Does a Family Trust Pay Capital Gains Tax? Why Most Californians Get This Wrong In 2025

Each year, thousands of California families shift investment property, stocks, or even family homes into trusts—usually believing it will shield them from capital gains taxes forever. Here’s the truth: the IRS and the Franchise Tax Board (FTB) get their cut unless you know the rules cold. The good news? When you understand the interplay between your family trust, step-up in basis, and timing of distributions, you can often save tens of thousands—sometimes even shut down a capital gains bill completely.

Quick Answer: Who Actually Pays Capital Gains on a Family Trust?

If you transfer assets to a “grantor” trust—think Revocable Living Trust—the trust itself doesn’t usually owe capital gains tax. You do, on your individual return, just like before. But with irrevocable trusts (which actually control or hold investments for years), things change: the trust can become its own taxpayer, filing IRS Form 1041. Income that stays in the trust gets taxed at the trust’s rates (which hit the top 20% capital gains threshold at just $15,450 in 2025). Distributions can shift liability out to beneficiaries.

Many clients ask me: does a family trust pay capital gains tax directly, or do beneficiaries pay it? The answer depends on whether the trust retains or distributes the gain. If the trust keeps the income, it files Form 1041 and pays at compressed trust rates (20% federal capital gains kicks in at only $15,450 in 2025). If the trust distributes the gain, the beneficiaries report it on their 1040s, often at far lower effective rates.

Bottom line: family trusts absolutely can incur capital gains taxes—unless you use step-up basis at death, carefully plan distributions, or employ specific California and federal exemptions. That’s the difference between a $75,000 tax bill and zero.

Here’s the trap: families often assume that once assets sit in a trust, capital gains “vanish.” In reality, the IRS is clear—does a family trust pay capital gains tax? Yes, if gains are recognized and retained inside the trust. Unlike individuals who can offset gains with $3,000 capital loss carryovers each year, trusts have very limited offset opportunities. That’s why planning the timing of distributions often makes the difference between a 37% trust-level tax vs. a 20% or even 15% personal rate.

The Big Levers: How Capital Gains Are (And Aren’t) Triggered In Family Trusts

Let’s work through a real example. Suppose you’re a Bay Area couple with $1.3M in rental property, held inside an irrevocable family trust. You want to sell—so what happens next?

• If the trust sells, and keeps all profits inside, the trust pays tax at the trust capital gains rate: the 20% bracket kicks in at just $15,450 of gains, vs $553,850 for married couples filing jointly.
• If the trust distributes the gain to you as a beneficiary, “you” pay, but at your own rate, often lower—income blending can matter.
• If you wait until death (using a revocable grantor trust), your heirs get “step-up in basis”—the property’s value resets to market value, often zeroing out capital gain tax for them. This only works if the trust is properly structured and not funded with irrevocable gifts years before death.

Here’s what nearly every California family misses: Irrevocable trusts protect assets but can skyrocket your tax bill without smart planning. That $1.3M property could be sold by the trust and owe over $190,000, while your heirs might owe zero if they inherit at a stepped-up basis.

KDA Case Study: High Net Worth Family Saves Six Figures by Timing Distributions

Consider a real California client—a retired couple with decades-old stock and two rental condos. Their irrevocable family trust was set to sell assets after a health crisis. Selling inside the trust would have triggered $290,000 in capital gains at trust rates.

KDA intervened. By making partial distributions to their adult children in strategic tax years, we pushed capital gains onto beneficiaries with lower income, trimmed the effective rate, and then delayed the bulk of sales until just after the grantor’s passing. The result? The remaining properties were stepped-up for heirs, and the overall tax paid dropped to $94,000—a savings of $196,000. The family paid KDA $10,500 for advanced trust tax planning and received nearly a 19x ROI in the first year.

Ready to see how we can help you? Explore more success stories on our case studies page to discover proven strategies that have saved our clients thousands in taxes.

Why Most Families Blow the Step-Up Basis Advantage

The “step-up in basis” is the most powerful—but most frequently misunderstood—tool in all of family trust tax planning. At the death of the grantor (the person who created the trust), most assets receive a new cost basis: their fair market value on the date of death. This erases years (sometimes decades) of potential capital gains taxes for heirs.

Here’s where Californians trip up:

• – Placing appreciated, income-producing properties in irrevocable trusts before death can DESTROY the step-up—heirs inherit old cost basis, not market value basis.
• – Triggering trust tax rates by keeping all sale proceeds inside the trust (top 20% capital gains rate at just $15,450 in 2025).
• – Failing to update trust language post-2017 TCJA means heirs face “hidden” taxes or can’t qualify for new state exemptions.

Action Step: Always coordinate with your trust attorney AND a tax strategist before transferring any high-growth asset. Changing the type of trust or distributing at the wrong time can obliterate your tax advantage. See our complete guide to estate and legacy planning in California for step-by-step details.

How Does California Treat Trust Capital Gains?

California is even less forgiving than the IRS. Unlike most states, the FTB does not recognize the federal qualified dividends or capital gains rates. All trust income—including realized capital gains—faces ordinary state income tax rates, which can exceed 13% for high earners.

For Californians, the answer to does a family trust pay capital gains tax gets even harsher. The Franchise Tax Board ignores federal preferential rates—capital gains inside a trust are taxed as ordinary income at state brackets that can hit 13.3%. Combine that with federal trust taxation, and you can easily lose 33–37% of a sale unless distributions or step-up basis planning are used.

