Living Trust Capital Gains: How Trusts Really Affect Your Tax Bill

Let’s clear something up right away: a standard revocable living trust does NOT, by itself, eliminate capital gains tax. However, it can dramatically affect when and how much tax gets paid—particularly for your heirs.

A living trust is simply a legal arrangement where you transfer ownership of your assets to a trust that you control during your lifetime, with instructions for how those assets pass to beneficiaries after your death. As one of several estate planning tools, a living trust works alongside other strategies to help individuals organize and protect their assets, minimize taxes, and facilitate the transfer of an estate.

Capital gains, on the other hand, represent the profit you make when you sell an asset for more than you paid for it.

For most U.S. families in 2024, the biggest capital gains impact of a living trust is the ability to preserve a step up in basis for heirs at death. This single benefit can erase decades of accumulated gains and save money that would otherwise go to taxes. This article focuses on real-world scenarios—like selling a house or investments held in a living trust—and current federal rules. Keep in mind that state tax laws can differ significantly.

Here’s what you’ll learn:

• How capital gains tax actually works and why “basis” matters

• Why a revocable living trust is tax-neutral during your lifetime

• The step-up in basis advantage that can eliminate capital gains for heirs

• Key differences between revocable and irrevocable trusts for tax purposes

• Common myths that lead to costly mistakes

• Practical planning tips to minimize your family’s overall tax bill

Understanding Capital Gains in Plain English

Before diving into how trusts affect your taxes, you need to understand two fundamental concepts: basis and capital gain. Getting these wrong can lead to expensive surprises when you sell property or when your beneficiaries inherit assets.

What Is Cost Basis?

Your cost basis is essentially what you paid for an asset, adjusted for certain expenses. Here’s a simple example:

You bought a house in 1995 for $150,000. Over the years, you put $30,000 into major improvements—a new roof, a kitchen renovation, an addition. Your adjusted basis is now $180,000.

How Capital Gain Is Calculated

When you sell an asset, your capital gain equals:

Sale price – Adjusted basis – Selling expenses = Taxable gain

Using our house example: You sell for $400,000, with $24,000 in selling costs (real estate commissions, closing costs). Your capital gain would be $400,000 – $180,000 – $24,000 = $196,000.

Short-Term vs. Long-Term Capital Gains

The IRS treats capital gains differently based on how long you held the asset:

For 2024, the long-term capital gains tax rates break down roughly as follows:

• 0% rate: Single filers with income up to about $47,000; married filing jointly up to about $94,000

• 15% rate: Most middle and upper-middle income taxpayers

• 20% rate: Single filers over roughly $518,000; married filing jointly over roughly $583,000

The Home Sale Exclusion

One crucial rule for homeowners: Under IRC §121, you can exclude up to $250,000 of capital gains ($500,000 for married couples) when selling your primary residence, as long as you’ve lived in the home for at least two of the last five years. This exclusion applies whether your home is in a living trust or held in your individual name.

Key definitions to remember:

• Cost basis = Original purchase price + improvements + certain acquisition costs

• Adjusted basis = Cost basis adjusted for depreciation, casualty losses, or additional improvements

• Capital gain = What you pocket after subtracting basis and selling costs from sale price

• Holding period determines whether gains are short-term (ordinary rates) or long-term (preferential rates)

• Home sale exclusion can shield significant profit from taxation

How a Revocable Living Trust Is Taxed During Your Lifetime

Here’s the straightforward reality: for income and capital gains tax purposes, a revocable living trust is typically treated as a grantor trust—which means the IRS treats it as if it doesn’t exist.

While you’re alive and retain the power to revoke or change the trust, all interest, dividends, rents, and capital gains generated by trust assets are reported on your personal tax return. The trust's income is treated as your own for tax purposes and is included in your taxable income each year. The trust uses the creator’s social security number for tax purposes rather than obtaining a separate tax ID. The IRS looks through the trust directly to you.

This means transferring your own assets into your own revocable living trust is not a sale or gift for tax purposes. It does not trigger capital gains tax in the year of transfer. You’re simply changing the title on assets you already own.

A Practical Example

In 2024, you sell stock inside your revocable living trust at a $40,000 profit. That gain is taxed to you exactly as if you held the stock in your own name. You’ll report it on Schedule D of your Form 1040, and you’ll pay taxes based on your personal tax rates.

