Trusts come in all shapes and sizes. One critical component being whether a trust is treated as a grantor trust for income tax purposes (as opposed to a non-grantor trust).

You may have noticed that I am specifying income tax because a trust can be treated differently for income tax purposes as it may be for estate tax purposes. This is a huge advantage for you as a taxpayer because it can give you the benefits of both worlds if you set up your trust structure correctly.

Why is knowing the difference between a grantor trust and non-grantor trust such a big deal? Let me give you two real world examples:

Getting the Section 121 Exclusion with an Irrevocable Grantor Trust

If you have a Medicaid trust (also known as a Masshealth trust in Massachusetts) or an income-only irrevocable trust, then you likely put your primary residence into the trust upon its creation to avoid the 5-year lookback period.

But, as time goes on, you may decide to downsize and sell the home currently held in trust. When you (or more accurately, when your trustee) sell the property, you are going to need to recognize the income (or capital gain) on that sale of property. The capital gain is the difference between the cost basis (generally, purchase price + recorded improvements) and the sales price (after fees).

For most people who bought a home 20-30 years ago, the capital gain could easily be at least $500,000 (especially if you live in Massachusetts).

And here’s the important part:

If that capital gain is recognized within a non-grantor trust, then you will pay a tax of around 20-25% on that capital gain - e.g., 500k x 25% = $125,000 in income taxes payable to the government.

BUT, if you have a grantor trust, then that property will still be treated as yours for income tax purposes, which means it could still qualify for the section 121 exclusion (applicable to your primary residence) and therefore have a $500,000 capital gains exclusion for married couples.

That means you may have just saved up to $125,000 by having a grantor trust as opposed to a non-grantor trust. This is why it’s so important to make sure your trust is set up properly.

But wait! You may think: If the trust owns the property then how do I qualify for section 121 if it’s been over 5 years since I transferred the property to my irrevocable trust?

Here’s how:

(3) Ownership -

(i) Trusts. If a residence is owned by a trust, for the period that a taxpayer is treated under sections 671 through 679 (relating to the treatment of grantors and others as substantial owners) as the owner of the trust or the portion of the trust that includes the residence, the taxpayer will be treated as owning the residence for purposes of satisfying the 2-year ownership requirement of section 121, and the sale or exchange by the trust will be treated as if made by the taxpayer.

Source: https://www.law.cornell.edu/cfr/text/26/1.121-1

IRS Link: https://www.irs.gov/taxtopics/tc701#:~:text=In%20general%2C%20to%20qualify%20for,to%20its%20date%20of%20sale.

What about income from other investments? Like rental income, interests, and dividends?

Passive income streams also provide a huge tax advantage for grantor trusts over non-grantor trusts in the long term.

To understand why there is an tax advantage for grantor trusts when it comes to rents, dividends, and interest, you need to take into account the marginal tax rates on trusts vs. individuals (please note: for purposes of this discussion I am referring to unqualified dividends taxed at ordinary rates rather than qualified dividends taxed at preferential rates):

As of this writing, non-grantor trusts have the following federal tax rates for TY 2023:

10%: for income between $0 – $2,900
24%: for income between $2,901 – $10,550
35%: for income between $10,551 – $14,450
37%: for income of $14,451 and higher

Source: https://www.irs.gov/pub/irs-drop/rp-22-38.pdf

You’ve read that right, if you are making more than 14,451 in taxable income (that is not capital gain), then you could be hit with a 37% tax on that income inside your trust. After state taxes, that could mean you are paying almost half of your investment income to the government in taxes once you get over the 14.5k threshold in a non-grantor trust with accumulated income.

But, here’s how the federal income tax rates work for a married couple filing jointly:

12% for incomes over $22,000
22% for incomes over $89,450
24% for incomes over $190,750
32% for incomes over $364,200
35% for incomes over $462,500
37% for incomes over $693,750

Source: https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2023#:~:text=32%25%20for%20incomes%20over%20%24182%2C100,for%20married%20couples%20filing%20jointly).

Since a grantor trust treats income of the trust as if it was owned by you (and reported on your 1040) rather than owned by your trust (and reported on a 1041), you save the difference between the trust income tax rates and your personal income tax rate every year your grantor trust generates taxable rental income, interest, and/or dividends.

That means that if you have investment income under $89,000, then you could be saving 25% on income taxes between the 14.5k threshold and the 89k threshold.

That’s an annual savings of about $18,000 per year thanks to your grantor trust. And the higher your investment income, the higher your savings.

So, if Grantor trusts are so great, why would anyone want a non-Grantor trust?

You’ll want a non-grantor trust if you don’t want the income tax liability to flow to you, but would prefer it goes to beneficiaries of the trust. This becomes especially common when the beneficiaries are young adults in low tax brackets since the distributions can be made to them to avoid tax liability at the trust level. In other words, as a family unit, a non-grantor trust may make more sense when you have beneficiaries in a lower tax bracket than you who are willing to report the income on their 1040s.