How Are Capital Gains in an Irrevocable Trust Taxed?

Capital gains in an irrevocable trust are taxed either to the grantor, to the trust itself, or to a beneficiary, depending on how the trust is classified and whether the gains are distributed. If the trust is a grantor trust, the person who created it reports the gains on a personal return at individual rates. If it is a non-grantor trust and keeps the gains, the trust pays, and it pays at brackets that reach the top federal rate almost immediately: for 2026, long-term capital gains above $16,250 are taxed at 20%, with a 3.8% Net Investment Income Tax often stacked on top.¹ If the trust properly distributes the gains to a beneficiary, the beneficiary reports them at that person’s own rates, which are usually lower.

Who the Taxpayer Is: Grantor or Non-Grantor

The threshold question is whether the IRS treats the trust as a separate taxpayer at all. Under IRC Sections 671 through 679, an irrevocable trust is a “grantor trust” if the person who created it kept certain powers over the property. Common triggers include the power to swap trust assets for assets of equal value, the power to control who benefits, or the right to borrow from the trust without adequate security. Any one of these retained powers is enough to make the trust transparent for income tax purposes.

In a grantor trust, all income flows through to the grantor’s personal return, capital gains included. The grantor pays tax at individual rates even if the trust distributed nothing. The trust still files Form 1041, but as an informational return that points back to the grantor’s Social Security number. Because individual brackets are far wider than trust brackets, this arrangement is often tax-favorable, and the grantor’s payment of the trust’s tax effectively transfers value to beneficiaries without using gift tax exemption.

A non-grantor trust is one where the grantor gave up all the prohibited powers. It has its own taxpayer identification number, files its own Form 1041, and pays its own tax on any capital gains it retains. From there, the real question is whether gains stay inside the trust at compressed rates or move out to beneficiaries at their personal rates.

Why Trust Tax Brackets Hurt So Much

A non-grantor trust reaches the top federal rate at a tiny fraction of the income it takes an individual to get there. For 2026, ordinary income inside a trust is taxed at 10% up to $3,300, 24% from $3,301 to $11,700, 35% from $11,701 to $16,000, and 37% on anything over $16,000.¹ Short-term capital gains, on assets held one year or less, are taxed at those ordinary rates and hit the ceiling almost immediately.

Long-term gains get preferential rates but still face compressed thresholds. For 2026, trust long-term gains up to $3,300 qualify for the 0% rate, gains between $3,300 and $16,250 are taxed at 15%, and gains above $16,250 are taxed at 20%.¹

The 3.8% Net Investment Income Tax then stacks on top. The NIIT applies to the lesser of the trust’s undistributed net investment income or the amount by which the trust’s adjusted gross income exceeds the dollar figure where the highest ordinary bracket starts.² For 2026, that threshold is $16,000.³ Capital gains, dividends, interest, and rental income all count as net investment income.

The combined ceiling is 23.8% on retained long-term capital gains and 40.8% on retained short-term gains. Those numbers are the reason trustees who have discretion over distributions usually think hard about using it.

Figuring the Gain: Basis Rules for Trust Assets

Before any rate applies, there has to be a gain, and the gain depends on the trust’s basis in the asset.

Lifetime Transfers Carry Over Basis

When someone transfers an asset to an irrevocable trust during life, the trust inherits the transferor’s original basis. Stock bought for $50,000 and transferred to the trust still has a $50,000 basis in the trust’s hands.⁴ When the trust later sells, the gain runs from that original cost, which can be large on assets held for years.

If the asset’s fair market value at the time of transfer is below the transferor’s basis, the trust’s basis for calculating a loss is capped at that fair market value. That rule stops someone from gifting a built-in loss into the trust.⁴

Step-Up at Death Depends on Estate Inclusion

Property passing from a decedent generally gets a basis stepped up to fair market value on the date of death, which can erase decades of unrealized appreciation. For trust assets, the key is whether the property must be included in the grantor’s gross estate for federal estate tax purposes. Section 1014(b)(9) ties the step-up to estate inclusion regardless of whether the asset sits in a trust.⁵

That creates a trade-off at the heart of trust planning. A grantor trust designed to be included in the estate qualifies for a step-up and wipes out pre-death capital gains, but the inclusion raises potential estate tax. A trust designed to stay out of the estate avoids estate tax but keeps the old carryover basis. In 2023, the IRS issued Revenue Ruling 2023-2 confirming the latter: assets in an irrevocable grantor trust that are not in the grantor’s gross estate do not receive a step-up when the grantor dies.

Where a step-up does apply, the trustee needs documentation of the date-of-death value. For real estate and closely held business interests that usually means a qualified appraisal. If the estate filed Form 706 and the beneficiary received a Schedule A to Form 8971, the basis reported on later sales must be consistent with the estate tax value, and an accuracy-related penalty can apply if it is not.⁶

Shifting Gains to Beneficiaries Through DNI

Because trust brackets are so compressed, the most common way to lower the tax on capital gains is to push them out to a beneficiary. The mechanism is Distributable Net Income, or DNI.

