A family we represent recently faced a common question. Their late father had placed his Manhattan brownstone into an irrevocable trust years ago. The children, now the beneficiaries, decided with the trustee that it was time to sell the property, which had appreciated significantly. The question that stopped the process cold: When the property sells for a multi-million-dollar gain, who writes the check to the IRS and the New York State Department of Taxation and Finance? The trust, or the beneficiaries?
This is not a minor detail—it’s a question that can shift the tax burden by tens or even hundreds of thousands of dollars. The answer depends entirely on the type of trust and the actions of the trustee.
The First Distinction: Revocable vs. Irrevocable Trusts
For tax purposes, the IRS draws a bright line between trust types. The tax treatment of a capital gain hinges on whether the person who created the trust—the grantor—is still considered the owner for tax purposes.
With a revocable living trust, the answer is simple. Because the grantor can change or dissolve the trust at will, the IRS considers it a “grantor trust”—a pass-through entity. Any income or capital gains generated by the trust’s assets are reported directly on the grantor’s personal income tax return (Form 1040). If the trust sells an appreciated stock, the grantor pays the tax as if they had sold it from their own brokerage account.
An irrevocable trust is different. By design, the grantor has given up control of the assets. The trust becomes its own legal and taxable entity, with its own Taxpayer Identification Number (EIN). It must file its own tax return, IRS Form 1041, the “U.S. Income Tax Return for Estates and Trusts.” This is where a trustee’s stewardship begins, because the trust itself now has the potential to pay tax.
The Trustee’s Critical Choice: Retain or Distribute the Gain
When an irrevocable trust realizes a capital gain, the trustee has a choice that carries significant financial weight. Does the trust hold onto the proceeds, or does it distribute them to the beneficiaries?
If the trustee retains the capital gain within the trust, the trust itself is responsible for paying the tax. This can be a costly option. Trust tax brackets are notoriously compressed—they reach the highest federal income tax rate at a much lower income level than an individual taxpayer. For 2024, a trust hits the top 37% bracket with taxable income over just $15,200. An individual, by contrast, doesn’t hit that bracket until their income exceeds $609,350 (or $731,200 for a married couple).
The more common and often more tax-efficient strategy is for the trustee to distribute the capital gain to the beneficiaries in the same year it was realized. When this happens, the tax liability “passes through” to the beneficiaries. The trust reports the distribution, and each beneficiary receives a Schedule K-1 detailing their share of the income. They then report that income on their personal tax return and pay the tax at their individual capital gains rate.
Making this decision correctly is a core part of a trustee’s fiduciary duty. It is not just an administrative task; it is an act of prudent financial management that directly impacts the value of the legacy intended for the beneficiaries.
The Prudent Investor and the “Step-Up” in Basis
A trustee’s decisions are governed by a strict set of legal duties. In New York, the Prudent Investor Act, codified in EPTL § 11-2.3, requires a trustee to manage trust assets with skill and care. This standard of prudence extends to tax management. A trustee who fails to consider the tax impact of retaining versus distributing a capital gain may be failing in their duty.
Another powerful tool is the “step-up” in basis. For assets in a revocable trust—or certain irrevocable trusts included in the grantor’s taxable estate—the cost basis is “stepped up” to its fair market value on the date of the grantor’s death. This provides a massive tax benefit. Decades of appreciation are wiped away for capital gains purposes. If an heir or a trustee sells the asset shortly after the grantor’s death, there may be little to no capital gain to tax at all.
Understanding whether a trust’s assets will receive this step-up is fundamental to long-term planning. It informs not only when to sell an asset but also how to structure the trust from the very beginning. Stewardship.
The tax treatment of capital gains in a trust is not automatic. It is the result of deliberate design and diligent administration. The rules are clear, but applying them to a family’s financial situation requires foresight.
If you are serving as a trustee and are planning to sell a significant trust asset, the first step is to model the tax outcomes of your choices. We regularly provide fiduciary counsel to help trustees project the tax impact of these decisions, ensuring they meet their obligations and preserve the trust’s legacy.
