Is a Residence in an Irrevocable Trust Eligible for the Capital Gains Exclusion?

When a trust in an estate plan includes the principal residence of the individual who creates the plan, a common question that arises is whether the capital gains exclusion for individuals and married couples under Section 121 of the Internal Revenue Code applies if the residence is sold. The answer depends in part on whether the trust is revocable or irrevocable, as well as on the nature of the trust itself. Careful drafting of the trust by a knowledgeable estate planning attorney is essential to ensuring that the exclusion is available, particularly for irrevocable trusts.

Section 121 of the Internal Revenue Code

Section 121 of the Internal Revenue Code is the provision in federal law that allows an individual or a married couple to claim a capital gains exclusion for sale of a principal residence when specific requirements are met. The exclusion is $250,000 for an individual. If married spouses sell a residence, two exclusions are allowed on a joint tax return, for a total exclusion of $500,000.

In general, to be entitled to the exclusion, an individual or married couple must have owned the property and used it as a principal residence for at least two of the last five years. (The two years do not have to be consecutive.) In addition, the exclusion is only available if it has not been used within the preceding two years. There are also limited exceptions that may apply if a home was previously used for a non-qualified purpose, such as a rental or business use.

Applicability of Section 121 to a Home Placed in a Trust

When a principal residence is transferred into a trust, the availability of the Section 121 exclusion depends in part on whether the trust is revocable or irrevocable.

For a revocable trust, a living grantor is treated as the owner of the property for purposes of taxation and for determination of the applicability of the exclusion. As such, sale of the residence by the trust is treated as sale by the owner, so the exclusion is available, whether the owner is an individual or a married couple, if the other requirements in Section 121 are met.

Sale of a residence in an irrevocable trust is treated differently. When property is transferred into an irrevocable trust, such as a Medicaid Asset Protection Trust, a Special Needs Trust, or another type of asset protection trust, the trust becomes the owner of the property. A trust is a legal entity, not an individual or married couple. Since the Section 121 exclusion is available only to individuals and married couples, and not to legal entities, the general rule is that the irrevocable trust cannot claim the Section 121 exclusion if the property is subsequently sold.

However, there is an exception that applies if an irrevocable trust is structured as an intentionally defective grantor trust (IDGT) as provided in the Treasury Regulations for Section 121 and Sections 671 to 679 of the Internal Revenue Code. The rules require that the trust be written so that the grantor is treated as the substantial owner of the trust (or of the portion of the trust that includes the residence), which means that all income, deductions, and credits attributable to the property are treated as if they are realized directly by the grantor.

This attribution includes ownership for purposes of applying the principal residence capital gains exclusion under Section 121. If the grantor is treated as the substantial owner under the terms of the trust, and the specific requirements of Section 121 are met, a sale of the property will be treated as made by the grantor for purposes of the exclusion.

In other words, an irrevocable trust can be drafted and structured in a way that the Section 121 exclusion is still available for a residence transferred into the trust. However, this type of trust is technically complex and must be properly set up as a grantor trust by a knowledgeable estate planning attorney for exclusion to be available.

Talk With an Experienced Georgia Estate Planning Attorney

Our Cartersville estate planning attorney at Asset Protection & Elder Law of Georgia focuses on helping clients find the right solutions for all their concerns related to their assets, families, and estates. If you have questions about any aspect of estate planning, please call us at (770) 382-0984 or contact us through our online form to schedule a consultation.