Can I Use Trusts to Minimize Capital Gains on CRE? (w/Examples) + FAQs

Yes, you can absolutely use specific types of irrevocable trusts to legally and effectively minimize, defer, or even eliminate capital gains taxes on the sale of your commercial real estate (CRE). This is not a loophole but a set of powerful, established strategies recognized by the IRS.

The primary conflict every CRE investor faces is rooted in Internal Revenue Code (IRC) Section 1001. This federal law mandates that when you sell a property, the entire profit you make is considered a “gain” that must be recognized as taxable income in the year of the sale. This rule directly clashes with your goal of preserving and growing your wealth, as it forces a substantial portion of your hard-earned profit—sometimes over 30% when combining federal and state taxes—to be paid to the government, drastically reducing the capital you have left to reinvest.

Consider that the average annual appreciation for commercial property has been significant over the past few decades, leading to massive embedded gains for long-term holders. ³ When you sell, you are not just paying tax on that appreciation; you are also paying a “depreciation recapture” tax of up to 25% on the depreciation deductions you’ve taken over the years. ⁴ These combined taxes can turn a successful exit into a major financial setback.

This article will provide you with a clear, actionable roadmap to navigate this challenge. You will learn:

✅ The critical difference between a revocable “living” trust, which offers zero capital gains tax savings, and an irrevocable trust, which is the essential tool for these strategies.
💡 Three powerful trust strategies—the Charitable Remainder Trust (CRT), Deferred Sales Trust (DST), and Intentionally Defective Grantor Trust (IDGT)—and a clear guide on which type of investor should use each one.
🔄 How to use the popular 1031 exchange with a special type of trust, the Delaware Statutory Trust (DST), to defer taxes and transition from an active landlord to a completely passive real estate investor.
❌ The most common and costly mistakes people make when setting up trusts for real estate—and exactly how you can avoid them to protect your assets and your family.
⚖️ The specific IRS rules you must follow to ensure your trust strategy is 100% legal and does not fall into the category of an “abusive tax scheme” that could lead to severe penalties.

The Core Problem: Understanding the Capital Gains Tax Hit

Why Selling Your Property Triggers a Massive Tax Bill

When you sell a commercial property for more than you paid for it, the profit is called a capital gain. The government taxes this profit. The amount of tax you pay depends on how long you owned the property.

If you owned it for one year or less, it’s a short-term capital gain. This is taxed at your regular income tax rate, which can be as high as 37% at the federal level. ¹ Most CRE investors hold property for longer than a year to avoid these high rates.

If you owned the property for more than one year, it’s a long-term capital gain. This is taxed at lower federal rates of 0%, 15%, or 20%, depending on your total income. ¹ For most successful CRE investors, the rate is typically 15% or 20%.

But that’s not the only tax. You also have to deal with depreciation recapture. Over the years you owned the property, you likely took depreciation deductions on your taxes to lower your taxable income. When you sell, the IRS “recaptures” a portion of your gain related to those deductions and taxes it at a rate of up to 25%. ⁴ When you add state capital gains taxes, which can be over 13% in states like California, the total tax bill can easily exceed 30% of your profit. ⁵

What Is a Trust, and Who Are the Key Players?

Before diving into strategies, it’s essential to understand what a trust is. Think of a trust as a legal container or a rulebook for holding and managing your assets. It’s a fiduciary arrangement, which is just a fancy way of saying it’s built on a duty of trust and loyalty.

There are three main roles involved in every trust: ⁶

The Grantor (or Settlor): This is you. You are the person who creates the trust and transfers your assets (like your commercial property) into it.
The Trustee: This is the manager. The trustee is the person or institution (like a bank or trust company) responsible for managing the assets in the trust according to the rules you’ve set. They have a legal duty to act in the best interests of the beneficiaries. ⁸
The Beneficiary: This is the person, group of people, or organization (like a charity) who will benefit from the trust. They receive the income or assets from the trust as specified in your rules.

These three roles are the building blocks of any trust structure, from the simplest to the most complex. The way these roles are defined and the powers they hold determine how the trust is treated for tax purposes.

The Single Most Important Concept: Revocable vs. Irrevocable Trusts

This is the most critical distinction in all of trust planning. Understanding this difference is the key to unlocking any tax-saving strategy. Failing to grasp this concept is why many people mistakenly believe their standard “living trust” will save them from capital gains taxes.