Property tax bills, 1099 forms, and brokerage statements may show the trust’s name, but the IRS still looks through to the grantor for tax reporting purposes.

Key points about revocable trust taxation:

• All income generated by trust assets flows through to your personal tax return

• Transferring assets to a revocable living trust triggers no immediate tax obligations

• You report gains and losses just as if you owned the assets directly

• The trust is essentially invisible to the IRS during your lifetime

• Irrevocable trusts follow very different rules (covered below)

Living Trusts and Capital Gains When You Sell a House

Many people assume that placing a home into a living trust somehow changes the tax implications when selling. It doesn’t—at least not while you’re alive.

If you, as grantor, sell your primary residence while it’s held in your revocable living trust, you can still claim the IRC §121 home sale exclusion ($250,000 single / $500,000 married) as long as you meet the use and ownership tests. The trust ownership doesn’t disqualify you.

A Real-World Home Sale Example

Consider this scenario: A married couple bought their home in 2000 for $200,000. In 2010, they transferred it into their revocable living trust for probate avoidance purposes. In 2024, they sell the home for $750,000.

Here’s how the math works:

• Original basis: $200,000

• Improvements over 24 years: $50,000

• Adjusted basis: $250,000

• Sale price: $750,000

• Gross capital gain: $500,000

• Home sale exclusion (married): $500,000

• Capital gains tax owed: $0

The couple owes no capital gains tax because their gain falls entirely within the exclusion. The fact that their home was titled in a revocable living trust made no difference whatsoever to the tax calculation.

Rental and Vacation Properties

For rental or vacation properties held in a revocable living trust, capital gains on sale are computed the same way as if owned in your individual name. This includes depreciation recapture for rental properties—that portion is taxed at a maximum 25% rate regardless of the trust structure.

The mere act of placing real property in a revocable living trust does not start a new holding period or change your eligibility for long-term capital gains rates. Your original purchase date still controls.

Important distinctions:

• Primary residence in a revocable trust: Home sale exclusion still applies

• Rental property in a revocable trust: Same tax treatment as individual ownership, including depreciation recapture

• Vacation home in a revocable trust: No home sale exclusion unless it qualifies as primary residence

• If the trust is irrevocable, the analysis shifts significantly—the home sale exclusion may not be available

Step-Up in Basis: The Key Capital Gains Advantage of a Living Trust

Here’s where living trusts provide peace of mind and substantial tax benefits: the step-up in basis at death.

When you die, most assets you own—including those in a revocable living trust—receive a new tax basis equal to their fair market value on your date of death. This is the key advantage that can save your family significant money.

Why the Step-Up Matters

The step-up in basis can erase decades of unrealized capital gains. If your heirs sell an inherited asset shortly after your death, their taxable gain may be very small or zero—regardless of how much the asset appreciated during your lifetime.

A Concrete Example

You bought a rental property in 1998 for $120,000. Through proper planning, you hold it in your revocable living trust. At your death in 2030, the property is worth $620,000.

Without step-up: Your heirs would inherit your $120,000 basis. If they sold for $620,000, they’d owe capital gains tax on $500,000 of profit.

With step-up: Your successor trustee and heirs receive a stepped-up basis of $620,000 (fair market value at death). If they sell for $620,000, their capital gain is $0. The entire $500,000 of appreciation that occurred during your lifetime simply disappears for tax purposes.

At a 15% long-term capital gains rate, that’s $75,000 in tax savings. At 20%, it’s $100,000.

Why Revocable Trusts Preserve the Step-Up

Assets in a revocable living trust are included in your taxable estate for federal estate tax purposes. While this might sound like a disadvantage, it’s actually what allows the step-up in basis under current law. The IRS considers these assets part of your estate because you retained control over them.

Community Property States

In community property states (like California, Texas, Arizona, and others), there’s potential for a “double step-up in basis” when spouses hold community property in a joint revocable trust. When the first spouse dies, both halves of the community property may receive a step-up—not just the deceased spouse’s half.

Critical distinction: Many irrevocable trusts do NOT receive a step-up in basis because the assets may be excluded from the grantor’s estate. This can result in significantly higher capital gains for heirs. Several factors determine whether a step-up applies, making professional guidance essential.

Capital Gains in Irrevocable vs. Revocable Trusts

Understanding the contrast between revocable and irrevocable trusts is crucial for proper estate planning. While revocable living trusts are common probate-avoidance tools, irrevocable trusts serve different purposes—asset protection, Medicaid planning, estate tax reduction, or to provide for family members with special needs—and come with very different tax consequences.

