Can Capital Gains Be Really Distributed From a Trust? – Don’t Make This Mistake + FAQs

Lana Dolyna, EA, CTC

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Confused about whether capital gains can be distributed from a trust? You’re not alone. Over 75% of trusts in the U.S. face tax inefficiencies due to improper capital gains treatment, potentially costing thousands in avoidable taxes.

Immediate Answer: Can Capital Gains Be Distributed?

Yes – capital gains from a trust can be distributed to beneficiaries, but only under specific conditions.

Under federal tax law, a trust’s long-term or short-term capital gains are typically considered part of the trust’s principal, not its income. By default, capital gains remain inside the trust and are taxed at the trust’s high tax rates, rather than automatically passing out to beneficiaries. In most cases, you cannot simply “distribute” capital gains for tax purposes unless the trust document or applicable law explicitly allows it.

To distribute capital gains to beneficiaries (so that they pay the tax instead of the trust), those gains must be included in the trust’s Distributable Net Income (DNI) calculation. DNI is essentially the pool of income that can be passed through to beneficiaries on a Schedule K-1.

Normally, DNI excludes capital gains by default, meaning unless certain exceptions are met, the capital gains will be “trapped” in the trust, and the trust itself pays the capital gains tax.

The bottom line: Capital gains can be distributed from a trust only if the trust language and IRS rules allow those gains to be treated as distributable income. In practice, most revocable and grantor trusts pass all taxes (including capital gains) to the grantor by default, while non-grantor trusts must meet specific requirements to push capital gains out to beneficiaries.

If those requirements aren’t met, the trust will pay tax on the gains and any distribution of the sale proceeds to a beneficiary is just a tax-free principal distribution (since the trust already paid the tax).

Biggest Mistakes to Avoid When Distributing Capital Gains ⚠️

Even savvy trustees and beneficiaries can slip up when dealing with capital gains in trusts. Here are the biggest mistakes to avoid:

Assuming All Gains Can Be Passed Out: Don’t assume that just because the trust sold an asset and has cash, you can simply give it to the beneficiaries and shift the tax to them. If the trust instrument doesn’t permit treating gains as income (or you lack a state law allowing it), the tax stays with the trust even if you distribute the cash. The IRS rules are clear: unless capital gains are properly included in DNI, distributing the proceeds won’t transfer the tax liability to the beneficiary. This mistake can lead to the trust paying taxes it could have avoided.
Failing to Draft for Capital Gains: If you’re setting up a trust (or administering one), be mindful of the trust provisions. A common error is not including language in the trust document allowing capital gains to be treated as income or giving the trustee discretion to do so. Without such provisions (and corresponding allowance under local law), you miss the chance to distribute gains for tax purposes. This oversight can cause beneficiaries to pay higher taxes indirectly because the trust might be stuck with the gains (and taxed at the trust’s compressed rates).
Overlooking Tax Brackets and Timing: Another mistake is ignoring the vast difference between trust and individual tax brackets. Trust tax rates hit the top 37% federal bracket at about $15,000 of income, plus 3.8% Medicare surtax on investment income. A trust accumulating capital gains can quickly face high federal tax on long-term gains even if the dollar amount of gain is modest. Meanwhile, a beneficiary might have paid 0% or 15% on those same gains if they were passed out. Failing to time distributions or structure them to use beneficiaries’ lower brackets (for example, distributing in a year the beneficiary’s income is low) is a missed opportunity. Also, not using the 65-day rule (which allows certain distributions made in the first 65 days of a new year to count for the previous tax year) can be a mistake if you need to push out income to reduce the prior year’s trust taxes.
Ignoring State Tax Implications: Many forget that state taxes can also bite. For instance, distributing capital gains to a beneficiary in a no-income-tax state while the trust is located in a high-tax state could save a substantial state tax bill – but only if structured correctly. Conversely, some states tax trusts based on the beneficiary’s residence. Not planning for state-specific rules is a costly mistake. For example, California can tax a trust’s capital gains if a beneficiary is a California resident, even if the trust is administered elsewhere. Failing to account for these nuances might mean paying state taxes that could have been avoided.
Breaching Fiduciary Duty When Allocating Gains: Trustees have a fiduciary duty to treat beneficiaries impartially. One subtle mistake is skewing distributions in a way that favors income beneficiaries over remainder beneficiaries (or vice versa) without considering the trust’s terms. For example, if a trustee aggressively allocates capital gains to income (so current beneficiaries get distributions and tax liability), it may benefit the income beneficiary at the expense of the remainder beneficiary (who loses out on trust growth). A trustee who does this without clear authorization can breach their duty. Always ensure that any strategy to distribute (or not distribute) gains aligns with the trust document and fairly balances the interests of all beneficiary classes.