A Revocable Trust, often called a “living trust,” is a trust that you, the grantor, can change or cancel at any time. You can add property, remove property, change who the beneficiaries are, or dissolve the trust entirely. ⁹ Because you retain complete control, the IRS essentially ignores the trust for tax purposes.

For the IRS, the assets in your revocable trust are still your assets. Any income the trust generates is reported on your personal tax return. If you sell a property held in a revocable trust, the capital gain is taxed directly to you as if you sold it yourself. ¹⁰ A revocable trust offers no capital gains tax benefits. Its main purpose is to help your assets avoid the costly and public court process of probate after you die. ¹²

An Irrevocable Trust is the opposite. Once you create it and transfer assets into it, you generally cannot change or cancel it. You permanently give up control and ownership of those assets. ⁹ This act of giving up control is precisely what creates the powerful tax and asset protection benefits.

Because the assets are no longer legally yours, they are typically removed from your taxable estate, which can save on estate taxes. ¹² They are also generally protected from your future creditors or lawsuits. ¹⁰ Most importantly for our purposes, certain types of irrevocable trusts are treated as separate entities that can sell an asset in a way that legally avoids or defers the capital gains tax.

| Feature | Revocable Trust | Irrevocable Trust |

| :— | :— |

| Your Control | You keep full control. You can change or cancel it anytime. 10 | You give up control. It generally cannot be changed or canceled. 9 |

| Capital Gains Tax on Sale | No benefit. The gain is taxed directly to you as if you owned the property. 11 | Potential for major benefits. Can be structured to defer, reduce, or eliminate capital gains tax. 13 |

| Asset Protection | None. Your creditors can still access the assets in the trust. 10 | Strong protection. Assets are generally shielded from your future creditors and lawsuits. 10 |

| Estate Tax Status | No benefit. Assets are included in your taxable estate. 9 | Major benefit. Assets are removed from your taxable estate, reducing potential estate taxes. 12 |

| Primary Purpose | Avoid probate and manage assets if you become incapacitated. 12 | Advanced tax planning, asset protection, and generational wealth transfer. 13 |

The fundamental trade-off is clear: to gain significant tax and asset protection benefits, you must be willing to relinquish direct control over the asset by placing it in an irrevocable trust.

Who Pays the Tax? Grantor vs. Non-Grantor Trusts

For income tax purposes, the IRS further classifies trusts into two categories: grantor trusts and non-grantor trusts. This determines who is responsible for filing tax returns and paying taxes on the trust’s income.

A Grantor Trust is a trust where the grantor (you) retains certain powers, so the IRS disregards the trust for income tax purposes. All income, deductions, and credits are reported directly on your personal Form 1040 tax return, just as if you owned the assets yourself. ¹⁴ All revocable trusts are grantor trusts. Some special irrevocable trusts are also intentionally designed to be grantor trusts to achieve specific goals.

A Non-Grantor Trust is recognized by the IRS as a separate, tax-paying entity. It must get its own Taxpayer Identification Number (TIN) and file its own annual tax return, Form 1041. ¹⁴ This is where things get tricky. Non-grantor trusts are subject to highly compressed tax brackets.

For example, in 2024, a trust hits the top federal income tax rate of 37% after earning just $15,450 in income. ¹⁵ In contrast, a single individual doesn’t hit that rate until their income exceeds $600,000. Because of this, it is often very tax-inefficient for a non-grantor trust to hold onto its income.

Instead, these trusts typically distribute their income to the beneficiaries. The trust then gets a deduction for the income it distributes, and the beneficiaries report that income on their personal tax returns. ¹⁵ This shifts the income from the trust’s high tax bracket to the beneficiaries’ potentially lower individual tax brackets.

Three Core Strategies Using Irrevocable Trusts

Now that we have the foundational concepts, let’s explore the three most powerful and popular irrevocable trust strategies used by CRE investors to handle capital gains. The right choice depends entirely on your ultimate goal: Do you want to benefit charity, create a diversified income stream for yourself, or pass wealth to your heirs?

Strategy 1: The Charitable Remainder Trust (CRT) for the Philanthropic Investor

A Charitable Remainder Trust (CRT) is a tax-exempt irrevocable trust perfect for CRE investors who are charitably inclined and want to convert a highly appreciated property into a reliable income stream. ¹⁷ This strategy allows you to achieve four goals at once: avoid capital gains tax, create an income for yourself or others, get an immediate tax deduction, and leave a legacy to a charity you care about.