Irrevocable trusts are generally treated as separate tax entities and are subject to higher capital gains tax rates compared to individuals.

How Irrevocable Trusts Are Taxed

Many irrevocable trusts are separate taxpayers with their own tax ID (EIN) and must file Form 1041 annually. The trust pays tax on undistributed income and capital gains.

Here’s the catch: trusts have compressed income tax brackets that reach the top federal rate much faster than individuals. In 2024, a trust hits the 37% tax bracket at roughly $15,000 of taxable income. An individual wouldn’t reach that rate until over $600,000 of income. This creates significant tax burdens for trusts that retain earnings.

Who Pays the Tax?

For non-grantor irrevocable trusts:

• Capital gains retained in the trust: Taxed at trust rates (potentially 37% at relatively low income levels)

• Capital gains distributed to beneficiaries: May be reported on the beneficiaries’ K-1s and taxed at their personal rates

The Basis Problem with Irrevocable Trusts

When you transfer appreciated assets to an irrevocable trust during your lifetime, the trust usually keeps your original basis. No step-up occurs at transfer, and there may be no step-up at your death if the assets are excluded from your estate.

Example: Irrevocable Trust Distribution

An irrevocable trust sells stock in 2025 with a $60,000 long-term capital gain and distributes all proceeds to a beneficiary. The trust deducts the distribution on its Form 1041 and issues a K-1 to the beneficiary. The beneficiary reports the $60,000 gain on their personal return and pays tax at their individual rate.

Summary of key differences:

Special Cases: Living Trusts, Inherited Property, and Advanced Planning

Certain scenarios—like inherited property, specialized trusts, and charitable strategies—require more nuanced capital gains planning. These specialized trusts, such as special needs trusts designed to provide for individuals with disabilities without jeopardizing government benefits, are among the estate planning tools available for unique family circumstances. These situations often involve tradeoffs between different tax benefits and require individualized advice.

Inheriting Assets from a Revocable Living Trust

When a beneficiary inherits assets from a revocable living trust, the basis is stepped up to fair market value on the date of death (or alternate valuation date if elected). This provides peace of mind because it allows for a smooth transfer with minimal immediate tax consequences.

Example: A child inherits a house through a living trust in 2032 when it’s valued at $800,000. The child sells it in 2033 for $820,000. The capital gains tax owed applies only to the $20,000 gain occurring after death—not to any appreciation that happened during the parent’s lifetime.

Qualified Personal Residence Trusts (QPRTs)

QPRTs and other specialized trusts are often used to remove a home from your taxable estate while you continue living in it. However, these irrevocable structures typically do NOT receive a step-up in basis. If the home has appreciated significantly, beneficiaries may face substantial capital gains when they eventually sell.

Charitable Remainder Trusts

Charitable remainder trusts represent advanced strategies where appreciated assets can be sold inside the trust with partial deferral of capital gains. The trust sells the asset, reinvests the proceeds, and pays income to beneficiaries for a term of years or for life. This is fundamentally different from a basic revocable living trust and serves specialized purposes.

Medicaid Planning Trusts

When families use irrevocable trusts to protect assets and qualify for government benefits like Medicaid, they may sacrifice the step-up in basis. This tradeoff can cause higher capital gains for heirs when assets are eventually sold.

Important note: These special cases involve significant assets and complex tradeoffs. They require individualized legal and tax advice—a common myth is that one-size-fits-all solutions exist.

Common Myths About Living Trusts and Capital Gains

People assume many things about living trusts and taxes that simply aren’t true. These misconceptions can lead to costly mistakes and unnecessary costs in estate planning. Let’s clear up the most common myths.

Myth 1: “Putting my house into a living trust means I won’t pay capital gains when I sell it.”

Reality: This is false. If you sell your home while you’re alive, the sale is taxed exactly as if you sold it personally. The good news is that you may still qualify for the home sale exclusion—but the trust itself doesn’t shield you from incurring taxes on the profit.

Myth 2: “A living trust automatically shelters my investments from capital gains tax.”

Reality: Ordinary revocable living trusts are completely tax-neutral for capital gains during your lifetime. The trust’s income is your income. The trust’s gains are your gains. There’s no shelter, no reduction, no deferral while you’re alive and the trust remains revocable.

