A revocable trust is a special legal entity set up to own property. When an owner puts property in a trust, he technically stops owning it, but can still control it and can benefit from it because he controls the trust. When he dies, the trust doesn't. Instead of having his assets go through probate, the person he designated to take care of the trust distributes his property in accordance with his wishes. While trusts avoid probate, they don't avoid taxes. A transfer from a revocable trust will be taxed the same way as a transfer made through a will.
Someone who inherits money from a revocable trust receives it tax-free, but the estate might have to pay estate tax on everything that it contains before distributing it. As of the 2013 tax year, the first $5.25 million of value in the estate could transfer tax-free, unless the person that died had given gifts that were higher than the annual gift exclusion prior to his death. In the event that he gave gifts that were subject to gift tax, the total value of those gifts would be subtracted from the $5.25 million exclusion.
Once someone inherits the money, it's his, and it's his responsibility. If he inherits the money in the form of shares of stock and doesn't sell them, he'll have to pay tax on any dividends that he receives starting on the date that he receives them. The same rule applies to money in an interest-earning bank account or income that he collects from a rental property that he inherits.
Selling the Inherited Asset
When an heir sells an inherited asset, its basis for capital gains tax purposes isn't based on what he paid for it -- which is nothing -- or what the person that left it to him paid for it. Instead, the basis gets adjusted to the asset's fair market value on the day that the decedent died. If the decedent bought stock for $10 a share, and it was worth $18 when he died, an heir who then sells it for $30 will only pay capital gains tax on the $12 profit.
The Irrevocable Trust Alternative
If an asset owner is planning his estate and thinks that he might be subject to the estate tax, funding an irrevocable trust long before he dies could be an option. Once money goes into an irrevocable trust, the trustor generally loses control of it, but it passes to his heirs without being subject to estate tax. With an irrevocable trust, transfers into the trust are subject to gift tax if the trustor gives more than the annual tax-free exclusion, but when the money comes out of the trust, it's technically not part of an estate, so it's not subject to estate tax.
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