By avoiding these mistakes, you can ensure that capital gains distributions (or retentions) are done in the most tax-efficient and legally sound manner.

Key Terms You Need to Know 📖

To navigate trust taxation and capital gains, you’ll need to understand some key concepts and terminology:

Trust Principal vs. Income: In trust accounting, principal (corpus) refers to the assets of the trust (the original funds and any capital growth). Income refers to earnings generated by those assets (interest, dividends, rent, etc.). Capital gains (profits from selling trust assets) are generally allocated to principal, not income, by default. This distinction matters because most trusts are required to distribute income to certain beneficiaries, but not principal.
Distributable Net Income (DNI): DNI is a tax concept (defined in IRC §643) that sets the maximum amount of income that can pass through to beneficiaries in a given year. It effectively caps the trust’s distribution deduction and the taxable income that beneficiaries must report. Importantly, DNI usually excludes capital gains, meaning trusts can’t normally pass out more than the trust’s income (excluding most gains) without incurring trust-level tax. However, if capital gains are included in DNI by meeting certain exceptions, they can be passed to beneficiaries.
Grantor Trust: A trust where the grantor (creator) retains certain powers or benefits such that, for income tax purposes, the trust is not a separate taxpayer. Instead, the grantor reports all trust income, deductions, and capital gains on their personal tax return. Revocable living trusts are by definition grantor trusts (since the grantor can revoke or control them). Some irrevocable trusts can also be intentionally structured as grantor trusts (e.g., IDGTs – Intentionally Defective Grantor Trusts). In a grantor trust, capital gains are effectively “distributed” to the grantor for tax purposes – the trust itself pays no income tax. The grantor pays the tax on trust gains, which can be a strategic estate planning benefit (it allows the trust assets to grow without erosion by taxes).
Non-Grantor Trust: A trust that is a separate tax entity from the grantor. Irrevocable trusts that don’t meet the grantor trust rules fall here. A non-grantor trust must obtain its own Tax ID and file Form 1041. It pays tax on any income not distributed to beneficiaries. With non-grantor trusts, distributed income (up to the DNI limit) is taxed to beneficiaries, and undistributed income is taxed to the trust. Capital gains for non-grantor trusts are usually undistributed (taxed to the trust) unless planning steps are taken.
Simple Trust: A simple trust is a non-grantor trust that is required to distribute all of its income annually and does not pay or set aside any income for charity. Simple trusts cannot accumulate income. Importantly, because capital gains are not part of “income” (accounting income) under default rules, a simple trust typically does not distribute capital gains – those gains stay in the trust corpus. Beneficiaries of a simple trust get yearly income distributions (taxable to them via K-1), but generally will not see capital gains on their K-1 in most years.
Complex Trust: Any non-grantor trust that isn’t simple is “complex.” Complex trusts may accumulate income, distribute or not distribute income in the trustee’s discretion, distribute corpus (principal), or make charitable payments. Most family discretionary trusts are complex trusts. A complex trust can potentially distribute capital gains, but only if the trustee has authority (and chooses) to treat those gains as part of distributable income or if the trust is terminating. Complex trusts offer flexibility to time distributions for tax planning.
Fiduciary Duty: The trustee’s legal duty to act in the best interests of the trust and beneficiaries. This term is crucial when considering capital gains distributions, because a trustee must consider not just tax efficiency but also fairness to all beneficiaries. For example, a trustee might save taxes by distributing all gains out to current beneficiaries, but if that leaves the trust principal depleted to the detriment of remainder beneficiaries, it could raise fiduciary issues. Many trusts and state laws (like the Uniform Principal and Income Act, UPIA) aim to give trustees guidance on investing and allocating returns fairly (e.g., investing for total return and using unitrust or adjustment powers to balance income and growth).
Pass-Through Taxation: This refers to income that passes through an entity (like a trust, estate, or partnership) to the end taxpayer. In the context of trusts, when a trust distributes income to beneficiaries and issues them a Schedule K-1, that income retains its character (e.g., dividends, interest) and is taxed to the beneficiary, not the trust. Most income distributed by a trust is pass-through (via DNI rules), but capital gains are a notable exception unless special conditions are met.
Schedule K-1 (Form 1041): The tax form used to report a trust beneficiary’s share of the trust’s income, deductions, and credits. If a trust distributes income to you, you’ll get a K-1 showing, for example, interest, dividends, etc. If capital gains are successfully included in DNI (per the strategies below), the beneficiary’s K-1 would also show capital gains, meaning the beneficiary must report those gains on their tax return. If the trust retains the gains, the K-1 won’t show them – the trust will pay the tax on its Form 1041 and the beneficiary won’t have capital gain income (just perhaps a principal distribution which is not taxed).