Here is how it works, step-by-step:

You Donate the Property: You transfer your appreciated commercial property into a specially designed irrevocable CRT. This removes the asset from your estate. ¹⁸
The Trust Sells the Property: The trustee sells the property for its full market value. Because the CRT is a tax-exempt entity under IRC Section 664, it pays zero capital gains tax on the sale. ¹⁸
The Trust Reinvests the Proceeds: The trustee takes the full, pre-tax sale proceeds (for example, the entire $5 million, not the $3.5 million you’d have left after taxes) and reinvests it into a diversified portfolio of income-producing assets like stocks and bonds. ¹⁸
You Receive an Income Stream: The trust pays you (or other beneficiaries you name) an income for a set term (up to 20 years) or for the rest of your life. ¹⁸
The Remainder Goes to Charity: When the trust term ends, whatever is left in the trust—the “remainder”—is donated to the charity or charities you designated. ¹⁸

In addition to avoiding the capital gains tax, you also get an immediate charitable income tax deduction in the year you fund the trust. ¹⁸ The amount of the deduction is based on a complex IRS calculation that considers the value of the property, the income stream you’ll receive, and your age.

There are two main types of CRTs: ¹⁷

Charitable Remainder Annuity Trust (CRAT): This pays you a fixed, predictable dollar amount each year. It’s like a pension.
Charitable Remainder Unitrust (CRUT): This pays you a fixed percentage of the trust’s value, which is recalculated annually. If the trust’s investments do well, your income goes up. If they do poorly, your income goes down.

The IRS has strict rules for CRTs. The payout rate must be between 5% and 50%, and the calculated value of the charitable remainder must be at least 10% of the initial contribution. ²⁰ Also, transferring a property with a mortgage into a CRT is highly problematic and can disqualify the trust, so this strategy works best for debt-free properties. ¹⁸

Investor Action	Direct Consequence
An investor transfers a $10M debt-free property (with a $3M cost basis) into a CRT.	The property is removed from the investor’s taxable estate, and they receive an immediate charitable tax deduction.
The CRT’s trustee sells the property for $10M.	No capital gains tax is paid. The full $10M is available for reinvestment, instead of ~$7.9M after tax. [19]
The trustee invests the $10M and pays the investor a 6% annual income ($600,000).	The investor receives a significantly larger income stream for life because it’s based on the pre-tax sale value.
The investor passes away.	The remaining assets in the trust are transferred to the designated charity, fulfilling the investor’s philanthropic goals.

Strategy 2: The Deferred Sales Trust (DST) for the Investor Seeking Diversification

The Deferred Sales Trust (DST) is a completely different strategy that is often confused with the Delaware Statutory Trust (discussed later). The DST is a proprietary legal strategy based on IRC Section 453, which governs installment sales. It is designed for investors who want to sell their property, defer the capital gains tax, and diversify their wealth into assets other than real estate, like a portfolio of stocks and bonds. ²¹

Unlike a CRT, there is no charitable component required. You get to keep all the proceeds for yourself over time.

Here is the unique, multi-step process:

You Establish the Trust: You work with a specialized third-party trustee to create a unique irrevocable DST. This must be done before you sell your property.
You Sell the Property to the Trust: You sell your appreciated CRE property to the DST. In exchange, the DST gives you a formal promissory note, which is an installment contract. This note details the payment terms (interest rate, principal payments) that the trust now owes you. ²¹
The Trust Sells the Property to the Buyer: The DST then turns around and sells the property to the end buyer for cash. The DST receives the full sale proceeds but pays no immediate capital gains tax. Its “cost basis” is the price it “paid” you for the property via the promissory note, so it has no gain to report. ²²
The Trust Reinvests and Pays You: The trustee invests the cash proceeds into a diversified portfolio of securities or other assets, as approved by you. The trust then makes payments to you over time according to the terms of the promissory note. ²²

The magic of this strategy is that you only pay capital gains tax as you receive principal payments from the trust. ²² This allows you to defer the tax liability over many years while the full, pre-tax sale proceeds are invested and generating returns for your benefit inside the trust. This provides far more flexibility than a 1031 exchange, which forces you to reinvest in more real estate.