DNI caps how much of a trust’s distributions count as taxable income to the beneficiary. The default rule under IRC Section 643(a)(3) excludes capital gains from DNI, because gains are typically allocated to trust principal rather than income.⁷ When gains sit outside DNI, the trust pays the tax at its own rates.

There are three main ways around that default. Capital gains are pulled into DNI, and therefore taxed to the beneficiary, if the trust document specifically requires gains to be distributed, if the trustee has and exercises a power under local law to allocate gains to income, or if the trust is terminating and all assets are being distributed. In a termination year, everything flows out, and so does the tax.

When a gain is properly distributed and included in DNI, the trust claims a distribution deduction on Form 1041, and the beneficiary gets a Schedule K-1 reporting the amount and character.⁸ Character carries through, so a long-term gain inside the trust stays a long-term gain on the beneficiary’s return.

The 65-Day Rule

Trustees often don’t know final income numbers until well after the tax year ends. IRC Section 663(b) lets a trustee elect to treat distributions made within 65 days after year-end as if they had been made on the last day of the prior tax year. For a calendar-year trust, that means distributions through March 6 can be pulled back into the prior year’s return. The election is irrevocable for the year it covers and is made by checking a box on page 3 of Form 1041. It is where most of the practical tax planning happens, because the trustee sees the final numbers before deciding how much to distribute.

Selling a Home Held in Trust

The Section 121 exclusion lets an individual exclude up to $250,000 of gain, or $500,000 for a married couple, on the sale of a principal residence after two of the last five years of ownership and use. Whether a trust can claim it depends on classification.

If the trust is a grantor trust, the grantor is treated as the owner of the residence. As long as the grantor meets the ownership and use tests, the exclusion applies to a sale by the trust the same way it would to a personal sale.⁹

A non-grantor irrevocable trust generally cannot claim the Section 121 exclusion, even if a beneficiary lives in the home. The exclusion requires ownership by the taxpayer, and the trust is the legal owner. The IRS has recognized a narrow exception where a beneficiary holds a withdrawal power over trust corpus, because that power can make the beneficiary a deemed owner of a portion of the trust under the grantor trust rules. The exclusion in that case is limited to the portion treated as owned by the beneficiary. For most non-grantor trusts holding real estate, the full gain is taxable. This is one of the more commonly missed consequences of putting a home into an irrevocable trust.

Capital Losses and What Happens at Termination

Inside the trust, capital losses work much like they do for individuals. Losses offset gains dollar for dollar, and up to $3,000 of net capital loss can offset other income each year. Unused losses carry forward and keep their short-term or long-term character.

When the trust terminates, unused capital loss carryovers do not disappear. Under Section 642(h), they pass through to the beneficiaries who receive the remaining trust property.¹⁰ Character is preserved: a long-term carryover in the trust becomes a long-term loss for the beneficiary. The beneficiary can first use the loss in the tax year the trust ends.

Multiple beneficiaries divide the losses in proportion to their shares of the distributed property. The carryover clock does not reset. Both the trust’s final year and the beneficiary’s first year of use count toward the carryover period, so losses should be used promptly.¹⁰

Filing, Estimated Payments, and State Tax

A calendar-year trust files Form 1041 and delivers Schedule K-1 to each beneficiary by April 15 of the following year.¹¹ An extension extends only the filing deadline, not the payment deadline. If the trust expects to owe $1,000 or more for the year after withholding and credits, the trustee must make quarterly estimated payments using Form 1041-ES.¹² Given how quickly a trust reaches the top bracket, most non-grantor trusts with investment activity cross that threshold.

Late filing and late payment each carry their own monthly penalties, with interest running on top of the tax.⁸ On a trust that sold a significant appreciated asset, a few months of delay can add real money to the bill.

State tax is a separate layer. Many states impose their own income tax on irrevocable trusts, and the rules for when a given state has jurisdiction vary widely. Some look at where the trust was created, some at where the trustee resides, and some at where the beneficiaries live. A trust with connections to several states may owe tax in more than one. Any trust expecting significant capital gains should account for state liability alongside the federal numbers.

1
IRS. Rev. Proc. 2025-32
2
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
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Internal Revenue Service. Topic No. 559, Net Investment Income Tax
4
Office of the Law Revision Counsel. 26 USC 1015 – Basis of Property Acquired by Gifts and Transfers in Trust
5
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
6
Internal Revenue Service. Gifts and Inheritances
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Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D
8
Internal Revenue Service. Instructions for Form 1041 and Schedules A, B, G, J, and K-1
9
eCFR. 26 CFR 1.121-1 – Exclusion of Gain From Sale or Exchange of a Principal Residence
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eCFR. 26 CFR 1.642(h)-1 – Unused Loss Carryovers on Termination of an Estate or Trust
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Internal Revenue Service. Forms 1041 and 1041-A: When to File
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IRS. 2026 Form 1041-ES – Estimated Income Tax for Estates and Trusts