Family trusts are one of many different ways that you can hold your rental property. Since they are generally pass-through entities, they don't affect how the properties are taxed. They also don't shelter the rentals from estate tax when they get passed on after the trustor's death. However, the rules for family irrevocable trusts are very different.
Family Trust Basics
A family trust is a legal entity that holds properties for estate planning purposes. What makes a trust a family trust specifically is when it is a revocable living trust that only has family members as beneficiaries. Transferring properties into family trusts is usually a simple process that involves signing a deed and should not incur transfer tax. It may, however, impact your property's loan and your ability to insure its title. As such, you may want to talk with your lender and title insurer as well as a trust attorney before transferring the title.
While you're alive, you pay taxes on a rental property in your family trust as if you owned it. You collect the rent and write off your expenses, including interest and depreciation. If you have a loss, you can claim it against profits at other properties. When you only have real estate losses in your trust, you can still use the IRS' special passive activity loss write-off to use at least some of the loss to offset other income as long as your adjusted gross income is below the threshold ($100,000 of adjusted gross income or less for the full deduction). You can also defer capital gains taxes on a sale by doing a 1031 exchange as well.
Upon Trustor's Death
When you die and the property passes to your heirs, it doesn't pass through probate, but it is subject to estate tax. The basis will be stepped up as of the date of your death, and estate tax will be charged if your estate is above the tax-free threshold. Furthermore, once your heirs get ownership of the property, they will pay tax on it as if they owned it.
If your family's trust is structured as an irrevocable trust, the transfer of ownership on your death isn't taxable, but income earned in the trust along the way may be. Money that gets sent out of the trust is tax exempt for the trust but taxable for you, just like money from a regular living family trust. Anything that sits in the trust is subject to taxes, though. Trusts have a special tax table that is like an extremely condensed version of the tax brackets that individuals pay. Any earnings over $11,950, as of 2013, are taxed at the top 39.6 percent rate, as well as being subject to the 3.8 percent investment income surcharge.
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