My mother-in-law is dying and my wife and her two other sisters are currently all three power of attorney for her property. They do have a trust already established via an attorney. Our question is all siblings will or may receive money from my mother-in-law's sale of her home after she passes. Will my wife and her sisters be taxed on the money they receive from the trust?
-John
Dear John,
Saying goodbye to a loved one is never easy – but sometimes understanding the next steps helps the road to farewell be a bit less rocky. By setting up a trust, it sounds like you are taking measures that will hopefully make the settling of your mother-in-law’s estate straightforward.
Whether your wife and her sisters will be taxed on the money they receive from the trust will depend on the type of trust and the instructions laid out, the assets titled in the name of the trust, and the timing of the distributions.
One of the most common trusts people set up is known as a Grantor Trust, also referred to as a Revocable Living Trust. This type of trust is flexible and allows the grantor (the person who creates the trust and whose assets are placed into the trust) to make changes to the trust up until their passing. Generally, once the grantor passes away, the trust becomes irrevocable. Usually, this means that changes to the trust are no longer possible.
Ordinarily, when a person dies, the assets they owned at the date of death receive a new basis or valuation. The new valuation is the fair market value as of the date of passing. The new valuation is referred to as a “step-up” in basis because many assets increase in value over time, although some assets may decrease. Generally, how the distributions from a trust are taxed will depend on the character of the underlying property being distributed. Here is an example.
Comprehensive Example
Nora and Nate’s Uncle Monty passed away on June 1, 2019. All of Uncle Monty’s assets were in his grantor trust and consisted of:
- Non-interest bearing checking account with a balance of $10,000
- 45 shares of Widgets R Us Stock Uncle Monty purchased in 1980 for $5,000. On December 1, 2019, the stock was worth $25,000. The stock was sold on December 2, 2019, for $30,000.
Nora and her brother Nate were the sole and equal beneficiaries of their Uncle Monty’s trust. According to the instructions in the trust, all of the income, including any capital gains, were to be distributed equally between Nora and Nate. In addition to the income and capital gains, Nora and Nate each received $4,000 from the checking account. The total cash Nora and Nate each received from the trust in 2019 was $19,000 broken down and taxed to them as follows:
- $4,000 from checking account - not taxable
- $15,000 from the sale of Widget R Us Stock, of which $2,500 would be taxable as a long-term capital gain to each of them. ($25,000 basis - $30,000 sales price = $5,000 gain)
Even though each of them received $19,000, only $2,500 would be considered taxable and reported to each of them on the 2019 Schedule K-1 from the trust. (To make the example less complicated, we are not taking into consideration any allowable expenses that would be deductible.) The character of the income in the hands of Nora and Nate will be the same as it was in the trust. Since the sale of the stock was considered a long term capital gain in the trust, it will be taxed as a long term capital gain on Nora and Nate’s income tax returns. (Keep in mind that the holding period for property a taxpayer receives due to the death of the original owner is considered long term and taxed as such.)
Assuming your mother-in-law has a standard grantor trust, the house has been titled in the name of the trust, sold within a few months after her passing, and there is no other taxable income within the trust, the sale of your mother-in-law’s home should not generate any taxable income for your wife and her sisters. It is likely a long term capital loss from the sale of the home will be passed to your wife and her sisters from the home sale. Let’s return to our example.
Comprehensive Example Continued
In addition to the assets listed above, Uncle Monty’s primary residence was also listed in the trust. Uncle Monty originally purchased his home in 1950 for $35,000. The home sold a couple of months after he passed away for $560,000. The selling expenses paid on the sale were $20,000. Unless there is an unforeseen circumstance, it is generally safe to assume that if a property sells within a few months from the date the owner passed away, the sales price would be equal to the fair market value of the property as of the date of the owner’s death. (It is considered a best practice to obtain an appraisal of any property the decedent owned as of the date of death from a qualified appraiser.)
Since the home sold within a couple of months after Uncle Monty passed, it is reasonable to assume the fair market value of the home on the date of his death was the sales price of $560,000. When calculating the net capital gain or loss from the sale of property, any selling expenses paid are subtracted from the gross sales price. Taking into consideration the $20,000 in selling expenses, the sale of the home generated a net loss of $20,000 calculated as follows: ($560,000 (basis) – $540,000 ($560,000 sales price - $20,000 in selling expenses) = $20,000 net loss).
In addition to the $19,000 distribution, Nora and Nate each received $270,000 from the sale of the home. None of the $270,000 distributed to Nora and Nate will be taxable to them. In fact, each of them had a $10,000 long term capital loss to report on their 2019 individual income tax returns, which was used to offset capital gains reported on their return from other sources.
If your mother-in-law has a more complicated estate plan and has a bypass or other type of irrevocable trust, then your wife and her sisters may have to pay tax on the sale of the home. This will depend on the instructions of the trust, the home’s basis, selling price, and the timing of the distribution.
One of the best ways to know what the tax consequences may be for your wife and her sisters will be to read the trust in its entirety. If the trust was established several years ago, and your mother-in-law is still able to make her own decisions, it may be good to have an attorney who specializes in trusts review it with her to make sure everything is in order. Trusts can be complicated and as unique as a fingerprint. Any specific questions or concerns you may have are best answered by a qualified trust attorney or tax practitioner who specializes in trust income tax preparation and who can thoroughly review your mother-in-law’s trust.
Wishing your mother-in-law a peaceful and gentle journey home.
Jean Lee Scherkey, EA