Capital gains tax on sale of home in irrevocable trust

What is an irrevocable trust? | Parties involved | Living vs. irrevocable upon death | Important provisions | Benefits | Selling a house in an irrevocable trust | Pros and cons | Trust modifications | FAQs

This article was reviewed by Wayne Patton, an asset protection and estate planning attorney in the state of Florida.

Irrevocable trusts protect assets from creditors and lower the net worth of an individual by removing those assets from their name. A trust is called “irrevocable” when it can’t be amended, modified, or dissolved by the person who created it.

Houses that are placed in an irrevocable trust can usually be sold, but how you sell and what happens to the profits depends on the terms that are laid out in your trust agreement.

The trust agreement is a document that the settlor (the creator of the trust) drafts with the help of an estate planning attorney. Think of it as a blueprint for your trust.

Even though irrevocable trusts come with a lot of limitations, in estate planning attorney Wayne Patton’s words, “If you’re creating your own trust, you can get really specific with the rules that you want to incorporate.”

In this guide, we'll help you understand exactly what an irrevocable trust entails and how you can sell a house included in one of these arrangements.

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An irrevocable trust is a trust that cannot be modified, amended, or dissolved by the settlor once it comes into existence (most of the time — there are exceptions, which we'll get to a bit later).

The settlor isn't allowed to have what are called “incidents of ownership” over the assets in the trust.

This legal jargon just means that the trust, under the direction of the trustee, has total discretion and ownership over any assets that are placed within it.

Parties involved in an irrevocable trust

There are three key parties in an irrevocable trust:

• Settlor/grantor: The individual who establishes the trust and places their assets within it. Upon the creation of the irrevocable trust, the settlor gives up any direct claim to ownership that they once had over the assets.

• Trustee: The individual or corporation appointed to manage the trust. The trustee’s mandate is to act in the best interest of the beneficiaries.

• Beneficiary: The individual or group whom the settlor has chosen to receive the assets placed in trust. There can be one or more beneficiaries.

In some trusts, a trust protector is also appointed. The role of a trust protector is to hold the trustee accountable.

A trust protector is not legally required, but sometimes they are included in an irrevocable trust because they can keep the trustee’s powers in check and even terminate the trustee, if necessary.

Trusts that are irrevocable upon death

A revocable trust can be set up so that it becomes irrevocable at the time of the settlor’s death.

“The main purpose of setting up a trust that way is to avoid probate court,” says Patton.

By letting a revocable trust become irrevocable, the settlor can maintain control of the trust until they die, at which point their assets are protected from creditors and can quickly be distributed to beneficiaries.

This arrangement sidesteps the lengthy and costly process of getting a will through probate court.

Living irrevocable trusts

The other option is to establish what is called a “living irrevocable trust.”

As the name suggests, a living irrevocable trust is irrevocable both while its settlor is alive and after they pass. Upon the settlor’s death, the trustee settles all debts in the trust and distributes the assets to the beneficiaries as instructed.

To create a living irrevocable trust, the settlor must freely give up their “incidents of ownership” (any personal claim to ownership over assets in the trust). In return, they can dramatically lower the value of their personal assets and access several tax benefits.

In either case, the trust will have its own tax identification number, and it is the responsibility of the trustee to pay taxes, manage assets, and keep records.

What should be included in an irrevocable trust agreement?

There are many provisions that could be included in a trust agreement, but a spendthrift clause is essential.

A spendthrift clause stipulates that a beneficiary is not able to transfer their interest in a trust away from themselves.

This important stipulation protects the assets in the trust from the creditors of the beneficiary.

For example, if one of the beneficiaries got divorced and their spouse was entitled to half of their assets, the assets in the irrevocable trust would be untouchable because of the spendthrift clause.

How to protect the settlor’s residence

One concern that some people have about putting their house in an irrevocable trust is that they’ll somehow lose their place of residence.

The best way to make sure this doesn’t happen is to create a lady bird deed — a document that exists outside the trust.

With a lady bird deed in place, the property is immediately deeded to the irrevocable trust at the time of the settlor’s death and maintains its protection from creditors.

More importantly, the lady bird deed protects the primary residence of the settlor from any actions that the beneficiary or trustee might take to sell their home. In other words, no one can kick you out!

“A lady bird deed says ‘I reserve a life estate in this homestead to myself — remainder interest to my revocable trust, which will be irrevocable at the time that I die,’” Patton explains.

“Remainder interest” refers to the future right to own the property, which will pass to the beneficiaries when the settlor dies.

Quick tip
You should never draft a trust agreement on your own, no matter how much you think you know!

Always consult an estate planning attorney.

Estate planning attorneys know the ins and outs of trusts and have a superior working knowledge of the applicable laws in your state.

