Capital gains tax can take a big bite out of an investor’s potential profits when a rental property is sold. Although conducting a tax deferred exchange is one way to defer paying tax, a 1031 may not make sense for every investor.
Selling a rental property held in a trust can help to minimize any capital gains tax owed, and avoid the costly and lengthy process of probate. Keep reading to learn how a real estate trust for rental property works, and the potential tax implications of selling a rental property held in a trust. As always, consult with a licensed professional for additional guidance on whether a trust vehicle makes sense for your individual circumstances.
Key Takeaways
- A real estate trust is a legal vehicle created to hold a rental property in.
- Benefits of holding rental property in a trust include estate planning and anonymity.
- Real estate trusts can be structured to be revocable or irrevocable.
- Parties in a trust are the settlor/grantor (usually the investor), trustee who administers the trust, and beneficiaries who receive the rental property upon the investor’s death.
- Cost basis of a rental property is stepped-up to current market value when a trust becomes irrevocable, helping to minimize any capital gains tax when and if the property is subsequently sold.
What is a trust for rental property?
A real estate trust for rental property is created by an investor (also known as the settlor/grantor) to place the rental property in.
After a trust for rental property is set up, the property is passed to the trust and the settlor relinquishes any direct claim of ownership. Instead, a trustee (such as an individual or corporation) is assigned to manage the trust for the benefit of the beneficiaries of the trust.
The legal resource website Nolo.com explains there are three main reasons why some investors may put rental property into a real estate trust:
- Multiple owners, and their ownership interests, can be documented in a consolidated fashion by using a real estate trust.
- Estate planning for real estate investors who wish to avoid estate taxes and to simplify ownership transfer of the rental property to the heirs when the investor passes away without going through the probate process.
- Provide a certain level of anonymity, although with more county assessors posting deeds and tax information online, disguising the name of the true property owner is increasingly difficult.
How to sell a rental property held in a trust
Let’s look at how to sell a rental property that is held in a real estate trust.
For the purposes of this example, we’ll assume that the type of trust is revocable. Also known as a living trust, a revocable trust allows an investor/grantor to control the assets while they are alive.
Although rental property held in the trust is retitled in the name of the trust, the property can be sold in the same manner that a traditional real estate sale is made.
While an investor may take the property out of the trust and retitle the property in his or her name, doing so is not necessary to sell a rental property held in a trust. Taxes work the same way as if the investor were selling the property directly.
When the investor passes away, the revocable trust becomes irrevocable and the assets in the trust are passed to the beneficiaries of the trust, such as the investor’s heirs.
One of the main advantages of a real estate trust is that the trust does not go through the probate process, which can take a year or more in some states. Heirs receive their inherited property more quickly, and ownership anonymity is still maintained because there is no transfer and re-recording of the property deed.
However, when and if the heirs of a property held in an irrevocable trust decide to sell the rental property, taxes on the sale of a rental property held in a trust work a little bit differently.
Tax implications of selling a rental property in a trust
When a rental property is inherited, the property is revalued at a “step-up basis” for tax purposes, based on the property’s market value at the time of inheritance. If the heirs decide to sell the inherited rental property shortly after the death of the investor/grantor, there may be little if any capital gains and capital gains tax to pay.
How capital gains tax normally works
Let’s assume an investor purchased a home to rent in Las Vegas ten years ago.
According to Zillow, the typical value of a middle price tier home back then was $127,000. When the investor purchased the property, closing costs that must be added to the basis of the home were $3,000, making the original cost basis of the home $130,000.
Fast forward to today, and Zillow shows that the same home is now worth $354,000 (as of July 31, 2021).
If the investor sold the home when he or she was alive, the capital gain subject to tax would be $224,000, before subtracting any tax deductible closing costs like a real estate sales commission or adding depreciable costs such as capital repairs to the original cost basis.