Let’s say your trust realizes $300,000 in long-term capital gains from a property. The trust will owe federal tax at 20% (if gains stay in trust), plus California income tax upwards of $39,000. Worse, the tax is due—regardless of whether cash was distributed to beneficiaries.

Pro Tip: The IRS allows “65-day rule” distributions (see IRS Form 1041 instructions)—as long as the trust distributes income within 65 days of year-end, it’s treated as income for beneficiaries instead of trust. This alone can save four or five figures per year in high-income families.

Red Flag Alert: Don’t Assume Your Trust Is ‘Grantor’ Forever

Most basic living trusts (in revocable form) are “grantor trusts”—they’re invisible to the IRS and FTB for tax purposes. But after death, or if a trust becomes irrevocable (which can happen automatically at incapacity), the rules flip. IRS Form 1041 filing begins, new EINs are needed, and a trust’s income and gains become subject to punishing trust rates. Red flag: Many heirs have sold trust property not realizing they shifted into a 20%+ bracket, when simply waiting or making a strategic distribution would have zeroed out that bill entirely.

FAQ: Capital Gains for W-2s, 1099s, Real Estate Investors & LLCs With Family Trusts

How Does a Family Trust Affect a W-2 Employee?

If you’re a regular W-2 wage earner but inherit or benefit from a family trust, any distributed gains report on your personal return, just like your salary. The difference: Your marginal bracket can spike due to trust income stacking on top. Plan distributions in low-income years or spread them among family members for best effect.

Can My 1099 Consulting Business or LLC Benefit from a Family Trust?

Absolutely. High-earning freelancers or LLC owners often use trusts to own business assets or pass S Corp/LLC interests to heirs. But beware: As with other investments, selling appreciated assets inside the trust can expose you to higher accelerated trust rates—especially problematic when stacking on self-employment income. Get tailored trust and business entity strategy advice with our tax planning solutions.

My Family Trust Holds My Rental Properties—Do I Pay Gains When I Sell?

Yes, unless the property was transferred via step-up basis, or distributed to you prior to sale (so you pay at your own, often lower, rate). Don’t fall for online myths—selling inside an irrevocable trust, especially in California, can mean a staggering combined tax bill. Talk to a specialist about timing distributions and leveraging any exclusions or exemptions available.

Is There Any Way To Avoid California Tax On Trust Gains?

Legally avoiding all California tax is nearly impossible unless you time distributions, utilize out-of-state residency planning, or qualify for exemptions (like family home exclusion under Prop 19 in limited cases). But strategic planning can minimize or shift the liability substantially.

Pro Tip: Turn Gains Into Gifts (The Gift of Basis Reset)

If your trust is set up correctly, making “upstream” gifts (to older relatives in lower tax brackets or shorter life expectancy) can reset basis for certain assets. This only works if the gift structure, state law, and trust language align. It’s advanced—never DIY this maneuver. We’ve seen California families save $30,000+ using this, but botched attempts can trigger gift tax or lose the step-up entirely. Always consult with both your trust attorney and tax strategist before gifting appreciated trust assets.

2025 Changes: What Should California Families Do Now?

This year, the IRS left capital gains thresholds unchanged, but estate tax exemption “sunset” is looming (dropping from $13.6M per individual to potentially $7M in 2026). Timing trust administration, asset sales, and distributions is rocket fuel for family savings. Even more critical: recent Prop 19 changes mean your family home might not retain Prop 13 property tax protections for heirs—so review your trust structures now.

This information is current as of 10/2/2025. Tax laws change frequently. Verify updates with the IRS or FTB if reading this later.

Common Mistake: Keeping Gains in the Trust Just Because “It Feels Safer”

Many trustees assume keeping all proceeds from a sale inside the trust avoids tax or keeps family assets protected. In reality, leaving large capital gains within the trust often just guarantees the highest possible tax rate. Sometimes a simple distribution and proper reporting slashes the effective rate by 50% or more.

Fast Tax Fact: Trust Capital Gains Example (2025)

Trust sells $500,000 appreciated stock. If income held in trust: 20% federal ($100,000) plus 13.3% CA ($66,500) = $166,500 tax. If trust distributes gains to three lower-bracket kids: each pays 15% federal + 9% CA (~$40,000 each) = family saves nearly $46,500, just by shifting who pays.

“The IRS isn’t hiding these write-offs—you just weren’t taught how to find them.”

More FAQs: Family Trusts, Capital Gains, and California Traps

Can My Trust Rollover Capital Gains (Like an IRA)?

No—there’s no direct rollover or deferral for standard trust proceeds. You must use sales structuring, installment sales, or invest in Opportunity Zones for any gain deferral.

What Documentation Do I Need?

Keep K-1s, Form 1041, appraisal reports, and distribution ledgers for all trust activity. For step-up basis, secure a date-of-death appraisal for each major asset.

I Inherited From a Trust Years Ago—Can I Still Fix a Tax Mess?

Sometimes. The IRS allows amended returns within three years if you overpaid gains, or missed a step-up. It’s worth a paid review if you feel something’s off.

Ready for a Custom Trust Tax Game Plan?

If you’re managing a family trust, on the brink of selling property, or planning your estate, fine-tuning the timing, structure, and type of trust can preserve a fortune for your family. Book a session with KDA’s estate tax strategists to see where you can shift, spread, or wipe away your family’s tax bill altogether.

Book Your Estate & Trust Strategy Session

If you’re unsure how much capital gains could hit your family trust, waiting could cost six figures. Book a personalized estate tax planning session and walk away with a custom, actionable plan. Click here to secure your appointment now.