’s personal tax return. This trust does not need to file a separate trust return because there are no other assets in the trust that earn income.
A grantor will generally want to take deductions for real estate taxes and mortgage interest. An irrevocable trust will not be able to claim these deductions. If the residence were titled in the grantor’s name (or in a revocable trust), the owner would get the tax benefit on their individual tax return.
Gain exclusion on the sale of primary residence
One of the significant concerns would be the primary residence exclusion under section 121 of the internal revenue code. The main issue is can of trust claim the $250,000 or $500,000 if you’re married capital gain exclusion from the sale of the principal residence. This could become a sticky issue.
The principal residence exclusion under section 121 allows an individual or married couple to exclude up to $250,000 or $500,000 of gain on the sale of a primary residence. But since an irrevocable trust is not a natural person, it is typically not allowed to use this exclusion. However, there are a few exceptions.
This capital gains exclusion is not available to trusts, only to individuals. If a trust sells the residence, any gain is subject to capital gains tax and possibly the 3.8% net investment income tax (NIIT).
In some situations, an irrevocable trust might qualify for the exclusion. Generally speaking, if the IRS considers the trust’s beneficiary and the trust to be the same person, the trust would be viewed as a disregarded entity. As such, if the beneficiary was living in the residence, then it might be possible to exclude or take advantage of the $250,000 capital gains exclusion.
It may be possible for a special needs trust to be set up to allow the owner to qualify for the exclusion. But special needs trust would only be allowable in certain circumstances.
Sale of Principal Residence by Irrevocable Trust
Suppose the trust didn’t qualify for the exclusion. In this instance, the owner would want to speak with an estate attorney or CPA familiar with special-needs planning to address the benefits and risks of distributing the money to the beneficiary to avoid having a truss pay the income tax.
But remember a critical point. Trusts have significantly higher tax rates than those assessed at the individual level. So make sure you review both options to see what makes sense for you.
Many estate attorneys create a revocable living trust. This is one of the most common estate planning tools. A revocable living trust is a structure used to manage a person’s estate assets during life and after death.
While grantors are still alive, they can manage trust assets as they see fit. Upon the grantor’s death, the trust will act as a Will, but with the additional benefit of avoiding probate. If a revocable trust is established, the grantor wants to transfer all assets and real estate. This includes the primary residence itself.
One additional estate planning tool is moving the primary residence to an irrevocable trust by setting up an intentionally defective grantor trust (IDGT). This structure can work particularly well for individuals doing Medicaid planning or VA benefit planning. An IDGT is a type of trust that is excluded from a grantor’s estate for estate tax purposes, but earnings are included in the grantor’s personal tax return.
A Qualified Personal Residence Trust (“QPRT”) works a little differently. It offers an estate exclusion, along with individual taxation.
Under a QPRT, the grantor is treated as owning the QPRT’s assets during the QPRT term. As such, the grantor reports all of the trust’s items of income, deduction, or credit directly on his own income tax return, Form 1040.
For the typical QPRT that holds no assets other than the donor’s personal residence, this means that the donor will continue to deduct the property taxes and mortgage interest on his residence on Schedule A of his Form 1040 in precisely the same manner as he did before creating the QPRT. It does not matter whether the trust pays these expenses or the donor pays them.
For the less-typical QPRT that receives some income (for example, interest on funds the trust is permitted to hold during the QPRT term or returns on other investments if the trust has converted to a GRAT or rental income, the grantor’s tax return must report the various income items as if they had been paid directly to the grantor.
Strangely enough, the IRS instructions for Form 1040 never mention this subject; the grantor must-read IRS Publication 525 to know how to do it.
The sale of a principal residence by an irrevocable trust is possible. But the real issue is whether it is tax efficient. The best scenario to minimize tax is usually by establishing a QPRT. But there are a few avenues to explore.
In summary, if correctly established, a primary residence could qualify for the capital gains tax exclusion under Section 121. Make sure you review and discuss your situation with an estate attorney and CPA to properly structure the ownership of your principal residence.