As an estate planning lawyer at Bryant & O’Connor Law Firm, I often come across clients who have concerns about the impact of trusts on their taxes. This concern is a smart thing to ask about, but it’s a common misconception that placing assets in a trust will automatically lead to higher taxes. In this blog, we will debunk this myth and provide you with clarity on how a revocable living trust affects your tax obligations.
Understanding Revocable Living Trusts:
Before we delve into the tax implications, let’s quickly go over what a revocable living trust is. Essentially, it is a legal arrangement that allows you to transfer your assets into a trust while retaining control over them during your lifetime. You are also almost always the beneficiary. This type of trust can be modified or revoked as you see fit, providing flexibility and peace of mind. The trust becomes irrevocable at your death, at which point a different set of rules (which you created) apply. Revocable living trusts have become popular among our clients because they create an organized and flexible framework designed to make succession planning for events like incapacity and death easier for your intended successors.
Debunking the Tax Myth:
Contrary to popular belief, a revocable living trust has no direct effect on your taxes during your lifetime. This is because, as the grantor of the trust, you maintain ownership and control over the assets placed within it. In the eyes of the IRS, the trust is treated as an extension of yourself, and therefore, any income generated by the trust is still taxable to you personally.
The source of concern is that the federal trust income tax rate is 37% for income over $14,450.00, which is much higher than the individual rate in almost all cases. What many people miss, however, is that this rate only applies if the trust actually realizes income that is not distributed to beneficiaries. Further, as discussed below, a revocable trust is a grantor trust during the grantor’s life, and all income is usually taxed to the creator of the trust just as if there were no trust at all.
Income Tax Considerations:
With a revocable living trust, all income generated by the trust’s assets is reported on your personal tax return (Form 1040). The trust itself does not have its own separate tax identification number. This means that the trust’s income is subject to the same tax rates and deductions that would apply if the assets were still in your individual name.
This is great news because it means that the trust’s income is subject to the same tax rates and deductions that would apply if the assets were still in your individual name. So, you don’t have to deal with any additional complexities or higher tax rates. Your trust’s income is treated just like your own.
By setting up a revocable living trust, you can enjoy the benefits of managing your assets while still maintaining the same tax advantages as if you held them individually. It’s a smart and convenient way to plan for your future.
Capital Gains Tax:
Another concern often raised is whether transferring assets into a revocable living trust will trigger capital gains tax. The good news is that assets held in a revocable living trust are not subject to capital gains tax upon transfer into the trust. This is because the trust is disregarded for tax purposes, and the assets are still considered yours. However, upon your death, assets held in a revocable living trust enjoy an adjusted basis (usually a step up) in the same way that the assets would get an adjusted basis if left through your estate. This is most helpful for appreciated assets like real estate and can save substantial sums.
Estate Tax Considerations:
Upon your passing, assets in a revocable living trust are treated as being part of your estate for estate tax purposes, meaning that your trust by itself won’t affect your estate tax liability if you are single. However, if you are married, your trust can be designed to maximize the unified estate and gift tax exemption between both spouses. The exemptions amount is currently (in 2023) more than twelve million dollars, so most estates are not taxable, but it’s still a good thing to discuss with your estate planning attorney to be sure you’re not missing something. Laws might change before your death, and if you were to have a taxable estate, the estate tax is very high.
Seeking Professional Advice:
It’s vital to remember that this blog is informational only and is not intended to provide legal or tax advice. Even for my estate planning clients, I always encourage my clients to consult with their CPA for tax questions. However, not all CPAs or Attorneys are familiar with revocable living trusts, and it’s important that whoever is providing you with advice understands the type of trust involved before scaring you with the idea that your taxes will be higher. In short, a revocable living trust is very unlikely to make your tax situation worse. Be sure whoever is giving you advice about taxes and trusts understands what kind of trust you are talking about.
In conclusion, the belief that placing assets in a revocable living trust will automatically lead to higher taxes is a common misconception. During your lifetime, a revocable living trust has no direct impact on your tax obligations. The trust’s income is reported on your personal tax return, and the assets are still considered yours for tax purposes. However, it’s always prudent to seek professional advice to fully understand the tax implications of trusts and ensure you make informed decisions regarding your estate planning.
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