APPLICATION OF CAPITAL GAINS TAX RULES TO TRUSTS As stated above, when an unmarried person or a married couple conducts a 1031 exchange with property titled in a basic revocable living trust, the tax consequence of the transaction will be no different than if the property were held in the owners’ names directly. Now suppose that a husband has died while he and his wife held their highly appreciated rental property in an “A/B” trust. If the couple lives in a Community Property state (AZ, CA, ID, LA, NV, NM, TX, WA, WI), the rental property could be subject to a full step-up in cost basis and re-titled in the name of the newly sprung bypass trust. If the widow in this scenario sells the property soon (in her role as trustee of her deceased husband’s bypass trust), would she need to conduct a 1031 exchange to avoid capital gains tax? The answer is probably no, because the capital gains taxes were effectively wiped away. A step-up in cost basis is a tax term. It means that the value of an asset, for purposes of determining capital gains taxes, is updated to reflect the current fair market value, regardless of the original purchase price or cumulative depreciation deductions.
There likely would be a different outcome outside the aforementioned Community Property states, which do not enjoy the same tax treatment of jointly held property under IRS rules. Suppose further that the same surviving spouse held the property for several years before deciding to sell. Should she do a 1031 exchange? The answer is… it depends. Again, depending on where the widow lives, there may have been a full step-up in basis or only a partial step-up in cost basis when her husband died. A tax professional would need to be consulted to determine the current cost basis of the property, and whether a 1031 exchange is warranted based on the potential tax liability. Finally, in an irrevocable trust, the cost basis for the current beneficiaries will depend on, among other factors, whether the property was gifted irrevocably during the grantor’s life or upon death. And even if a property was inherited via a now-irrevocable trust, there could have been enough appreciation since the grantor’s death to warrant a 1031 exchange of the property today. Bottom line on capital gains taxation —the sale of a trust-titled property often merits a 1031 exchange, but it is important to investigate how the history of the trust may impact the property’s cost basis.
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