Now that we’ve clarified key terms, let’s dive into how capital gains distribution works in real-world trust scenarios.

Detailed Examples of Capital Gains Distribution in Trusts

To illustrate the possibilities (and limits) of distributing capital gains, let’s examine three common scenarios and how the taxes are handled in each.

Scenario 1: Revocable (Grantor) Trust – Grantor Pays the Capital Gains Tax

Example: John creates a revocable living trust and transfers some stocks into it. The trust sells some stock in 2025, realizing a $50,000 long-term capital gain. John then takes a distribution of $50,000 from the trust (perhaps to use the cash elsewhere).

Trust Type	Revocable Grantor Trust (John’s living trust)
Who is Taxed on Gain?	John (the grantor) reports the $50,000 capital gain on his personal 1040. The trust is ignored for income tax.
Can the Gain Be Distributed?	Yes, effectively by default. Because the trust is a grantor trust, all income and gains are treated as John’s. The $50,000 withdrawn is not a taxable event itself – it’s akin to John moving his own money.
Notes	Revocable trusts do not shield income from taxes – John pays the capital gains tax as if he held the asset outright. The trust doesn’t file a separate return in this scenario.

In this scenario, “distributing” capital gains simply means John, the grantor, took money out of his own trust. There’s no special tax maneuver required; by definition all trust income and gain is already John’s income. This scenario is straightforward – it’s mentioned here to contrast with non-grantor trusts below.

Scenario 2: Irrevocable Non-Grantor Simple Trust – Capital Gain “Trapped” in the Trust

Example: The Smith Family Trust is an irrevocable trust for the benefit of Alice. The trust document requires all income be paid to Alice annually (making it a simple trust). In 2025, the trust sells real estate, generating a $100,000 capital gain. The trustee distributes $5,000 of trust income (interest and rents) to Alice, but retains the $100,000 from the sale (adding it to principal).

Trust Type	Irrevocable Simple Trust (non-grantor)
Who is Taxed on Gain?	The trust pays tax on the $100,000 capital gain. It will report the gain on Form 1041 Schedule D and owe tax at trust rates (long-term capital gains rate likely 20% + 3.8% NIIT). Alice’s K-1 will not include this gain.
Can the Gain Be Distributed?	No, not for tax purposes. By default, capital gains are allocated to principal, not income. Because the trust didn’t have provisions to treat it otherwise, the $100,000 is not included in DNI. Even if the trustee gave Alice that $100,000 in cash, it would be considered a principal distribution – not a distribution of DNI – so Alice still wouldn’t report the gain.
Notes	This is the common outcome in many trusts: capital gains stay with the trust. The trust will reach the top tax bracket quickly and pay federal tax (and state tax, if applicable) on the gain. Any distribution of the sale proceeds to Alice is treated as a non-taxable return of principal (after the trust’s taxes).

