Capital gains realized inside a trust are treated as principal by default, which means they stay in the corpus and the trust pays the tax at its own compressed rates rather than passing the liability to the current beneficiary. Whether capital gains in a trust belong to principal or income can shift, though, based on three things: what the trust document says, what state law provides, and how the trustee exercises discretion. Each path sends the tax bill to a different taxpayer, and in 2026 that difference can be worth tens of thousands of dollars on a single sale.
The Default: Gains Are Principal
When the trust instrument is silent, state law decides. Under the Uniform Principal and Income Act and its successor, the Uniform Fiduciary Income and Principal Act, capital gains are classified as principal.1Uniform Law Commission. Uniform Fiduciary Income and Principal Act (2018) If a trustee sells stock the trust bought for $400,000 and receives $600,000, the $200,000 profit stays in the corpus. It does not flow out to the income beneficiary.
The reasoning tracks how the two beneficiary roles are supposed to work. The income beneficiary receives the ongoing yield (dividends, interest, rent), while the remainder beneficiary eventually receives the assets themselves. Letting appreciation leak out as current income would slowly hollow out the trust. A majority of states have adopted some version of these uniform acts, so a trustee who follows the default is on solid legal ground.
When the Trust Document Says Otherwise
The trust instrument outranks the default. A settlor can direct that some or all realized gains be treated as income, and the trustee must follow that instruction. The most common version is a trust that defines “net income” to include realized capital gains. In a year with a large sale, that one definitional choice can substantially increase what the income beneficiary receives.
Other documents take a narrower path, allocating gains from specific categories (publicly traded securities but not real estate, for example) to income. Precise drafting matters. Vague references to “profits” or “earnings” invite disputes over whether the settlor meant to sweep in capital gains or was only thinking about dividends and interest, and ambiguous language routinely ends up in court because the income and remainder beneficiaries have directly opposite financial interests.
Trustee Power to Adjust and Unitrust Conversions
Even when the document and state law both classify gains as principal, modern fiduciary statutes give trustees a safety valve. Most states grant a power to adjust between principal and income when the default produces an unreasonable result. This comes up constantly with growth-oriented portfolios. A trust invested heavily in low-dividend stocks generates almost nothing distributable for the current beneficiary even as the portfolio appreciates. The trustee can reclassify a portion of realized gains as income to provide reasonable support. Because that discretion is exactly what a remainder beneficiary will challenge if things go wrong, the trustee needs to act impartially and document the reasoning.
A more permanent fix is converting the trust to a unitrust, where the income beneficiary receives a fixed percentage of trust value each year regardless of whether the return came from yield or appreciation. Treasury regulations treat a unitrust payout between 3% and 5% of fair market value as a reasonable apportionment of total return.2eCFR. 26 CFR 1.643(a)-3 Most states that permit conversions set the allowable rate within that band. The conversion makes the principal-versus-income line functionally irrelevant for distribution purposes.
How the Allocation Controls the Tax Bill
The allocation decision is not just accounting between beneficiaries. It controls who pays the tax and at what rate. Under IRC Section 643(a)(3), capital gains allocated to principal are excluded from the trust’s distributable net income (DNI).3Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D When gains stay out of DNI, the trust pays the tax. When they get pulled into DNI, the trust can claim a distribution deduction and the beneficiary pays instead.
Treasury regulations identify three ways capital gains can enter DNI: the trust terms or state law allocate them to income; the trustee consistently treats them as part of distributions on the books and returns; or the gains are allocated to principal but actually distributed to the beneficiary.2eCFR. 26 CFR 1.643(a)-3 The middle path matters because it means a trustee can move gains into DNI through consistent practice, not only through a document instruction.
2026 Trust Tax Rates
Trust brackets are severely compressed. For 2026, a non-grantor trust hits the top federal rate of 37% once taxable income exceeds $16,000.4Internal Revenue Service. Rev. Proc. 2025-32 An individual does not reach the same rate until income runs into the several-hundred-thousand-dollar range. The full 2026 ordinary schedule for trusts:
- 10% on taxable income up to $3,300
- 24% from $3,301 to $11,700
- 35% from $11,701 to $16,000
- 37% above $16,000
Long-term capital gains retained in the trust get preferential rates: 0% up to $3,300, 15% from $3,301 to $16,250, and 20% above $16,250. A $50,000 long-term gain retained by the trust would owe 20% on most of the amount. The same gain distributed to a beneficiary earning $60,000 in wages might be taxed at 15%.4Internal Revenue Service. Rev. Proc. 2025-32
Net Investment Income Tax
On top of the regular tax, trusts face the 3.8% net investment income tax on undistributed investment income once the trust’s adjusted gross income exceeds the threshold where the top bracket begins. For 2026 that threshold is $16,000. Capital gains count as investment income, so a trust retaining a substantial long-term gain can face an effective rate above 23%. A beneficiary’s own NIIT threshold is much higher: over $200,000 for single filers and $250,000 for joint filers. Pushing the gain out often eliminates the NIIT on that income entirely.
The 65-Day Election
Trustees rarely have complete numbers before year-end. IRC Section 663(b) gives them a look-back window. Any amount properly paid or credited to a beneficiary within the first 65 days of a new tax year can be treated as if it were distributed on the last day of the prior year.5Office of the Law Revision Counsel. 26 USC 663 – Special Rules Applicable to Sections 661 and 662
This is especially useful when a large gain lands late in the year. The trustee can close the books, run the numbers, and then distribute in January or February while still claiming the deduction on the prior year’s return. The amount eligible for the election cannot exceed the greater of the trust’s accounting income or its DNI for that year, reduced by distributions already made.6eCFR. 26 CFR 1.663(b)-1 – Distributions in First 65 Days of Taxable Year The election must be affirmatively made on Form 1041, and it applies only to the year it is filed. Missing the window means the distribution counts in the current year, which can leave the trust paying at its compressed rates on gains that would have been cheaper in the beneficiary’s hands.
Capital Losses and Trust Termination
Losses follow the same allocation logic as gains: they are charged against principal by default. The trust can offset losses against gains in the same year, and any excess carries forward within the trust subject to the same $3,000 annual deduction against ordinary income that applies to individuals.
Termination is where losses become interesting. If unused capital loss carryovers remain when the trust closes, they pass through to the beneficiaries who receive the remaining property. The carryovers keep their long-term or short-term character in the beneficiary’s hands, with one exception: a corporate beneficiary treats all inherited losses as short-term regardless of their original character.7Office of the Law Revision Counsel. 26 USC 642 – Special Rules for Credits and Deductions The beneficiary’s first eligible year for the carryover is the tax year in which the trust terminates. A trust carrying a $40,000 unused loss effectively passes a tax asset to its remainder beneficiaries, so a trustee winding things down should track those numbers and flag them on the final K-1.
Grantor Trusts Work Differently
The framework above applies to non-grantor trusts, which are separate taxpayers. Grantor trusts operate under a different set of rules. Under IRC Sections 671 through 677, if the person who created the trust retains certain powers or interests, the IRS treats the grantor as the owner of the trust assets for income tax purposes.8Office of the Law Revision Counsel. 26 USC 671 – Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners All income, deductions, and capital gains flow onto the grantor’s personal return.
That makes the principal-versus-income allocation irrelevant for income tax purposes in a grantor trust. The trust still matters for fiduciary accounting between beneficiaries, but the IRS ignores it when deciding who owes tax on a gain. The grantor pays at individual rates, which almost always beats the compressed trust brackets. Revocable living trusts, the most common estate planning vehicle, are grantor trusts during the settlor’s lifetime and convert to non-grantor trusts after the settlor dies.