When a trust distributes property instead of cash, the default tax rule is that the trust recognizes no gain or loss, the beneficiary takes the trust’s existing basis in the asset, and the distribution carries out the trust’s distributable net income (DNI) up to the lesser of that basis or the property’s fair market value. That DNI becomes taxable income on the beneficiary’s return. The trustee can override this default by electing under Section 643(e)(3) to treat the transfer as a deemed sale at fair market value, which forces the trust to recognize gain but gives the beneficiary a stepped-up basis and shifts more income onto the beneficiary’s return. Which path costs less tax depends on the trust’s built-in gain, the beneficiary’s bracket, and whether the beneficiary intends to sell.
The Default Rule: No Gain, Carryover Basis
An in-kind distribution does not trigger a taxable event at the trust level under the default rule. The property moves from the trust to the beneficiary, and the beneficiary inherits the trust’s adjusted basis, increased or decreased by any gain or loss the trust recognized on the transfer (zero, under the default).1Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D
Carryover basis means the beneficiary steps into the trust’s shoes. Suppose the trust bought a rental property for $200,000, took $50,000 in depreciation, and later distributes it to a beneficiary when it’s worth $400,000. The beneficiary’s basis is $150,000. When they eventually sell, they owe capital gains tax on the difference between the sale price and that $150,000. The appreciation that built up inside the trust doesn’t disappear; it waits for the beneficiary’s sale.
The DNI side of the analysis follows a parallel rule. The amount of DNI carried out by the distribution is the lesser of the beneficiary’s carryover basis or the fair market value.1Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D For appreciated property, basis is lower than FMV, so basis controls. A cash distribution of the same dollar value would push out more DNI, so an in-kind distribution of appreciated property leaves more income taxed inside the trust than a cash gift would.
The mechanics of how DNI flows work the same as for cash. The trust claims a distribution deduction on Form 1041, capped at DNI.2Office of the Law Revision Counsel. 26 USC 661 – Deduction for Estates and Trusts Accumulating Income or Distributing Corpus The beneficiary reports the same amount as income on Form 1040.3Office of the Law Revision Counsel. 26 USC 662 – Inclusion of Amounts in Gross Income of Beneficiaries of Estates and Trusts Accumulating Income or Distributing Corpus Income keeps its character on the way through, so dividends stay dividends and tax-exempt interest stays tax-exempt.
The Section 643(e)(3) Election
The trustee can override the default by making an election under Section 643(e)(3). With the election, the trust is treated as if it sold the property to the beneficiary at fair market value. The trust recognizes any built-in gain and pays tax on it. In return, the beneficiary’s basis is the FMV on the distribution date, not the trust’s lower carryover figure.1Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D
The DNI calculation shifts too. Instead of the lesser of basis or FMV, the full fair market value is what the distribution carries out. More income moves to the beneficiary’s return, and the trust claims a larger distribution deduction against its own income.
Three features of the election make it a serious commitment. It’s all-or-nothing for the year: it applies to every in-kind distribution the trust makes during that tax year, with no picking and choosing between assets. It’s made on the trust’s Form 1041 for the year of the distribution. And once filed, it’s irrevocable without IRS consent.1Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D
When the Election Actually Pays Off
The election is a bet on where the gain gets taxed cheaper: at the trust now, or at the beneficiary later. Trusts run on a viciously compressed bracket schedule. For 2026:
- 10% up to $3,300
- 24% from $3,301 to $11,700
- 35% from $11,701 to $16,000
- 37% over $16,000
A trust hits the top 37% rate at $16,000 of taxable income.4Internal Revenue Service. 2026 Form 1041-ES Estimated Income Tax for Estates and Trusts An individual doesn’t reach that rate until taxable income runs well over $600,000. A trust with adjusted gross income above $16,000 also owes the 3.8% net investment income tax on undistributed investment income, pushing the effective top rate past 40%.
The election generally helps when the beneficiary sits in a meaningfully lower bracket than the trust and intends to sell the asset soon. Making the election recognizes gain at the trust, but it also flushes more DNI to the beneficiary (potentially at lower rates) and hands the beneficiary a clean, high basis for the coming sale. Skip the election, and the same gain hides inside the asset until the beneficiary sells, at which point the beneficiary pays capital gains tax on the full spread from the old basis.
The election rarely pays off when the beneficiary plans to hold the property indefinitely. Paying tax now to buy a basis the beneficiary won’t use for decades is usually a losing trade. It can also backfire when the trust would otherwise have little taxable income for the year: recognizing a large gain inside the trust can burn through the low brackets and drive the trust to 37% on income that would have sat at 10% or 24% otherwise.
Carryover Basis Isn’t Always the Low Number
Carryover basis is the mechanical rule, but the actual number carried over depends on how the property entered the trust. This distinction trips up beneficiaries who assume the trust’s basis is the grantor’s original purchase price.
Property included in a decedent’s gross estate for estate tax purposes generally receives a stepped-up basis to fair market value at the date of death.5Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent This applies to assets held in a revocable living trust, the most common estate planning vehicle. When the grantor dies and the trust becomes irrevocable, the assets inside get a fresh basis equal to their date-of-death value. If the trustee later distributes that property in-kind under the default rule, the beneficiary’s carryover basis is the already-stepped-up figure, not what the grantor originally paid.
