If you are asking can an irrevocable trust buy a house, the short answer is typically yes. An irrevocable trust can buy a house. Unless the trust expressly prohibits buying a house. Typically, one of the trustee’s powers in an irrevocable trust is to buy and sell real property, which includes a house. But when an irrevocable trust buys a house, you have to be careful to not have any negative consequences with any of the following:
- fiduciary duty
- conflict of interest
- public benefits
If you want to know can an irrevocable trust buy a house in your particular situation, we at the Law Offices of Albert Goodwin are here for you. You can call us at 718-509-9774 or send us an email at firstname.lastname@example.org.
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When an irrevocable trust buys a house, can that save money on capital gains taxes?
When you want to sell your house, you have probably come across an article of an irrevocable trust purchasing real property, which allows you to save and defer the payment of capital gains taxes. The second and more important question is, how can an irrevocable trust’s purchase of your house save you on capital gains taxes?
A new type of irrevocable trust, called a deferred sales trust, is currently being used to purchase real property, such as a house, on installment. When an irrevocable trust purchases your house on installment, you only pay capital gains tax based on the installment amount that you receive and not the total purchase price. This method finds a basis in the Internal Revenue Code (IRC) § 453, which provides for the definition of an installment sale and its recognition of income for purposes of tax. It states that an installment sale is “a disposition of property where at least one (1) payment is to be received after the close of the taxable year in which the disposition occurs.” In installment sales, only the proportion of payment received for that taxable year in which the gross profit bears to the total contract price will be recognized as income for purposes of tax. Under Treas. Regs. § 15a.453-1, the installment method reporting can only be used for capital assets of real property and casual sales of personal property.
IRC § 453 also provides for the tax treatment, in cases of dispositions between related parties. Dispositions made by the taxpayer to a related party, when the related party subsequently disposes of the property before paying the taxpayer the full amount, is considered a disposition of the taxpayer. IRC § 267(b) defines a related party, which includes, among others, dispositions between grantors and fiduciaries of any trust or fiduciaries and beneficiaries of a trust.
The irrevocable trust buying a house is normally used in cases where the real property has a low basis with a current high fair market value. For example, you have a house you bought in 1970 worth $100,000. Now, around fifty years later in 2021, you want to sell your house, which currently has a fair market value of $900,000. However, you are worried about the capital gains tax because of your net gain of $800,000 from the sale. Under the federal income tax brackets, if you have a taxable income of $518,401 or more, you will pay $156,235 plus 37% of the amount over $518,400, or a total capital gains tax of $260,427.
You’re probably now wondering, how you can reduce or defer this capital gains tax if you sell your house. Recently, financial institutions have been pitching the deferred sales trust as an irrevocable trust that can buy your house and reduce or defer your capital gains tax. So far, it has been allowed by the IRS, provided that the grantor, trustee, or beneficiary of the irrevocable trust is not the seller of the house.
In the example above, you sell your house to ABC Trust for $900,000 on installment for 10 years. ABC Trust will pay for your house $90,000 annually or $7,500 monthly plus 7% interest on the remaining balance. This installment sale will be secured by a promissory note issued by ABC Trust in your favor, giving you, as a creditor, a security interest over ABC Trust’s assets. From the 37% tax bracket, if you received the $900,000 sale price upfront, you will now pay a lower capital gains tax based on your profit from the installment amount you received plus the interest. In this case, since you will receive $90,000 annually and the basis for your house is $10,000, your net gain that will be taxable is only $80,000 for that year. With an income of $80,000 (assuming there are no other deductions, not taking into account the interest you will receive on the remaining balance), your tax is $4,617.50 plus 22% of the amount over $40,125, or a total of $8,772.50. In ten years, you would pay a capital gains tax of $87,725.00, as opposed to an upfront capital gains tax of $260,427.
Now that the irrevocable trust has your house, the irrevocable trust will now sell this house to a third-party buyer who will pay for the house upfront at the same value that it purchased it, $900,000. Because the irrevocable trust purchased your house at the same price as the price it sold it for, the irrevocable trust will not have to declare any income from the sale. Thus, the irrevocable trust will not pay any capital gains tax.
The irrevocable trust will then use the proceeds from the sale of the house and invest it to make more money. This allows the irrevocable trust to pay you the monthly payments of $7,500 plus the 7% interest on the remaining balance annually.
IRS can declare the irrevocable trust a sham trust in some circumstances
As mentioned earlier, IRC §§ 453 and 267 provides for related party dispositions in installment sales. The Internal Revenue Service will declare the irrevocable trust as a sham trust if you or your spouse are the grantor, trustee, or beneficiary of the irrevocable trust or if the irrevocable trust and you are considered related parties under IRC § 267(b). When it is declared a sham trust, it is considered a disposition between related parties, and the irrevocable trust’s sale to the third party is considered your sale. You will be considered as receiving the entire cash proceeds from the subsequent sale and will be taxed on that basis, even if you are only receiving installment amounts.
How you are protected in receiving your installment amounts
Generally, the trust agreement of the irrevocable trust will provide that no distributions can be made to the beneficiary until all its debt obligations are satisfied. Since you are considered a creditor holding a promissory note, then no distributions can be made until the debt obligations in your promissory note are paid. In addition, the creditor has to agree in writing on the trustee’s compensation. Other protections may be provided for, depending on your agreement with the financial institution that will serve as trustee of the irrevocable trust.
If you are wondering whether an irrevocable trust can buy your house, whether you can reduce capital gains with an irrevocable trust’s purchase of your house, whether you need advice on a deferred sales trust that has been pitched to you, or if you want to know how to reduce capital gains tax on low basis-high fair market value properties, we, at the Law Offices of Albert Goodwin, are here for you. We have offices in New York, NY, Brooklyn, NY, and Queens, NY. You can call us at 718-509-9774 or send us an email at email@example.com.