What about homestead laws?

Homestead laws are written into the constitutions of some states to protect homeowners from having their home seized by creditors, to provide exemptions from property taxes, and to provide shelter to a surviving spouse.

This means that if you live in a state like Florida or Texas with strong homestead laws, your primary residence is automatically shielded from creditors by law.

Homestead protections are limited to a certain dollar value in most states, so you may have only partial coverage, depending on where you live.

Using an irrevocable trust to protect your home from creditors or creating up a lady bird deed may not be necessary if your state’s homestead protections are strong enough.

Consult an attorney to learn more about the homestead laws in your state, or take a look at the table below.

Homestead laws by state

Benefits of an irrevocable trust

Qualifying for Medicaid

You can place significant assets like your house in an irrevocable trust in order to drastically reduce the value of your personal assets, potentially helping you to qualify for Medicaid.

For seniors, Medicaid covers the cost of long-term care. However, individuals who are above their state’s asset threshold do not qualify.

While an irrevocable trust can be used to accomplish this purpose, there can be a penalty.

“You can’t say, ‘I want to qualify for Medicaid now, so I’m just going to gift my assets to my children.’ There is a lookback period,” says estate planning attorney Wayne Patton.

The lookback period is a set length of time from the date the trust was created. During the lookback period, the trust’s assets are still viewed as the personal property of the Medicaid applicant.

The lookback period is typically five years, so anyone who is planning to use an irrevocable trust to qualify for Medicaid should plan ahead.

Medicaid asset thresholds by state

Avoiding estate tax

The total value of a person’s estate can be brought below the estate tax threshold by placing large assets in an irrevocable trust.

Estate tax kicks in when an individual dies and the total value of their estate exceeds the estate tax threshold, which the IRS currently has set at $11.5 million.

The federal estate tax threshold used to be just $1.5 million in 2004, but it has been gradually rising ever since. Because the threshold is so much higher now, using irrevocable trusts to avoid estate tax is becoming less common since it makes sense only for high net worth individuals.

Skipping probate court

In most situations, distributing assets from an irrevocable trust is faster than getting a will through probate court, resulting in significant legal cost savings.

Your will has to go through probate court when you die, so it can be reviewed and processed by the will’s executor — a process that can be both lengthy and expensive.

The time that it takes to process a will in probate court varies from six weeks to several months. It depends on the specific probate process in your state, the complexity of the will, and whether or not any disputes arise when the will is being executed.

However, if all of your assets are in an irrevocable trust, the trustee can quickly distribute them to the beneficiaries by transferring ownership or liquidating the assets and passing on the proceeds.

Reducing capital gains

There may be little or no realized capital gain if the beneficiaries decide to sell the house in an irrevocable trust shortly after the settlor’s death. Of course, this “step-up in basis” is only allowed if the trust was revocable while the settlor was alive and became irrevocable upon their death.

A “step-up in basis” means that the initial value of the home that acts as a base for calculating the capital gain is “stepped up” to the time of the settlor’s death.

In this case, the capital gains in a trust are calculated using the value of the home at the time of the settlor’s death — not the price that was originally paid for the home.

For example, say that the settlor originally paid $150,000 for their house, which they then placed in a revocable trust, and it had a value of $200,000 when they died. If the beneficiaires sold the home shortly thereafter for $220,000, there would only be a capital gain of $20,000, not $70,000.

The downside of an irrevocable trust

The biggest downside of setting up an irrevocable trust is that you effectively give up all control over the assets that you place in the trust.

You can’t shut the trust down, change the trustee, modify the beneficiaries, or manage the assets. That’s a pretty significant opportunity cost.

This downside can be somewhat mitigated by:

• Picking a trustee whom you have a good relationship with.

• Writing considerations into the trust agreement that you would like the beneficiaries/trustee to take into account when they are making decisions.

Still, by removing all “incidents of ownership,” you're ultimately placing all of the control in someone else’s hands.

Can you sell a house in an irrevocable trust?

The short answer is yes, you can sell a house in an irrevocable trust.

When the trust was established and what parties have decision-making authority will both be important factors when it comes to selling a house in an irrevocable trust.

Once again, the trust agreement is the instrument that will guide this process.

Pros and cons of selling a house in an irrevocable trust

Selling a house in a living irrevocable trust

A home that's in a living irrevocable trust can technically be sold at any time, as long as the proceeds from the sale remain in the trust.

Some irrevocable trust agreements require the consent of the trustee and all of the beneficiaries, or at least the consent of all the beneficiaries.

In any agreement, the settlor has no direct control over whether or not the house is sold.

Who can actually start the sale?

The trustee must initiate the sale of any property in the trust since they're responsible for managing the assets.

