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Wendy Reed
Wendy Reed, Finance Enthusiast
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Experience:  Over 10 years tax preparation corresponding with financial advice.
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What is the tax treatment of Capital Gains in an ...

Customer Question

What is the tax treatment of Capital Gains in an irrevocable trust not included in DNI? Does the Trust itself pay tax on it or is it tax free?
Submitted: 6 years ago.
Category: Finance
Expert:  Wendy Reed replied 6 years ago.

Hello There!

If the trust has a net capital gain, then how it is treated depends upon whether net capital gain is allocable to income or principal under the terms of the trust agreement or state law. Generally it is better for the capital gain to be allocated to beneficiaries, because individual tax rates are less than estate tax rates.

If the gain is not allocable to income, then it is allocated to principal of the trust. As such, you will need to file Form 1041, U.S. INcome Tax Return for Estates and Trusts, and Schedule D for Form 1041 to figure the tax. The capital gain is not tax free, it is taxable to the trust.

 

Wendy Reed, Finance Enthusiast
Category: Finance
Satisfied Customers: 3346
Experience: Over 10 years tax preparation corresponding with financial advice.
Wendy Reed and 5 other Finance Specialists are ready to help you
Customer: replied 6 years ago.
I am a beneficiary of a trust and the trustees claim that in 5 years of taxable gains, including capital gains that the TRUST does not have to pay taxes and that the only time it is taxed is when it is distributed to the beneficiaries and they pay tax. In other words, since they sold 6 properties in 2004 and had a net capital gain of $1.4 Million, they are saying that they do not have to file tax returns for 2004 and as long as the Capital gain portion is NOT distributed to the beneficiaries, it is never taxed.... What you are saying is that it must be taxed. Either the Trust pays the tax in 2004 or it is distributed and allocable to DNI and taxed to the beneficiaries.... right? I will give a bonus for this followup. Thanks, Chris
Expert:  Wendy Reed replied 6 years ago.

Hi Chris,

Trusts can be very complex, and have all types of rules and specifications that must be considered before making a general statement regarding whether or not such income is taxable and to whom. For example, there are rules on accumulated distributions, capital gain set aside to corpus for charities where a deduction is allowed, etc. These types of sophisticated arrangements are beyond my scope and I do not know the particulars of your trust.

However, in general, capital gains allocated to the corpus (or body, principal) of the trust are taxable not to the beneficiary, but to the trust. I am not sure why the trustees are telling you that the capital gain is never taxed, unless there is some sort of tax deferral strategy in use that is spelled out within the trust.

Here is a page from the IRS regulations on taxation of undistributed capital gain, and there is an example which shows that capital gain retained by corpus is taxable to the trust:

http://money.cnn.com/pf/features/lists/taxesbystate2005/index.html

Here is the actual Code and section which discusses the options of allocating capital gain to either corpus or income, and the implications. There are multiple examples, and example 1 shows capital gain retained by the trust is taxable to the trust:

http://a257.g.akamaitech.net/7/257/2422/03apr20061500/edocket.access.gpo.gov/cfr_2005/aprqtr/26cfr1.643(a)-3.htm

 

 

Again, these are the general rules of the trust. I would find an enrolled agent or CPA in your area who specializes in trust taxation, (or speak to the person who actually prepares the trust return and K-1's) and can look at the trust document, so that he or she can give you more specific advise about your particular trust and how the income/gains are taxed.

I hope this helps!

Customer: replied 6 years ago.
Thank you very much... you have been very helpful.
Chris

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