Can a Trust Deduct Property Taxes?

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 work quite like that.

Trust taxation is similar to 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 taxation works with trusts.

Types of Trusts

We'll 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 the 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 RLT income is the trustor’s income. The trust does not pay any income taxes.

Most RLTs must pay out income annually. 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 held in an individual’s name but under the trust entity, which fully owns them. Unlike a revocable trust, this basically protects the trust’s assets from liability. 

However, the trustor can’t take assets out of the 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 the 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 trusts.

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 the property was transferred into a trust. Specifically, an individual's property was transferred to 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 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.

Irrevocable trusts are different. 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.