Capital gains taxes are currently 0%, 15%, or 20%. Assuming the investor is in an upper income tax bracket, capital gains tax owed would be a whopping $44,800 ($224,000 capital gain x 20%).
Calculating capital gains for selling rental property in a trust
Now, let’s look at this same scenario a little bit differently by assuming that the investor passed away a couple of months ago with the rental home still held in the trust.
When the investor dies, the cost basis of the rental property held in the trust is “stepped-up” to the current market value at the time of the investor’s death.
Zillow reports that two months ago the value of a middle price tier home in Las Vegas was $331,000, which becomes the stepped-up cost basis of the property, assuming the home is appraised at the middle price tier value.
If the heirs decide to sell the home at the current typical value of $354,000, the initial gain would be just $23,000 ($354,000 sale price – $331,000 stepped-up cost basis) instead of the taxable gain of $224,000 that the investor faced when alive.
Assuming that closing costs ran 2% and the heirs sold their inherited rental property on Roofstock where the sales commission for the transaction would be only 3%, deductible closing costs would be $17,700 ($354,000 x 5%).
The amount subject to capital gains tax would be reduced to just $5,300 ($23,000 initial gain – $17,700 deductible closing costs) which, even at the highest tax bracket, would result in only $1,060 in taxes.
Who pays capital gains tax for the sale of a rental property in a trust?
If the profits from the sale of the rental property remained in the real estate trust, the trust would be responsible for paying capital gains tax.
On the other hand, if the sale profits from the rental property were passed through to the heirs, the heirs would be responsible for reporting and paying capital gain tax using their personal tax returns.
Of course, it’s also possible that the heirs could have a loss when the property was sold, at least for tax purposes. For example, the Las Vegas real estate market could enter a normal downward cycle and home values could decrease.
If the heirs sold the property for less than the stepped-up basis, they would have a loss for tax purposes. The heirs may then be able to use the loss to offset capital gains from the sale of other investments, or as a credit against their individual taxable net incomes.
Tax law and calculating gains and losses from the sale of a rental property held in a real estate trust can be complicated. So, investors and heirs may wish to consult with their tax professional to receive guidance specific to their unique situations.
Rental property real estate trust FAQ
Q: What are the main benefits of having rental property in a real estate trust?
A real estate trust for a rental property is used for three main reasons, according to the legal resource website Nolo.com: Disguise owner names, help with estate planning, and allow a group of people to invest without getting taxed differently.
Q: Who are the main parties in a real estate trust?
There are three main parties in a real estate trust that is used for rental property.
- Settlor/Grantor is the individual who sets up and transfers the rental property into the trust, such as the property owner.
- Trustee is a person or entity that is appointed to manage the trust in the best interest of the beneficiary.
- Beneficiary is an individual or group of people that the Settlor has chosen to receive the rental property that is placed in the real estate trust.
Q: Who owns the rental property held in a real estate trust?
Once the rental property is transferred into a trust, the trust is the legal entity that owns the real property.
If the trust is revocable, the original owner (settlor/grantor) may change, revoke, or cancel the trust. Upon the grantor’s death, a trustee is responsible for the administrative duties of the trust. On the other hand, if a trust is irrevocable, generally the grantor may not make changes to the trust after the rental property is transferred and a trustee is appointed to administer the trust.
Q: Does rental property held in a trust have to go through probate court when the owner dies?
In general, a rental property held in a real estate trust does not have to go through probate, which can take months or even years. Assets in an irrevocable trust can be quickly distributed to the beneficiaries or sold.
Q: How are capital gains taxed when a rental property held in trust is sold?
Capital gains in a revocable trust are treated for tax purposes as if the investor (settlor/grantor) still held the rental property and not the trust. Upon the death of the investor, when the trust becomes irrevocable, the cost basis of the property is stepped-up to the current market value. When and if the property is sold, any resulting capital gains taxes are paid by the trust if the profits from the sale remain in the trust, or by the beneficiaries if the profits are distributed.
