Inheriting a house from an irrevocable trust means the property passes to you according to the trust’s specific terms, bypassing probate. The trustee manages the transfer, and you likely will not receive a "step-up" in basis, potentially leading to higher capital gains taxes if sold. The trust may distribute the home directly or hold it, allowing you to live there or rent it out, but the trust's rules apply.
What happens to an irrevocable trust when the grantor dies? When a grantor dies, assets to beneficiaries are typically distributed to the beneficiary according to the terms of the trust. Usually, the trust will dissolve once the assets have been fully distributed.
Irrevocable trust distributions can vary from being completely tax free to being taxable at the highest marginal tax rates, and in some cases, can be even higher. Therefore, understanding the tax implications is critically important—which is why we focus on irrevocable trusts in the discussion below.
Disadvantages of Irrevocable Trusts
While California does not impose a strict, one-size-fits-all deadline for distributing a house held in a trust, the law does require trustees to act within a reasonable timeframe.
The "3-year rule" for irrevocable trusts, specifically Irrevocable Life Insurance Trusts (ILITs), means that if you transfer an existing life insurance policy into the trust and die within three years of the transfer, the policy's death benefit is included in your taxable estate, potentially defeating the estate tax benefits. To avoid this, it's better to have the ILIT purchase a new policy on your life from the start, as the trust (not you) owns the policy from issuance, bypassing the 3-year waiting period.
While an irrevocable trust can protect assets for beneficiaries, it can also create unintended challenges: Restricted access to funds: Beneficiaries may not have immediate access to assets, even in emergencies.
Yes, you can sell a house held in an irrevocable trust, but the trustee (not the original owner) must manage the sale, follow the specific trust terms, and the proceeds typically must stay within the trust, often to buy another asset or be invested, rather than being given directly to the grantor for personal use, ensuring asset protection. This process involves strict adherence to the trust document, potential tax filings (like Form 1041), and ensuring the buyer pays the trust, not the individual.
When it comes to paying property taxes in a trust, the responsibility typically falls on the trustee. The trustee is the individual or entity that holds the legal title to the property and manages the trust's assets for the benefit of the beneficiaries.
The IRS's Revenue Ruling 2023-2 significantly changed irrevocable trust rules, stating assets in trusts not included in the grantor's taxable estate won't get a "step-up in basis," meaning beneficiaries inherit the original cost basis, potentially facing large capital gains taxes. To retain the step-up benefit (receiving assets at fair market value at death), the assets must now be included in the grantor's taxable estate, requiring careful restructuring of irrevocable trusts, possibly by reserving certain rights or using specific types like SLATs (Spousal Lifetime Access Trusts).
Capital gains are not considered income to such an irrevocable trust. Instead, any capital gains are treated as contributions to principal. Therefore, when a trust sells an asset and realizes a gain, and the gain is not distributed to beneficiaries, the trust pays capital gains taxes.
Assets placed under an irrevocable trust are protected from the reach of a divorcing spouse, creditors, business partners, or any unscrupulous legal intent. Assets like home, jewelry, art collection, and other valuables placed in the trust are guarded against anyone seeking litigation against you.
Suze's Warning About Irrevocable Trusts
While an irrevocable trust can, in some cases, protect assets from being counted for Medicaid eligibility, Orman pointed out a major trade-off: "It no longer is part of your estate. It's now out of your hands. Somebody else is in control of it — you are not."
Changes to an Irrevocable Trust
The trustee and any named beneficiaries would need to agree to a change mutually. They would need to decide that removing assets would best serve the trust and would need to go to court to explain the reasoning. Even then, the assets could not come back to you directly.
Cons. Complexity and costs: Selling a house in a trust may involve more complex paperwork and legal considerations. As a result, it often requires attorney support, which can add to costs. Trustee limitations: Generally, you'll need to follow the terms outlined in the trust document.
Upon the grantor's death, the trustee continues managing the irrevocable trust or distributes the assets according to the trust's terms. Unlike a will, an irrevocable trust avoids probate, often expediting the asset distribution process and making it an appealing option for some families.