Trust capital gains tax question

[PughDunc]

Jurisdiction

New Jersey

An irrevocable trust was created by the grantor in 2021. Purpose - stop arguments among heirs. Trust included an investment account and the grantor's house. House never rented.

Grantor died a couple of years later and the house was sold recently. Two conflicting opinions on capital gains.

One says that the basis for the house was assumed by the trust on the day of transfer - original purchase price for 1/2, date of death for the other (grantors spouse who died early 2000s)

Other opinion says that based on IRS section 2036 "Retained Enjoyment", the house is considered to remain in taxable estate and the step up in basis occurred at date of grantors death.

There is a very large difference in tax liability! Which opinion is correct?

 

[zddoodah]

Purpose - stop arguments among heirs.

Among whose heirs? Arguments about what?

the house was sold recently.

I would say that the entirety of the time since 2021 can be considered "recently." In what year did the sale occur?

Two conflicting opinions on capital gains.

Who rendered these opinions? Does the trustee have legal counsel? If so, did the attorney render one of the opinions and, if so, is he/she a tax attorney? Has the trustee consulted a CPA?

By the way...what is your connection to this situation? Are you the trustee?

 

[PughDunc]

Among whose heirs? Arguments about what?

The grantors heirs obviously. About everything.


I would say that the entirety of the time since 2021 can be considered "recently." In what year did the sale occur?

25 or 26. After grantor death is the important thing.


Who rendered these opinions? Does the trustee have legal counsel? If so, did the attorney render one of the opinions and, if so, is he/she a tax attorney? Has the trustee consulted a CPA?

Two different trust attorneys. Yes and yes. No cpa yet.

By the way...what is your connection to this situation? Are you the trustee?

Yes

 

[PughDunc]

Duplicate

 

[Tax Counsel]

An irrevocable trust was created by the grantor in 2021. Purpose - stop arguments among heirs. Trust included an investment account and the grantor's house. House never rented.

Grantor died a couple of years later and the house was sold recently. Two conflicting opinions on capital gains.

One says that the basis for the house was assumed by the trust on the day of transfer - original purchase price for 1/2, date of death for the other (grantors spouse who died early 2000s)

Other opinion says that based on IRS section 2036 "Retained Enjoyment", the house is considered to remain in taxable estate and the step up in basis occurred at date of grantors death.

There is a very large difference in tax liability! Which opinion is correct?

The answer to that question depends on exactly what the trust terms are and how the property was used after it was put into trust. I don't have any of that information and therefore cannot give you a specific answer. Typically, once an asset is placed into an irrevocable trust, it won't get the basis step-up at death because the assets in the estate are not subject to the federal estate tax. The way the federal estate rules for trusts work is that to get the step up in basis, the trust must be a grantor trust. Assets in a grantor trust are subject to the federal estate tax of the grantor, which is why those assets get the step-up in basis. Grantor trusts are those trusts in which the powers retained by the grantor are such that the grantor retains sufficient rights or powers in the trust that he or she has control much as though he still owned the home directly.

This is the reason the vast majority of trusts used in estate planning today are revocable living trusts. The revocable feature of the trust means that the grantor is still viewed as the direct owner of the trust assets because he can at any time do away with the trust and the assets revert back to his ownership. In that situation the trust isn't really meaningful until the trust grantor dies. Thus, the assets get the basis step up along with the flexibility to change what happens to the trust assets any time. For those estates that will not be large enough to be subject to the estate tax this is the sweet spot to be in. You get to have a trust that bypasses the probate court procedures (which in some states is expensive and takes considerable time), which in turn means the trust property may be distributed to the beneficiaries shortly after death. The trust's flexibility means the grantor can freely change his/her choice of beneficiaries any time up until death or until the grantor becomes incompetent. And, upon death, the assets get the step up in income tax basis. So long as you don't have to worry about the estate tax, that's about as ideal as most estates can get.

If the trust is not revocable then the grantor must have other retained rights that are specified in the Internal Revenue Code (IRC) that make it a grantor trust. These kinds of trusts are much less common than the revocable living trust because they provide to the grantor less flexibility to change things later.

IRC § 2036 is not a grantor trust provision. It is a provision that deals with one of the other popular estate planning tools to get the step up in basis. That is the transfer of property with a retained life estate. The life estate that is retained by the grantor essentially gives the grantor all the rights and enjoyment of the property as though he or she still owns it, except that he or she cannot change who will get it when he or she dies.

In general, IRC § 2036 will not apply to transfers of assets in trust. It's specifically meant to deal with life estates. The kinds of trusts that can still qualify as grantor trusts that are not revocable living trusts are few in number and require retention of very specific powers. These trusts are today uncommon because grantors don't want to restrict their options any more than necessary to get the benefit of the basis step up. The grantor typically has some non tax reason for setting up one of these other types trusts.

A key thing to note: if the opinion about qualifying under § 2036 rests solely on the fact that after the transfer to the trust the grantor continued to live on the property up until his or her death that opinion is flawed. For a grantor trust, the rights have to be specifically reserved in the trust instrustment. Similarly, for a life estate, the reservation of the life estate to the grantor must be specifically set out in the deed. This is why the exact wording of the document matters.

So the key question here is this: what rights did the grantor retain in the irrevocable trust? Unless it was one of the very limited number of rights that make it a grantor trust, the assets don't get the basis step up.

Have a tax attorney review the trust instrument and the deed transferring the home to the trust to get a good opinion on whether the home gets the basis step-up. Just from the very little you've provided I suspect the answer will be no, but there is no substitute here for reading the details of the trust and the deed transferring the property to the trust.