Property contributed to an irrevocable trust during the grantor’s lifetime is different. Those assets don’t get a step-up at death (unless the trust was structured to be included in the gross estate). The trust’s basis is the grantor’s original cost basis, and that lower figure is what carries to the beneficiary. A home purchased in 1985 for $120,000 and worth $900,000 at the grantor’s death has a $900,000 basis if it passed through a revocable trust, but only $120,000 if it was gifted to an irrevocable trust years earlier.
Before deciding on the 643(e)(3) election, confirm which regime applies. Electing to recognize gain on property that already has a stepped-up basis close to FMV generates little or no gain and accomplishes nothing.
Pecuniary Bequests: Gain Recognition Is Automatic
A pecuniary bequest is a distribution of a specific dollar amount rather than a fractional share of the trust. “Distribute $100,000 to my niece” is pecuniary. When the trustee uses property instead of cash to satisfy a fixed-dollar obligation, the transaction is treated as a sale by the trust and gain recognition is automatic. Section 643(e)(4) excludes pecuniary bequests from the in-kind distribution rules, so no election is available and none is needed.1Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D
The gain equals fair market value on the distribution date minus the trust’s adjusted basis. Using stock with a $60,000 basis and $100,000 current value to satisfy a $100,000 pecuniary bequest gives the trust $40,000 of capital gain. Trustees are sometimes caught off guard by this, particularly when they pick appreciated property for a pecuniary distribution because it’s convenient. A fractional share distribution of the same stock to the same beneficiary triggers no gain at all under the default rule. If you’re a trustee with discretion over which assets to use for a pecuniary distribution, choosing assets with minimal built-in gain saves the trust real money.
Losses on Depreciated Property Are Disallowed
Distributing property that has fallen in value creates a trap. Section 267 prohibits loss deductions on transactions between related parties, and a trust and its beneficiaries are explicitly listed as related.6Office of the Law Revision Counsel. 26 US Code 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers Even if the trustee makes the 643(e)(3) election and treats the distribution as a deemed sale at FMV, the trust cannot deduct the loss.
A partial offset exists on the other end. When the beneficiary later sells the property to an unrelated buyer at a gain, they can reduce that gain by the amount of the loss disallowed at the trust level.6Office of the Law Revision Counsel. 26 US Code 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers But the offset only works against gains; it cannot create or increase a loss on the beneficiary’s return. If the property keeps sliding, the disallowed loss vanishes.
The practical move: if the trustee wants to harvest a loss on trust-owned property, sell the asset to an unrelated third party and distribute the cash. Distributing the depreciated asset directly wastes the loss.
Retirement Account Assets Follow Different Rules
When a trust is named as the beneficiary of an IRA or other retirement account, distributions from that account are governed by a different regime entirely. Retirement account distributions are ordinary income whether they come out as cash or as an in-kind transfer of investments held inside the account. There is no carryover basis benefit, and the 643(e)(3) election is irrelevant because income recognition is mandatory.
Under the SECURE Act rules, most non-spouse trust beneficiaries must drain an inherited IRA within 10 years of the account owner’s death. If the original owner died on or after their required beginning date, the trust must also take annual minimum distributions during years one through nine, with the balance out by the end of year ten. If the trust then distributes those IRA assets in-kind to individual beneficiaries, the value carries out DNI and is reportable as ordinary income on the beneficiary’s return. The beneficiary’s basis in the transferred investments is their fair market value on the distribution date, and capital gains treatment only applies to appreciation after the transfer.
Reporting the Distribution
The trust reports in-kind distributions on Form 1041, due by the 15th day of the fourth month after the trust’s tax year ends. For a calendar-year trust, that’s April 15.7Internal Revenue Service. Forms 1041 and 1041-A When to File The 643(e)(3) election, if made, appears on this return, and any gain recognized under the election is reported on Schedule D of the 1041.
The trustee also prepares Schedule K-1 for each beneficiary, showing their share of income, deductions, and credits. The beneficiary uses the K-1 to complete Form 1040.8Internal Revenue Service. Instructions for Schedule K-1 (Form 1041) for a Beneficiary Filing Form 1040 or 1040-SR For in-kind distributions, the K-1 must reflect the valuation dictated by whichever path the trust took: the lesser-of-basis-or-FMV figure under the default rule, or the full FMV if the trustee elected. Mismatched reporting between the trust return and the beneficiary’s return invites IRS attention.
Non-marketable assets, including real estate, closely held business interests, and collectibles, require a qualified appraisal from an independent professional to support the FMV reported on the return. Publicly traded securities are valued at the closing market price on the distribution date. Appraisal documentation stays with the trust’s records rather than the return, but must be produced if the IRS questions the reported value.
A 20% accuracy-related penalty applies when a beneficiary reports a basis in inherited property inconsistent with the value reported by the estate or trust. The basis a beneficiary claims cannot exceed the value the estate or trust reported. If the trustee’s basis information is wrong and the beneficiary relies on it, both parties face exposure, and trustees who fail to furnish the required basis statements face separate information-return penalties.