Sale of an inherited primary residence by an irrevocable trust

[JFW3]

I am using TT to do my brother's irrevocable Trust (formed at my parents' death) and his personal tax return.  From what I can tell, an heir can get the $250/$500k exclusion for a primary residence if they lived in the house for two of the last five years.  The Trust owns and will sell the house in 2024.  My brother (an adult) is the trust beneficiary and has lived in the house for the required years.  House has appreciated since parents' death so there will be a gain on sale (above stepped-up inheritance basis).  Will the trust be issued a 1099-S or my brother?  Does the trust report the gain on home sale on the K-1 and my brother then report on his individual tax return with the exemption?  If the trust has been distributing capital gains, does it need to distribute the capital gains on the sale of the house to my brother?  If so, how does that work in TT?  I don't see anything on the K-1 other than a regular capital gains tax.  Or do I have the taxes completely wrong on this, and somehow my brother does not get the primary residence exception even though he has lived there for 20+ years since it is owned by his irrevocable trust (I hope not)?  

[pk]

@JFW3 , please can you clarify somethings  :

(a)  Are you saying that  the revocable trust of your parents became irrevocable on the passing of your parents   OR that your parents set up an irrevocable trust  with assets  ( house ) and the only beneficiary is your brother ?

(b) if the latter,  and the house has been your brother's  abode for  all these years -- the irrevocable trust acting as a conservatorship for the benefit of your brother -- and trust has and still owns the  house -- true ?

(c)  what I am trying to get to is that if the  trust owns the house and sells it -- there is  no step-up and/or  " main residence" gain exclusion --- therefore the questions to understand the situation.

[JFW3]

Champ, Thanks for the interest and questions.  My mother had a revocable trust, which owned my folks' home after my father passed.  The house was transferred to a new (irrevocable) trust in my brother's name upon my mother's death.  My brother is the only beneficiary of that Trust.  It's not a conservatorship.  My brother lived with my parents in the house when they were alive and continued to live in the house after they died.  His trust (created when my Mom died) currently owns the house.  I found an article online that indicates, "Section 121(d)(9)(C) stipulates that the (residency) exclusion also applies if a trust sells a property where the grantor or the heir uses the home as a primary residence."  So say my folks paid $200k for the house; it was worth $275k when my mother passed, and it is now worth $300k.  I believe my brother's basis is $275k, and he should get a residency exclusion for a $25k gain if sold at $300k.  I was just trying to see if someone in the TT community had experience with this as I'm sure it's not unique.

[M-MTax]

Your brother's basis would be $275k and he would get the exclusion provided the trust was a grantor trust.....there is a specific exception for trusts in Reg Sec 1.121-1 

[NCperson]

@JFW3 be careful of who the owner of the house is.  From the way you describe it, the irrevocable trust is the owner of the home- not your brother.  he is a beneficiary of the Trust.  He did not inherit the residence.  The irrevocable trust became the owner per the terms of the revocable trust, right?

please reconfirm the IRC paragraph - I can't find the language you are stating in section 121.  Can you please provide a link? 

[JFW3]

NCperson, Thanks for your reply and you are so right, it appears that the interaction between trusts and home sales seems very complicated.  I'm not a tax accountant and perhaps I need a CPA to work rather than me finding the correct box in the TT income tax trust form.  There are many rules, but it appears the end result is that a person (including the beneficiary of a grantor trust) can exclude the gain from the sale of a primary residence that is owned by a trust if they meet the two-year ownership criteria and the trust is correctly worded.  I was wondering if folks had experience on how to make that happen in TT.

[M-MTax]

a person (including the beneficiary of a grantor trust) can exclude the gain from the sale of a primary residence

That is correct provided it is a grantor trust. I already gave the link in my previous post -

Reg. §1.121-1(c)(3)

[NCperson]

@JFW3 I get all that, but I am not aware that an irrevocable trust can be a grantor trust.    best to consult a lawyer and confirm whether the trust that owns the home meets the definition of a grantor trust or not. It would depend on how the document is written.  

