What Happens to Our Capital Gain Exclusion When We Put Our Home Into a Revocable Trust?
In short, nothing happens. But here’s the long explanation…
Let’s Peek Into the Internal Revenue Service Code…
IRC § 121 provides the exclusion of gain from the sale of a principal residence. Up to $250,000 of gain may be excluded by an individual, and a married couple filing jointly may exclude up to $500,000 if they satisfy the requirements in IRC § 121(b)(2) and the special joint-return rules in IRC § 121(d)(1).
Now Let’s Look at the Relevant Treasury Regulation…
Treas. Reg. § 1.121-1(c)(3)(i) directly addresses residences owned by trusts. It says, “If a residence is owned by a trust, for the period that a taxpayer is treated under [IRC] sections 671 through 679...as the owner of the trust...the taxpayer will be treated as owning the residence...and the sale or exchange by the trust will be treated as if made by the taxpayer.” This regulation is the authority that preserves the principal residence exclusion when the residence has been transferred to a revocable living trust (a grantor trust).
And Back to the IRC…
The way this works is through IRC §§ 671–679 (Grantor Trust Rules). A typical revocable living trust is a grantor trust because the grantor retains the power to revoke it (see particularly IRC § 676). Since the grantor is treated as the owner for federal income tax purposes, placing the home into the revocable trust is generally ignored for purposes of the IRC § 121 exclusion.
How This Plays Out in Real Life…
For a married couple, let’s assume that husband and wife own and occupy their principal residence. They transfer title to their revocable living trust with a new deed, and the trust is a grantor trust under §§ 671–679. They later sell the home while filing jointly.
The transfer to the revocable trust does not forfeit or reduce the IRC § 121 exclusion. Under Treas. Reg. § 1.121-1(c)(3)(i), the spouses are treated as continuing to own the residence, and the sale by the trust is treated as though made directly by them. If the other IRC § 121 requirements are met, they remain eligible for the $500,000 exclusion available to qualifying married couples filing jointly.
The regulation most commonly cited in estate planning and tax practice is Treas. Reg. § 1.121-1(c)(3)(i). This regulation states that ownership through a grantor trust (including a standard revocable living trust) is treated as ownership by the taxpayer for purposes of IRC § 121.