Investor Action	Direct Consequence
An investor sells a $2M property to a Deferred Sales Trust in exchange for a promissory note.	The investor has not received cash, so no capital gains tax is immediately due. The tax is deferred.
The DST sells the property to an outside buyer for $2M cash.	The DST has a cost basis of $2M (the value of the note), so it recognizes no gain and pays no tax. The full $2M is invested.
The trust pays the investor interest-only payments for 10 years.	The investor pays ordinary income tax on the interest received but continues to defer the large capital gains tax.
The trust begins making principal payments to the investor in year 11.	The investor now pays a proportional amount of capital gains tax only on the principal they receive each year.

Strategy 3: The Intentionally Defective Grantor Trust (IDGT) for Generational Wealth Transfer

The Intentionally Defective Grantor Trust (IDGT) is a highly sophisticated estate planning tool, not a direct capital gains avoidance strategy for a sale to a third party. Its primary purpose is to “freeze” the value of an appreciating asset for estate tax purposes and transfer all future growth to your heirs (children or grandchildren) with minimal to no gift or estate tax. ²³

The name sounds strange, but it’s very descriptive. The trust is “defective” for income tax purposes, meaning it’s a grantor trust. The IRS sees you and the trust as the same person for income taxes. However, it is “effective” for estate tax purposes, meaning the assets are successfully removed from your taxable estate. ²³

This dual status creates a unique opportunity:

You Create and “Seed” the Trust: You establish an irrevocable IDGT for your children. You typically make an initial gift to the trust (the “seed money”) to give it economic substance, often around 10% of the asset’s value. ²⁴
You Sell the Asset to the Trust: You then sell your highly appreciating CRE property to the IDGT in exchange for a promissory note. The note’s interest rate is set at the minimum allowed by the IRS, known as the Applicable Federal Rate (AFR), which is often very low. ²³
The “Sale” is a Non-Event for Income Tax: Because the IDGT is a grantor trust, the IRS views the transaction as you selling the asset to yourself. A sale to yourself is not a taxable event. Therefore, no capital gains tax is recognized on this transfer. ²³
Future Growth Happens Outside Your Estate: The property is now inside the trust, and all its future appreciation and growth occur outside of your taxable estate. The only thing left in your estate is the promissory note with its low interest rate. All the growth passes to your heirs completely free of estate and gift taxes. ²⁴

As an added benefit, because it’s a grantor trust, you are personally responsible for paying the income taxes on any income the trust generates. The IRS views this tax payment not as a gift, but as you paying your own tax obligation. This allows you to make an additional “gift” to the trust each year without using up any of your gift tax exemption, further enhancing the wealth transfer. ²³

Investor Action	Direct Consequence
A high-net-worth investor sells a $15M CRE property to an IDGT for their children in exchange for a promissory note.	No capital gains tax is triggered. The IRS views this as a sale to oneself, which is a non-taxable event. ²³
The property appreciates to $25M over the next 10 years inside the IDGT.	The $10M of appreciation occurs completely outside the investor’s taxable estate, passing to the heirs free of estate tax.
The investor pays the income taxes on the rent generated by the property each year.	This is considered an additional, tax-free gift to the trust, allowing more wealth to accumulate for the heirs. ²³
The investor’s estate only includes the original $15M promissory note.	The investor has successfully “frozen” the asset’s value for estate tax purposes, transferring all future growth tax-efficiently.

The 1031 Exchange and Its Trust-Based Supercharger: The DST

The Section 1031 “like-kind” exchange is one of the most well-known tax deferral strategies in real estate. While not a trust itself, it is frequently used with a specific trust structure—the Delaware Statutory Trust (DST)—that has become a game-changer for many CRE investors.

What is a 1031 Exchange?

Under IRC Section 1031, you can sell an investment property and defer paying all capital gains and depreciation recapture taxes, provided you reinvest the proceeds into another “like-kind” investment property of equal or greater value. ²⁵ The term “like-kind” is very broad for real estate; you can exchange an office building for an apartment complex or raw land. ²⁶

The process has very strict rules and deadlines:

You must use a Qualified Intermediary to hold the sale proceeds. You cannot touch the money yourself. ²⁵
You must formally identify potential replacement properties within 45 days of selling your original property. ²⁶
You must close on the purchase of the new property within 180 days of the original sale. ²⁶

The 45-day identification deadline is notoriously difficult to meet, especially in competitive markets. This is where the Delaware Statutory Trust comes in.