Myth 3: “I lose the step-up in basis by using a living trust.”

Reality: This common myth causes unnecessary worry. Assets held in a revocable living trust generally still receive a full step-up in basis at death. Your heirs benefit from the fair market value basis just as they would if the assets were left unchanged in your individual name.

Myth 4: “Any trust will get a step-up in basis at death.”

Reality: This is dangerously wrong. Many irrevocable trusts do NOT receive a step-up because the assets aren’t included in the grantor’s taxable estate. If you’ve transferred appreciated property to an irrevocable trust for asset protection or to avoid estate tax liability, your beneficiaries may face significant capital gains when they sell.

Bottom line: Always confirm any “trust and tax” advice with a licensed estate planning attorney or tax professional, especially when large property values or multi-state issues are involved. Relying on general information—even from well-meaning family members—can lead to legal complications.

Practical Planning Tips for Minimizing Capital Gains with a Living Trust

While a basic living trust doesn’t erase capital gains, careful planning can reduce how much tax your family ultimately pays. Here are actionable steps to consider.

Confirm Title and Beneficiary Designations

Make sure significant assets—your primary residence, long-held investments, rental properties—are correctly titled in the revocable living trust. This ensures they pass smoothly at death, avoid probate, and benefit from the step-up in basis. A common mistake is creating a trust but never actually transferring assets into it.

Avoid Unnecessary Lifetime Gifts of Highly Appreciated Assets

When you gift appreciated assets during your lifetime, the recipient inherits your low basis. This is called “carryover basis.” If you instead leave those same assets to heirs through your revocable living trust at death, they receive a stepped-up basis.

Consider this tradeoff: Paying a potential 1.5% probate fee might be far cheaper than heirs paying 15-20% in capital gains taxes on decades of appreciation. Estate planning attorneys can model these scenarios for your specific situation.

Coordinate with Overall Estate Tax Planning

For larger estates, marital trusts, bypass trusts, and credit shelter planning can protect both estate tax exemptions and step-up in basis opportunities. These specialized trusts can play a crucial role in comprehensive estate planning, but they require careful coordination to avoid court involvement and preserve tax advantages.

Model Different Scenarios for Investment Properties

For rental or business properties with large built-in gains, work with a tax professional to compare outcomes:

• Selling during life (immediate capital gains tax, but access to proceeds)

• Holding until death (step-up in basis for heirs, but no access to proceeds)

• 1031 exchange strategies (deferral but complexity)

Realistic growth and tax assumptions, left unchanged over time, can reveal which approach saves money for your family.

Review State Tax Rules

Don’t forget that state income and estate tax rules vary significantly. Some states have their own estate or inheritance taxes with lower exemptions than federal law. Others tax trusts based on residency of the settlor or beneficiaries. A public record search won’t reveal these complexities—you need professional guidance.

Planning checklist:

• Verify all major assets are properly titled in your living trust

• Avoid gifting highly appreciated assets during lifetime when possible

• Coordinate living trust with broader estate tax planning strategies

• Model sell-now vs. hold-until-death scenarios for investment real property

• Review state-specific tax implications with local professionals

Conclusion: Using a Living Trust Wisely for Capital Gains and Beyond

A revocable living trust won’t cut your capital gains tax while you’re alive—that’s a common myth that deserves to stay busted. But a properly structured living trust is a powerful estate planning tool that preserves the step-up in basis and simplifies how appreciated assets pass to your beneficiaries.

Key takeaways to remember:

• Revocable living trust vs. outright ownership: Tax-neutral during your lifetime, but beneficial at death through probate avoidance and smooth transfer of assets

• Revocable vs. irrevocable trusts: The step-up in basis typically applies to revocable trusts but often doesn’t apply to irrevocable structures

• Who pays capital gains: During your life, you pay taxes on trust gains through your personal tax return; at death, the step-up can eliminate those gains entirely for heirs

To make the most of these tax benefits, take time to inventory your highly appreciated assets—homes, rentals, concentrated stock positions. Confirm how each asset is titled and understand how it would pass at death. Then sit down with an estate planning attorney and tax professional to align your living trust structure with your capital gains, estate tax, and family goals.

With proper planning, a living trust can help minimize taxes for heirs, avoid probate, keep your affairs out of the public record, and provide clarity and control over how your wealth passes to the next generation. The benefit isn’t just financial—it’s the peace of mind that comes from knowing your plan works.