What’s Your Tax Issue? Residence in a Trust

Our House is a very very very fine house

                  –Crosby, Stills, Nash & Young

The Tax Issue

I am a member (beneficiary) of a family trust that was set up years ago by my Dad. The trust currently owns two houses. I live in one, and my sister, who is also a member of the trust, is married and lives in the other. We were told that we will have taxes to pay we sell our homes. Can this be true? Please help, as no one seems to know the answer.

The Answer

The principal residence rules that apply to personal trusts are surprisingly restrictive and can be a trap for the unwary.

A trust is treated as a person for tax purposes. As such, it does have access to the principal residence exemption on the sale of a home. But here’s the kicker: if a trust designates a home as a principal residence for a given year, then every beneficiary of that trust who lived in or used the home owned by the trust is deemed to have made the designation. And remember, a person can only designate one property as her principal residence. This applies to a trust as well. This means that if the trust sells the home you are living in and claims it as a principal residence, then when the trust sells your sister’s home, the trust is precluded from making the designation on the second home. Her home becomes ineligible for the exemption for those years even though it may be the only home she’s lived in. This might come as a shock, and it seems unfair, but that is the way the law works.

So, let’s look at an example. Say the trust owned your home since 2000 and it is sold in 2012 at a gain of $500,000. Furthermore, let’s assume the trust owned your sister’s home since 1996, and sells in 2012 at a gain of $400,000. If the trust claims the full principal residence exemption on your home, then it will be precluded from claiming the exemption for the years 2000 – 2012 on your sister’s home. In fact, for the 16 years the trust owned your sister’s home, only 4 will qualify, so only 4/16 of the gain will be exempt. (Actually, the formula generously adds 1 year to numerator, so technically 5/16, or $125,000 of the total gain will be exempt).

Also, if a trust claims the principal residence exemption on home, then all beneficiaries of that trust who may have used the home are deemed to have used their own principal residence exemptions on that property. So, for example, if a summer cottage is owned by a trust and is used by all the family members, some of whom own their own homes, they could lose their exemptions if the trust claims the cottage as a principal residence.

Taxpayers thinking about placing personal homes in a family trust should always seek professional tax advise.

One thought on “What’s Your Tax Issue? Residence in a Trust

  1. Dear Sir/Madam:

    We have a situation where real estate agents are coming to ask Dad to sell his principle residence. Dad owns a vacation property in Florida too, but will keep it for himself.

    We are three children in our late fifties, and Dad has a home on 10 acres that he wishes to sell all or in parts without tax consequences.

    Naturally Dad wants to leave us equal portions from the sale. By the way one brother wishes to keep the house and stay in the house only (he is not wanting anything from the sale of the land).

    How can Dad sell his property, claim principle residence exemption, and transfer proceeds from the sale equally to his adult children in the most tax wise way?

    This is a great website, thank you for all your help.

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