The Delaware Statutory Trust (DST) Solution

A Delaware Statutory Trust (DST) is a legal entity that holds title to one or more large, institutional-grade commercial properties. ²⁷ The IRS issued a ruling in 2004 (Revenue Ruling 2004-86) that confirmed a beneficial interest in a properly structured DST is considered “like-kind” property for a 1031 exchange. ²⁹

Instead of scrambling to find and buy an entire property yourself, you can use your 1031 exchange funds to purchase a fractional interest in a pre-packaged DST. ²⁷ These DSTs are put together by large real estate firms called “sponsors,” who acquire the property, arrange financing, and handle all aspects of management. ²⁸

This structure has become incredibly popular for two main types of investors:

Investors who are tired of the “tenants, toilets, and trash” and want to transition to completely passive real estate ownership. ³⁰
Investors who are up against their 45-day deadline and need a reliable, pre-vetted replacement property to close on quickly. ³⁰

DSTs allow individual investors to own a piece of massive, high-quality assets—like a portfolio of medical office buildings or a distribution center leased to Amazon—that they could never afford on their own. ³²

Weighing the Good and the Bad: Pros and Cons of DSTs

DSTs offer a compelling solution, but they are not without significant trade-offs. You are exchanging active control for passive income, and that comes with its own set of risks.

Pros of Delaware Statutory Trusts	Cons of Delaware Statutory Trusts
Completely Passive Management: The sponsor handles all management duties. This is ideal for investors seeking to retire from being a landlord. ³⁰	Total Lack of Control: You have zero say in any management decisions, from leasing to capital improvements to when the property is sold. [30, 33]
Access to Institutional-Grade Assets: You can own a fractional share of large, high-quality properties that are typically inaccessible to individual investors. ³²	Highly Illiquid: Your investment is locked in for a long holding period, typically 5-10 years. There is no established secondary market to sell your interest early. [33, 34]
Portfolio Diversification: You can spread your 1031 proceeds across multiple DSTs, diversifying by property type, geography, and sponsor. ³⁰	Significant Fees: DSTs come with multiple layers of fees, including upfront acquisition fees, ongoing asset management fees, and disposition fees that reduce your overall return. [33, 35]
Non-Recourse Financing: The debt used by the DST is typically non-recourse to you personally, limiting your liability to your equity investment. [32, 29]	Sponsor Risk: Your investment’s success is entirely dependent on the expertise, integrity, and performance of the sponsor company. [35]
Speed and Certainty of Closing: DSTs are “pre-packaged” and can often close in 3-5 days, making them a reliable backup to meet the strict 1031 deadlines. [30, 34]	Regulatory Restrictions (The “Seven Deadly Sins”): The trust is bound by strict IRS rules that limit the trustee’s ability to adapt to changing market conditions, such as renegotiating leases or raising new capital. ²⁹

Putting It All Together: A Practical Guide to Setting Up Your Trust

Translating these complex strategies from theory into practice requires a careful, step-by-step process. An error at any stage can undermine the entire structure.

The Step-by-Step Process of Creating and Funding a Real Estate Trust

While the specifics will vary based on the type of trust, the general roadmap for establishing a trust and funding it with your commercial property is as follows: ³⁶

Step 1: Clearly Define Your Goals.

First, you must decide what you want to achieve. Is your primary goal to avoid capital gains tax, create a retirement income stream, protect assets from creditors, or pass wealth to your children? Your answer will determine which type of trust is right for you. 38

Step 2: Choose Your Key Parties.

You need to formally name the essential roles:

Trustee: Who will manage the trust? For a simple revocable trust, it’s usually you. For complex irrevocable trusts, you may need an independent third party or a professional corporate trustee. ³⁸
Successor Trustee: This is critical. Who takes over as trustee if the initial trustee can no longer serve (due to death, incapacity, or resignation)? ³⁷
Beneficiaries: Who will benefit from the trust? Be specific. Name primary beneficiaries and also contingent (backup) beneficiaries. ³⁸

Step 3: Hire an Experienced Attorney to Draft the Trust Document.

This is not a do-it-yourself project. You need a qualified estate planning or trust attorney to draft the legal document. 39 This document is the rulebook for your trust and must be customized to your goals and comply with both federal and state laws.

Step 4: Sign and Notarize the Trust Document.

To make the trust a legally valid instrument, you must sign the document in front of a notary public, as required by your state’s law. 37 This officially brings the trust into existence, but it’s still just an empty shell.

Step 5: FUND THE TRUST.

This is the most important and most commonly failed step. An unfunded trust is completely useless. 40 For your commercial real estate, funding the trust means formally transferring the title of the property from your name into the name of the trust.