On the other hand, is it worth it.  You state the capital gain is currently $25k.  How much is your brother's income.  for most the capital gains rate is 15% ($3750 in this case if no exclusion) and if his total income including the $25k is below $44k, there is no capital gains tax to be paid in any event.  You could burn a lot up with lawyers figuring this out. 

[pk]

@JFW3  agreeing with my colleagues @NCperson  and @M-MTax ,  just want to add :

(a)  not knowing the antecedents  ( why was the  trust created , the actual language etc. ), where we are trying to go is  ( and has been quite clearly articulated in section 121 of IRC )  to determine  the extent of dominion  of your brother ( beneficiary )  over the asset  ( either  declared at origination or after certain  condition such as  reaching an age  etc. ).      To the extent of the dominion over the asset , he is privy to the benefits of gain exclusion  etc.    This is why we have been going back and forth -- we do not know the extent of dominion.

(b)  I agree with   @NCperson  that  while a discussion with an attorney may be advisable but the cost may or may not be worth it for  just this purpose ( sale of the asset and  recognition of income).     The language  in the trust  should be enough for you to determine the dominion question.

Is there more one of us can do for you ?     As always if the question does not lend itself to  general interest, you can always PM one of us  and keep it reasonably private.

pk

[M-MTax]

I am not aware that an irrevocable trust can be a grantor trust. 

Yet it can.......just because a trust is irrevocable does not mean it cannot be a grantor trust either in whole or in part.

[JFW3]

Again, thanks to those who responded.  I pulled out the Trust documents and the Trustee may distribute the trust principal for support and maintenance.  If the Trust distributes the house to my brother and then my brother sells it as an individual, there should be no problem with him taking the primary residence exemption (he has certainly lived there long enough and has paid real estate taxes).  I think that might be the easiest way to handle it.  He takes the principal, in this case, the house at the trust's basis or the date of death basis.  Then when my brother sells, he will have a capital gain for appreciation over the trust's basis, but can use the primary residence exemption.  As far as I know doing the K-1 for the trust, there's no reporting of principal distribution as it's not an income event for the trust or beneficiary.

[pk]

@JFW3 , generally agreeing with your conclusions  ( i.e. the understanding of the rules / text of the Trust docs & conditions ).  Where I have an issue  is that  for your brother to meet the  gain exclusion, he must have owned the property ( for 2 years) and  used as main residence ( for 730 total days ).   If you transfer/distribute the  asset to him, his ownership  comes into being ONLY  after transfer ( he would have dominion ).

You are also correct that the distribution of the corpus of a trust is  generally not income to the beneficiary.

Does this make sense ?

[JFW3]

Thanks.  I think he might be considered a substantial owner for the time the house was owned by his Trust.  I'm now looking at the Federal Tax Coordinator Analysis (RIA),  which observed that "any person (beneficiary or a grantor) who is treated as the owner of the trust under the grantor trust rules could exclude the gain from the sale of a residence" if they satisfied the ownership and use test described.  And "for  purposes of determining whether the ownership test is satisfied, presumably, the person treated as owner of the trust could combine any period that he owned the residence individually with the period of time that the trust had owned the residence."  I just need to get a little more into the tax code and the revenue rulings (assuming they are still good after the Chevron decision).  This is not my area of expertise (took one tax class in getting a Masters degree) .... I just know enough to research items to be dangerous.  

[pk]

@JFW3  I agree  that the  trust rules  matter here  ( how it is exactly worded  --- this could be treated as a case of  equitable ownership   ( think there was case  in California  where  Person A lived in the house , paid all the  dues as if he owns the place, He had person B buy the house for him because he could not qualify  for the loan.  It was always understood that  B was owner on paper but the house was for benefit / use of Person A.    I brought this because of this  -- can he claim to be the equitable owner ?

[M-MTax]

presumably, the person treated as owner of the trust could combine any period that he owned the residence individually with the period of time that the trust had owned the residence.

Yeah, that's called "tacking" and it is allowed for other purposes but NOT for the purposes of complying with the ownership requirements of Sec 121.