In this scenario, a simple trust’s rules mean that while Alice receives her share of income, the capital gains are not passed on. The gains remain in the trust, causing the trust to pay a higher tax rate on the gains, which is why planning ahead is essential.

Scenario 3: Irrevocable Non-Grantor Complex Trust – Capital Gain Passed Out to Beneficiaries

Example: The Lee Family Trust is a discretionary complex trust. The trust document grants the trustee power to treat capital gains as part of income and distribute them. In 2025, the trust sells stock for a $30,000 gain. The trustee, exercising discretion, distributes the $30,000 to the two trust beneficiaries (who each receive $15,000) and allocates the gain to trust income per the trust terms.

Trust Type	Irrevocable Complex Trust with discretionary powers
Who is Taxed on Gain?	The beneficiaries. Because the trustee included the $30,000 gain in distributable income, the trust will report a distribution deduction for the $30,000 and issue K-1s to the beneficiaries showing $15,000 of capital gains each. They will each pay the capital gains tax on their share (perhaps at 15% rate if they are in a middle tax bracket). The trust itself pays no tax on that gain (it was passed through).
Can the Gain Be Distributed?	Yes. This is a valid way to distribute capital gains – by including it in DNI via trust provisions and actually distributing the cash to beneficiaries in the same year. The key is that the trust is allowed to treat that gain as income (either by explicit trust language or a state law if it allows an adjustment, or by using the “trustee discretion” method in the tax regulations). Because this was done, the capital gain is part of DNI and thus “carried out” to the beneficiaries.
Notes	Proper documentation is important. The trustee should reflect in the trust’s books/records that the $30,000 gain was allocated to income and distributed. Consistency matters – if a trustee uses this method in one year, they often should continue similar treatment in future years for consistency (unless using a more flexible method that doesn’t require year-to-year consistency). This scenario benefits the beneficiaries if their personal capital gains tax situations (brackets or available losses) are more favorable than the trust’s.

This scenario demonstrates one of the exceptions where capital gains can be included in DNI. Under IRS regulations, if the trust instrument and/or state law permits, and the trustee follows the requirements, capital gains can be treated as part of the income distributed to beneficiaries. Essentially, the trust “passes through” the gain, benefiting the beneficiaries by shifting the tax liability to them if they are in a lower tax bracket.

The Evidence: IRS Rules and Trust Taxation

Understanding why capital gains usually stay in a trust (and when they can be paid out) requires looking at the IRS rules and tax laws:

