For some, trusts seem to take on a powerful aura. They believe that by setting up a trust, they'll avoid probate, protect their assets, and save on taxes. You might be disappointed to know that it doesn't quite work like that.
Trust taxation is similar to that of an LLC. With all of the tax advantages available in real estate investing, is there at least an angle for deducting property taxes through a trust? To answer that question, we’ll go over the two main types of trusts and how taxing works with trusts.
Types of Trusts
We’re going to keep it simple and talk about two main categories of trusts — revocable and irrevocable. But before we do, let’s discuss a few terms.
Grantor/Trustor/Settlor — This is the person who creates the trust. The Settlor can be a separate person who transfers assets into the trust.
Trustee — Manages the trust and has a fiduciary responsibility to carry out the trust's mandate, which the trust owner usually creates.
Beneficiary — Receives the benefit of the trust. This person is usually an heir of the trustor.
The following two trusts can be grantor trusts. This means one person holds the above three titles.
A revocable living trust (RLT) is designed to avoid probate. There's a common misconception that it is a legal umbrella that protects assets. That is not true. Probate can be very expensive and time-consuming. An RLT helps avoid probate when set up correctly. An RLT provides an orderly distribution of assets upon passing of the trustor. This may be immediately or at some later time.
A revocable trust can be undone so that the trustor can take the assets back. That is why it’s called revocable and also why it doesn’t provide any legal protections. There are no income tax advantages, no capital gains tax advantages, and no estate tax advantages to setting up an RLT.
From the government's point of view, it’s as if the trust doesn’t exist (i.e., disregarded entity). It’s the trustor that matters.
Like an LLC, an RLT is a flow-through entity. Income is taxed on the trustor’s personal tax filing. All income generated by the RLT is the trustor’s income. The trust does not pay any income taxes.
Most RLTs must pay out any income every year. If the trust accumulates earnings, it becomes a complex trust (i.e., irrevocable trust). An RLT is not a complex trust and is instead called a simple trust.
Once the owner of an RLT passes, the trust can become an irrevocable trust.
An Irrevocable Income-Only Trust is a stand-alone entity. Assets are not under an individual’s name and instead are under the trust entity. The trust fully owns the assets. Unlike a revocable trust, this basically protects the trust’s assets from liability.
However, the trustor can’t take assets out of trust because they are no longer his assets. Those assets belong solely to the trust.
Trusts and Taxes
When money is paid out to beneficiaries, is it taxable? If the trust did not pay taxes on annual income, then yes. Otherwise, no. When the trust distributes its income, it gets a deduction, and the beneficiary pays the taxes.
If principal (i.e., assets transferred into the trust) is being distributed, it was taxed when it went into the trust, so no taxes are paid upon distribution. This scenario might be different for states that have an inheritance tax.
Trusts have a high tax rate. For 2021, the highest income tax rate for trusts is 37% for income over $13,050. The NIIT also applies to trust.
For an irrevocable trust, which has an EIN, trust tax rates can be avoided by paying/distributing out all earnings from the trust. The trust will also receive a deduction for distributing earnings. It is the beneficiary who will be taxed based on their personal tax filing status.
Trusts use IRS Form 1041-ES.
Property Tax Deductions
We’re going to assume property was transferred into a trust. Specifically, property owned by an individual was transferred into a revocable living trust. The trust holds title to the property instead of the individual. However, as previously mentioned, the property is still owned by the individual, and they will continue paying any taxes on the property.
As mentioned earlier, the RLT doesn't provide any tax advantages. The individual who transferred the property into this trust will still take the same property-related deductions as before. Any property tax deductions should not be impacted.
The situation is different for an irrevocable trust. Since the trust fully owns the property, any earnings on the property are trust income. Deductions, including property taxes, can be taken against this income, reducing the trust's net income.
Setting up a trust is tedious. Sometimes when a trust is set up, people believe their assets are instantly under the trust. However, all assets stated in the trust must be transferred into the trust for everything to work as planned. Working with a real estate attorney can help ensure the trust is set up properly.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.