Trusts are commonly used in California estate planning because they offer flexibility, control, and tax advantages when used correctly. A trust can hold a variety of assets, including real estate, investment accounts, and business interests. Because a trust is treated as a distinct legal entity in many cases, questions often arise about how capital gains taxes apply when those assets are sold. Understanding the interplay between trust structures and tax consequences is essential to ensure proper planning and administration. With that in mind, the Los Angeles attorneys at Schomer Estate & Wealth Advisors discuss how capital gains taxes impact assets held in a California trust.
Types of Trusts and Their Tax Characteristics
Trusts fall into two primary categories: testamentary trusts and living trusts. A testamentary trust is established through the terms of a Last Will and Testament and only becomes effective after the testator passes away. Because a Will can be changed until death, a testamentary trust is inherently revocable up to that point. A living trust, on the other hand, is created and funded during the lifetime of the person setting it up (referred to as the Settlor or Grantor). These trusts are classified as either revocable or irrevocable. The distinction between the two plays a significant role in how capital gains taxes are assessed.
Capital Gains Tax Basics
Capital gains taxes are triggered when an asset is sold for more than its original purchase price. The difference between the sale price and the initial cost, known as the cost basis, represents the capital gain. For example, selling a California home purchased for $400,000 for $650,000 would result in a $250,000 gain. Depending on various factors such as how long the asset was held and your income level, that gain may be subject to federal and California capital gains taxes. The rules governing how and when these taxes are imposed become more nuanced when a trust owns the asset.
Revocable Trusts and Capital Gains
In California, revocable living trusts are a cornerstone of estate planning due to their ability to avoid probate and maintain privacy. A key feature of a revocable trust is that the Settlor retains full control over the assets during their lifetime. Because the trust is not treated as a separate taxpayer, all income, including capital gains, is reported on the Settlor’s individual tax return. This means that if real estate held in a revocable trust is sold and a profit is realized, the resulting gain is taxed to the Settlor personally. Since the revocable trust functions as an extension of the individual, there is no difference in the way capital gains are calculated or reported compared to owning the asset outright.
Irrevocable Trusts and Tax Treatment
Irrevocable trusts are different in that the Settlor typically gives up all rights to control or revoke the trust once it is created. Because of this transfer of ownership, the IRS treats the trust as its own taxpayer. When assets in an irrevocable trust are sold, the trust, not the Settlor, may be responsible for paying capital gains tax on the realized profit. Determining who pays the tax depends in part on how the trust is structured. A simple irrevocable trust must distribute all its income annually, with that income being taxed to the beneficiaries. Capital gains, though, are usually not classified as income. Instead, gains from the sale of trust assets are treated as additions to the trust principal, meaning they are retained within the trust and taxed at the trust level. In California, where both federal and state income taxes apply, a trust retaining capital gains may pay a substantial amount in taxes due to compressed tax brackets and high state rates. For that reason, planning for capital gains exposure is essential when using an irrevocable trust.
What Happens When Assets Are Distributed Instead of Sold
If the Trustee of an irrevocable trust transfers an asset directly to a beneficiary rather than selling it, no capital gains taxes are immediately due. The beneficiary then becomes the new owner, and the asset receives a new basis equal to its value at the time of the distribution if the trust is structured to allow this. When the beneficiary later sells the asset, capital gains taxes will be calculated using this adjusted basis, rather than the trust’s original purchase price. For example, if a beneficiary receives a piece of real estate valued at $600,000 at the time of transfer and later sells it for $700,000, capital gains would apply only to the $100,000 difference. This approach can sometimes reduce the total tax burden, but whether this method is advantageous depends on several factors, including the trust’s structure, timing of the sale, and the applicable laws in California.
Do You Have Questions about How Capital Gains Taxes Might Impact Your California Trust?
For more information, please join us for an upcoming FREE seminar. If you have additional questions about how capital gains taxes might impact your California trust, contact the experienced Los Angeles estate planning attorneys at Schomer Estate & Wealth Advisorsby calling (310) 337-7696 to schedule an appointment.
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