Internal Revenue Code & DNI: The IRS code covers taxation of estates and trusts. IRC §643(a) defines distributable net income (DNI). The formula for DNI explicitly subtracts capital gains (except in certain cases). The reason is that, by default, capital gains are allocated to principal, which typically benefits remainder interests, not the income beneficiaries. Including all capital gains in DNI would allow current beneficiaries to potentially deplete a trust’s growth, which isn’t usually intended. So Congress set it up that unless the gains are actually being distributed (or required to be), they aren’t counted as distributable income.
Treasury Regulation §1.643(a)-3: This key IRS regulation provides the exceptions under which capital gains can be included in DNI (and thus passed out to beneficiaries). In general, the regulation says capital gains can be in DNI if they are: (1) allocated to income by the trust instrument or local law, (2) allocated to corpus but consistently treated as income by the trustee on the trust’s books and records (e.g., a consistent practice of distributing gains each year), or (3) allocated to corpus but actually distributed to the beneficiaries (or used by the trustee in determining how much to distribute). The trust must also meet a requirement of being allowed by trust agreement or state law to do this, or the trustee must have discretion and act impartially. These rules are why Scenario 3 above was possible. If you don’t meet one of these methods, the default rule applies and gains stick with the trust.
Form 1041 and Schedule D: A trust (non-grantor) reports its income on Form 1041. When capital assets are sold, the gains are reported on Schedule D attached to the 1041. If a trust is distributing capital gains properly, the Schedule D and the K-1s will show that (there are mechanisms on the 1041 to indicate capital gain in DNI, often via allocation on worksheets). If not, the Schedule D total gain will just flow into the trust’s taxable income. The trust then calculates tax on that – note that for 2024, a trust pays capital gains tax starting at a relatively low threshold, and the compressed bracket is why trustees often try to push gains out to beneficiaries when possible.
IRS Stance on Improper Capital Gains Distributions: If a trustee mistakenly treats a capital gain distribution as carrying out income when it shouldn’t, the IRS can deny the trust a distribution deduction for it. Essentially, the IRS expects adherence to the rules above. Simply distributing cash equal to a capital gain is not enough – the trust must have the authority to characterize it as income. The burden is on the trust to show it meets an exception if it tries to deduct distributed gains.
Fiduciary Accounting vs. Tax Accounting: The concept of principal vs. income is governed by state law (often UPIA – Uniform Principal and Income Act – in many states) which trustees follow for accounting. Tax law then piggybacks on those definitions for DNI. If state law or the trust instrument allows treating some or all capital gain as income (for example, some states let trustees make an adjustment between principal and income to be fair to both beneficiary types), then the tax law will typically respect that in determining DNI. That’s why in Scenario 3, the trust assumed language or state law support to do that allocation.
Grantor Trust Rules: Under IRC §§ 671-679, if a trust is deemed a grantor trust, all its income is taxed to the grantor or another owner. This is why revocable trusts (grantor trusts) don’t pay their own taxes and by extension why capital gains are “distributed” to the grantor by default. The grantor trust rules are beyond the scope of this article, but it’s worth noting that many sophisticated estate plans intentionally use grantor trusts so the grantor continues to pay tax (allowing the trust to grow without erosion by taxes). The key takeaway is if you have a revocable or other grantor trust, you don’t worry about DNI or capital gain trapping at all – everything flows to the grantor’s return automatically.

The IRS framework essentially ensures that someone pays the tax on capital gains – either the trust or the beneficiary – but leans toward the trust unless you’ve met conditions to shift it. With this understanding, let’s compare how different state laws can affect the picture.

Comparing Trust Taxation Across Different States

Trust taxation isn’t just a federal issue – each state has its own rules on taxing trust income (including capital gains). Where a trust is considered a resident and how states tax trust income can drastically affect the total tax burden. Here are a few state-level nuances to be aware of:

