Does starting a Living Trust reduce or increase my income tax liability?
The mere creation of an estate plan with a Living Trust has no bearing on your income taxes. However, before funding a Living Trust by putting assets into it, you may want to consult a tax professional or ask a Rocket Lawyer network attorney for guidance on the tax consequences.
If you establish a revocable Living Trust, which uses your Social Security number as its Tax Identification Number with the IRS (and state tax authorities, if applicable), it is generally a tax-neutral event to transfer assets into it. However, you are required to report any income the trust’s assets earn on your personal income tax return. Essentially, the assets continue to be considered the taxpayer’s individual assets during the grantor’s lifetime.
An irrevocable Living Trust may carry capital gains or gift tax implications on assets transferred during the grantor’s lifetime. This determination requires a situation-specific analysis, so talk to a tax advisor or estate planning lawyer who can advise you on any impacts to your circumstances.
The taxability of income from an irrevocable trust depends on whether the trust is structured as a “grantor” or a "non-grantor” trust. In a grantor trust, income is taxable to you just like with a revocable Living Trust. A non-grantor trust is one that is set up using its own tax ID number. The terms of the trust dictate this structure. Generally, even if you are the beneficiary of an irrevocable trust that is structured as non-grantor for tax purposes, taxable income distributions are taxed at the trust level, rather than being reportable on your individual taxes. However, there are exceptions to this general rule in certain advanced planning trust scenarios. Get started today on your estate plan using our Estate Planning Worksheet.
What are the estate tax benefits or consequences of a Living Trust?
Creating and funding a revocable Living Trust is unlikely to provide income tax benefits or consequences during your lifetime. This is because you do not effectively relinquish control over the assets in the trust. However, you could structure a revocable Living Trust to provide potential estate tax savings after your death. Using credit shelter trusts (also known as bypass trusts) is a common estate planning strategy for married couples whose combined estate could trigger estate taxes.
Transferring assets to a revocable Living Trust does not, by itself, remove assets from your probate estate for tax purposes. That’s because the assets remain under your control even after you transfer them to the trust. After you die, those assets end up included in your gross estate for estate tax liability purposes. But, you could structure your revocable Living Trust to minimize estate taxes.
Making an irrevocable Living Trust, and transferring assets to it during your lifetime, could provide estate tax benefits while protecting assets from creditors (when the trust is structured to do so). However, you may be required to file a gift tax return to document the value of assets transferred into an irrevocable trust, as this is considered a gift to another taxable entity. Gift taxes are discussed in greater detail below.
If you have an estate that is likely to be subject to estate taxes when you die, your heirs and beneficiaries could benefit from the transfer of your home or other personally owned real estate into an irrevocable trust. Real estate inside an irrevocable trust may also receive a step-up in cost basis, which is likely to have the effect of minimizing capital gains for the trust entity (ultimately benefiting the beneficiaries of the trust). However, the IRS has clarified that there are certain situations in which real estate inside irrevocable trusts is not eligible for a stepped-up basis. An attorney or tax professional may be able to help you understand these potential pitfalls of estate and tax planning.
Ultimately, Living Trusts aren’t just worthwhile for those with millions of dollars in assets. As a rule of thumb, if you own real estate and have a net worth of at least $100,000, creating and funding a trust could benefit your estate. While the value of your estate may be under the estate tax threshold, a Living Trust may prove to be worthwhile alongside a Last Will and Testament for simplifying the probate process for your heirs.
Are there tax benefits to a revocable or irrevocable Living Trust?
Revocable Living Trusts typically do not provide any tax benefits to grantors, either lifetime benefits or at the death of the grantor. This is because the IRS views the trust entity as an extension of the individual settlor(s) for federal income tax purposes. Similarly, as discussed in greater detail above, a revocable Living Trust does not automatically provide estate tax benefits. However, there are ways to incorporate estate planning strategies into a revocable Living Trust in an attempt to lower the estate tax bill your heirs may ultimately face.
Irrevocable Living Trusts, which are taxed as IDGTs (intentionally defective grantor trusts) do not offer any federal income tax benefits to grantors, but assets in properly structured IDGTs can be considered removed from the grantor’s estate for estate tax purposes.
Non-grantor, irrevocable Living Trusts can be categorized as either simple or complex. Simple trusts require that all income be distributed each tax year. That income is reportable on Schedule K-1 and is taxable to the recipients, rather than at the trust level. However, the trust is responsible for paying any capital gains taxes incurred.
In contrast, income earned in a complex irrevocable Living Trust may be retained at the trust level. Tax on the income may be the responsibility of the beneficiaries, the trust, or some combination of the two. Trust tax rates are typically higher than individuals’ tax rates, which may be a factor to consider when deciding on a tax structure for an irrevocable Living Trust.
Are there gift tax consequences to starting a Living Trust?
While a full discussion of gift taxes is outside the scope of this article, transferring assets into an irrevocable Living Trust could come with gift tax implications and obligations. As previously noted, transfers into a revocable Living Trust are not considered completed gifts for tax purposes, so such transfers are gift tax-neutral. This is true whether the asset is real estate, stocks or brokerage accounts, bank accounts, or any other asset.
Transferring significant assets of any type into an irrevocable trust may, however, trigger gift tax return filings. If you gift more than the annual exclusion amount to your irrevocable trust in a calendar year ($18,000 in 2024, or $36,000 if you are married and you and your spouse choose to combine your annual gift tax exclusions), then the amount of the gift over the exclusion amount is generally required to be reported on a gift tax return using IRS Form 709. As the donor of the gift, you would typically be responsible for paying any gift taxes due, although gift taxes are usually only due after the lifetime gift tax exemption has been reached. The gift and estate tax exemption for someone dying in 2024 is $13,610,000.
Using a Living Trust can be helpful when it comes to estate and tax planning. If you have more questions about your taxes or estate planning, reach out to a Rocket Lawyer network attorney for affordable legal advice. Need help with filing your tax returns? Get matched with a tax pro via Rocket Tax™ to save time and money filling your tax returns.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.