However, who actually decides that the house will be sold is another matter. As attorney Wayne Patton notes, “It’s going to be completely dependent on the language in the trust.”

Check the wording of your trust agreement to see what's allowed.

Selling a house after the irrevocable trust’s settlor has died

Following the death of the trust’s settlor, it's still the responsibility of the trustee to initiate the sale of the property in the trust.

If the beneficiaries and/or trustee don't wish to sell the property, ownership can be transferred directly to the beneficiaries.

If ownership is transferred to the beneficiaries, they're free to sell the property on their own or keep it for their personal use.

Do you need a real estate agent to sell a home in an irrevocable trust?

The trustee has the option to sell the property in an irrevocable trust privately, or to seek the services of a real estate agent.

This choice is usually left to the discretion of the trustee because they're responsible for managing the sale. The trustee can hire a real estate agent if they deem one to be necessary.

If you are the trustee in an irrevocable trust, working with a real estate agent has several advantages:

• Trustees have many other details to take care of when a trust is dissolved, so leaving the property sale to an expert gives them one less thing to worry about.

• Properties in irrevocable trusts can be larger and more expensive than average, so finding the right buyer could require help from a connected professional.

• While trustees are generally proficient when it comes to managing investments, they don't necessarily have any experience or expertise in real estate.

• Enlisting a professional will assure the beneficiaries that every aspect of the sale has been executed fairly.

» FIND: Top real estate agents in your area.

What states allow irrevocable trusts to be modified?

Approximately two-thirds of the 50 states in the U.S. have rules regarding “consent modification” for irrevocable trusts.

Consent modification refers to the ability to modify or amend an irrevocable trust with the consent of one or more concerned parties.

In addition to consent, some states require a court order or a non-judicial settlement agreement (NJSA). An NJSA is basically a legally binding agreement that carries the same authority as a court order.

States with no consent modification laws place more weight on the exact language contained in the trust agreement.

Irrevocable trust consent modification laws by state

Conclusion

The language in the original trust agreement and the laws in your state will be key to determining how and when you can sell a property that’s held in an irrevocable trust.

While irrevocable trusts can offer lots of advantages, they can also be a huge headache if you don’t have a carefully written trust agreement.

Attorney Wayne Patton’s bottomline advice is to make sure you get an expert involved: “You need to work with a lawyer who is licensed in the state where you live to figure out what makes sense.”

FAQs

Should I put my house in an irrevocable trust?

It really depends on your situation and goals. Irrevocable trusts can offer significant tax advantages, but they require you to relinquish control of your assets.

If you’re considering an irrevocable trust, talk to a qualified estate planning attorney who can help you weigh the pros and cons of placing your house in an irrevocable trust.

Who can create an irrevocable trust?

Anyone can set up an irrevocable trust, provided they have the mental capacity to understand the consequences of their actions.

The standard that’s typically employed when it comes to trusts is “contractual capacity.”

“Contractual capacity” means that an individual has the wherewithal to enter into a contract and understands the implications of doing so.

People who can’t meet the standard of contractual capacity include:

• Minors

• Mentally challenged persons

• Persons under the influence of drugs/alcohol

• Incarcerated persons

The purpose of using contractual capacity as a standard when establishing a trust is to protect vulnerable people from being coerced into signing away their assets.

Who can be the trustee in an irrevocable trust?

The trustee can be an individual person or a corporation. Typically, a corporate trustee is a professional trust service that will charge a fee.

The trustee should be someone whom you really do trust because they’ll have significant access to your assets.

As a general rule, a good trustee will be financially responsible and have the ability to manage investments prudently.

Friends and family members can be appointed as trustees, but it can get pretty messy having cousin Bob in such a powerful position.

A friend or family member may have relationships with the beneficiaries or a personal dispute with you, the settlor, which could easily cloud their judgement.

Who pays the mortgage in an irrevocable trust?

You can’t put your house into an irrevocable trust if you still have a mortgage on it.

However, a house with a mortgage can still be placed in a revocable trust, and the debt will remain in your name.

In a situation where your trust becomes irrevocable at the time of your death, the remaining mortgage payments would have to be paid by the trust.

Who pays the property tax in an irrevocable trust?

Typically, the beneficiaries of the trust itself will be responsible for paying property taxes. It depends on the terms laid out in the trust agreement because tax treatment in an irrevocable trust can actually be customized.

For example, the settlor can opt to pay tax on income in the trust, which is called a “grantor’s trust.”

Whichever party pays the property taxes can claim a property tax deduction on their tax return, but the deduction cannot be claimed by both parties.

Schedule K-1 can be used to pass property taxes through to a beneficiary, so they can claim property tax deductions on their personal tax return.

Additional reading