California: California is known for aggressive trust taxation. A trust is considered a California resident (and taxed on all its income, including capital gains) if the trustee or a beneficiary is a California resident (for non-contingent beneficiaries). This can result in California taxing trust income even if the trust was created elsewhere. California’s top income tax rate is 13.3%, and it does not differentiate capital gains (they are taxed as ordinary income at the state level). For example, if a California resident is beneficiary of a non-grantor trust that accumulated capital gains, California may tax a portion of those gains, even if not distributed, under certain circumstances. Notably, after recent legal decisions, a state can’t tax a trust solely because a beneficiary lives there if the beneficiary has not received any distributions and has only a contingent interest. California will only tax current distributions to a resident beneficiary or tax a resident beneficiary on accumulated trust income when distributed under throwback rules.
New York: New York considers a trust a resident trust if it was created by a New York domiciled individual (for an inter vivos trust) or a testamentary trust of a NY decedent. However, New York allows a resident trust to be exempt from NY income tax if the trust has (a) no NY resident trustees, (b) no NY assets, and (c) no NY-source income. This means NY wealthy grantors often set up trusts with out-of-state trustees and assets to avoid NY trust tax. Capital gains in such an exempt trust would escape NY tax. But New York also has a throwback tax: if that trust later distributes accumulated income (including capital gains) to a NY resident beneficiary, the beneficiary may owe NY tax on that previously untaxed income. New York’s top tax rate is around 10.9% (plus additional local taxes if applicable). The key point: New York can either tax the trust’s gains at the trust level (if it’s a resident trust that doesn’t qualify for exemption) or tax the beneficiary when they receive distributions of prior gains.
States with No Income Tax: States like Florida, Texas, Nevada, South Dakota, Washington, and a few others impose no state income tax on individuals or trusts. If you can establish a trust in a no-tax state (and ensure it’s not deemed a resident of a taxing state), the trust’s capital gains will escape state tax entirely. This is a major incentive for high-net-worth families in high-tax states to use trust planning. For example, a family in California might set up a Nevada Incomplete Gift Non-Grantor Trust (“NING”) – an irrevocable trust designed so that the grantor is not taxed on its income and the trust is a Nevada resident trust with Nevada trustees. The trust could sell assets with large gains and pay zero state tax, something that would have cost 13.3% in California. Careful planning is needed to avoid triggering home state tax, but it’s a popular strategy to save on state capital gains taxes.
Allocation and Source of Income: States also differ on how they allocate income to beneficiaries. Most states follow the federal treatment of distributions (i.e., beneficiaries pay tax on distributed DNI). But some states may tax the trust and beneficiary on the same income in certain cases (credit is usually given to avoid double tax). Also, if a trust has income from a business or real estate in one state, that state will claim tax on that income even if the trust is based elsewhere. Capital gains from the sale of real estate are sourced to the state where the property is located. So, for example, if a trust in Florida (no tax) sells property in California, California will tax that capital gain as source income, trust or no trust.
Other States: Every state has unique criteria. For instance, some states tax trusts if the grantor was a resident or if the trust is administered within the state, sometimes at a flat rate. These differences are quite technical, but the lesson is that state trust taxation varies wildly.

In summary, the state where a trust is considered a resident can significantly impact whether capital gains should be distributed or retained:

In high-tax states, distributing gains to beneficiaries who live in lower-tax jurisdictions can save state tax (assuming it’s permissible).
In some cases, relocating the trust (changing trustees or situs) to a no-tax state can eliminate state tax on trust capital gains.
Always consider both the trust’s state and the beneficiaries’ states. A distribution might shift tax from the trust’s state to the beneficiary’s state (for better or worse, depending on those states’ rates).

Because state rules are complex and ever-changing, consult a trust tax expert or attorney in the relevant states to optimize state income tax results.

FAQs: Trusts and Capital Gains Distributions 🤔

Below we answer some common questions from forums and discussions about trust capital gains.

Q: Do trust beneficiaries pay taxes on capital gains distributions from a trust?
A: Yes. If a trust properly distributes capital gains and issues a K-1 showing those gains, the beneficiaries must report and pay tax on them. Otherwise, no, the trust pays.

Q: Can a simple trust distribute capital gains to the beneficiary?
A: No. A simple trust by definition only distributes income. Since capital gains are principal, they stay in the trust and cannot be passed to the beneficiary as income.

Q: Does an irrevocable trust pay capital gains tax?
A: Yes, if it’s a non-grantor irrevocable trust and it doesn’t distribute the gains to beneficiaries, the trust will pay the capital gains tax (often at the highest rate due to low brackets).

Q: Are capital gains considered income for trust distribution purposes?
A: No. Generally capital gains are considered principal, not income, for trust accounting and distribution requirements. They become distributable income only if the trust terms or law permit treating them as income.

Q: Can a trustee avoid taxes by distributing trust assets in-kind instead of selling?
A: Yes – in a way. In-kind distributions of appreciated assets let the trust avoid realizing capital gains. The beneficiary takes the asset at the trust’s basis and only owes tax when selling later.