Trusts serve as a central tool in California estate planning because they allow you to manage property efficiently, maintain privacy, and structure distributions with precision. When you place assets such as real estate, brokerage accounts, or ownership interests in a business into a trust, you create a framework that governs how those assets are controlled and eventually transferred. At the same time, you must consider how taxation applies when those assets are sold. Capital gains taxes can significantly affect the overall value passed to beneficiaries, making it essential for you to understand how different trust structures influence tax liability. With that in mind, the Los Angeles attorneys at Schomer Estate & Wealth Advisors explain how capital gains taxes may impact your California trust.
Understanding How Trust Structure Shapes Tax Outcomes
Trusts generally fall into two categories: those created during your lifetime and those established through your Will. A trust formed through your Will becomes effective only after your death, meaning it does not hold assets during your lifetime. By contrast, a living trust is created and funded while you are still alive, allowing you to transfer ownership of assets into the trust immediately.
Living trusts can be divided into revocable and irrevocable trusts, a distinction that carries substantial tax implications. A revocable trust allows you to retain full authority over the assets, including the ability to amend or terminate the trust. An irrevocable trust requires you to relinquish control once it is established, which changes how the law treats ownership and taxation. The way capital gains taxes apply depends heavily on which structure you choose.
What Are Capital Gains Taxes?
Capital gains tax arises when you sell an asset for more than its original purchase price. The difference between what you paid for the asset and what you receive upon sale is referred to as the gain. That gain becomes subject to taxation under both federal law and California law. For example, if you purchase a property for $400,000 and later sell it for $650,000, you realize a gain of $250,000. That amount is potentially taxable, depending on factors such as how long you held the asset and your overall income level. Assets held for more than one year are typically subject to long-term capital gains rates, which are generally lower than short-term rates. California, unlike the federal system, does not provide a preferential rate for long-term gains, meaning all capital gains are taxed as ordinary income at the state level. When a trust owns the asset, you must determine whether the gain is attributed to you personally, to the trust itself, or to the beneficiaries.
How Revocable Trusts Are Treated for Capital Gains Purposes
If you establish a revocable living trust in California, you retain control over the trust assets during your lifetime. From a tax perspective, the law treats you and the trust as one and the same. The trust does not file a separate income tax return for capital gains. Instead, all income generated by the trust, including gains from the sale of assets, is reported on your individual tax return. This means that if you sell a piece of real estate or liquidate an investment held in your revocable trust, the tax consequences mirror what would occur if you owned the asset directly. Because the revocable trust functions as an extension of you, it does not create an independent layer of taxation. This structure simplifies reporting and allows you to maintain flexibility in managing your assets. At the same time, it does not provide insulation from capital gains taxes during your lifetime.
Tax Implications After the Death of the Settlor
When you pass away, the nature of your revocable trust changes. The trust typically becomes irrevocable, and its tax treatment shifts accordingly. At that point, the trust may be required to obtain its own taxpayer identification number and file separate tax returns. The Trustee assumes responsibility for managing the trust’s financial and tax obligations.
One important tax concept that arises at death is the step-up in basis. Assets included in your estate generally receive a new cost basis equal to their fair market value at the time of your death. This adjustment can significantly reduce or eliminate capital gains taxes if the asset is sold shortly thereafter. For example, if you purchased a property decades ago for $200,000 and it is worth $800,000 at the time of your death, the basis resets to $800,000. If the Trustee sells the property for that same amount, little or no capital gain is recognized.
How Irrevocable Trusts Are Taxed
An irrevocable trust operates under a different set of rules because you no longer retain ownership or control over the assets. The Internal Revenue Service generally treats the trust as a separate taxpayer. As a result, when assets within the trust are sold, the trust itself may be responsible for paying capital gains taxes.
The way those taxes are assessed depends on how the trust is structured and how income is allocated. Some irrevocable trusts require the Trustee to distribute all income to beneficiaries each year. In those cases, ordinary income is typically taxed to the beneficiaries rather than the trust. Capital gains, though, are often treated differently. In many situations, gains from the sale of trust assets are classified as additions to principal rather than distributable income. That means the trust retains the gain and pays the associated tax.
Trust tax brackets are highly compressed compared to individual tax brackets. This means that a trust can reach the highest federal tax rate at a much lower income threshold. When you combine federal taxation with California’s state income tax rates, the overall burden on retained capital gains can be substantial. For that reason, you need to evaluate carefully whether an irrevocable trust aligns with your tax planning objectives.
Distributing Assets Instead of Selling Them
In some situations, the Trustee may transfer assets directly to beneficiaries rather than selling them within the trust. This approach can alter the timing and impact of capital gains taxes. When an asset is distributed in kind, the trust does not recognize a taxable gain at the moment of transfer. The beneficiary becomes the new owner and assumes the tax basis associated with the asset, subject to certain adjustments depending on the trust structure.
If the asset has received a step-up in basis, the beneficiary may inherit it at its current market value. If not, the beneficiary may take on the trust’s original basis. When the beneficiary later sells the asset, capital gains tax is calculated based on the difference between the sale price and that inherited basis.
For example, if you transfer property valued at $600,000 to a beneficiary and the basis is adjusted to that amount, a later sale for $700,000 results in a $100,000 gain. This method can sometimes reduce the overall tax burden, particularly if the beneficiary is in a lower tax bracket or if the asset has already received a favorable basis adjustment.
Do You Have Questions about Capital Gains and Your California Trust?
For more information, please join us for an upcoming FREE seminar. If you have additional questions or concerns about capital gains and your California trust, contact the experienced Los Angeles trust attorneys at Schomer Estate & Wealth Advisors by calling (310) 337-7696 to schedule an appointment.
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