This is done by preparing and executing a new deed. The deed will change the owner from, for example, “Jane Smith” to “Jane Smith, as Trustee of the Smith Family Irrevocable Trust.” This new deed must then be recorded with the county recorder’s office where the property is located. ⁸ Only then does the trust legally own the property.

You Need a Professional Team

Implementing these strategies requires a coordinated team of specialists. Trying to do this alone is a recipe for disaster. Your team should include: ⁴¹

Estate Planning Attorney: This is your quarterback. They provide the strategic legal advice, draft the trust documents, and ensure the entire structure is legally sound and compliant. ⁴²
Certified Public Accountant (CPA): Your CPA analyzes the tax implications of each strategy, advises on compliance, and prepares the necessary tax filings, such as the trust’s annual Form 1041 tax return. ¹⁸
Financial Advisor: Your financial advisor helps ensure the chosen strategy aligns with your broader financial plan, retirement goals, and risk tolerance. They often manage the investment of the trust’s assets after the property is sold. ²⁹
Corporate Trustee: For complex or long-term irrevocable trusts, using a professional corporate trustee instead of a family member can provide expertise, impartiality, and continuity. They are regulated, insured, and handle all administrative duties professionally. ⁴³

Mistakes to Avoid: Common and Costly Errors in Trust Planning

Even the most sophisticated plans can fail due to simple, avoidable mistakes. Here are the most common errors that can derail your trust strategy.

Failing to Fund the Trust. As mentioned, this is the number one mistake. You can have a perfectly drafted trust, but if you never record a new deed transferring your property into it, the trust owns nothing. Consequence: The property will likely have to go through probate, and any intended tax benefits will be lost. ⁴⁰
Choosing the Wrong Trustee. Naming a trustee who lacks financial expertise, is not impartial, or simply doesn’t have the time to manage the trust properly can lead to disaster. Naming adult children who don’t get along as co-trustees is a common way to guarantee family conflict. ⁴⁰ Consequence: Mismanagement of assets, costly legal battles between beneficiaries, and a failure to follow your wishes.
Using DIY or “Boilerplate” Trust Documents. Using a cheap online form for a multi-million dollar commercial real estate transaction is incredibly risky. These documents are often too generic and may not comply with your state’s specific laws or properly execute the advanced strategy you need. ³⁹ Consequence: The trust could be deemed invalid by a court or challenged by the IRS, leading to the very taxes and probate you were trying to avoid.
Ignoring State Laws. Trust and tax laws vary significantly from state to state. A strategy that works perfectly in one state may be ineffective or even create tax problems in another. This is especially true for state-level capital gains and income taxes. ⁴⁴ Consequence: You could face an unexpected and substantial state tax bill, even if you’ve successfully addressed the federal tax issues.
Setting It and Forgetting It. A trust is not a static document. Life changes—marriage, divorce, the birth of a child, a change in financial circumstances, or new tax laws—can all impact your plan. ⁴⁰ Consequence: Your trust becomes outdated and may no longer reflect your wishes or be effective for your current situation, potentially leading to assets going to the wrong people.

State Law Nuances: Why Your Location Matters

Federal tax law provides the framework for these strategies, but state laws add a critical and often expensive layer of complexity. Where you live and where your trust is legally based (its “situs”) can have a massive impact on your final tax bill.

The Impact of State Capital Gains and Income Taxes

The first major consideration is your state’s tax on capital gains. The benefits of a tax-deferral strategy are magnified in high-tax states.

High-Tax States: States like California (with a top rate of 13.3%), New York, and New Jersey impose significant state-level capital gains taxes on top of federal taxes. ⁵ In these states, a strategy that defers or eliminates tax can save you an enormous amount of money.
No-Tax States: On the other hand, eight states currently have no state capital gains tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Wyoming. ⁴⁵ If you are a resident of one of these states, your focus will be primarily on the federal tax implications.

Using Trust Situs for State Tax Planning

This is where advanced planning comes into play. For non-grantor trusts (which are separate tax-paying entities), it is sometimes possible to establish the trust in a state with more favorable tax laws. This is known as choosing the trust’s situs.

States like South Dakota, Nevada, Delaware, and Wyoming have become leading trust jurisdictions. ⁴⁶ They have enacted laws that are highly attractive for trust planning, including:

No state income tax on non-grantor trusts.
Strong asset protection statutes.
The ability to create perpetual “dynasty” trusts.

By working with an attorney and a trustee in one of these states, an investor from a high-tax state like California may be able to create a specific type of trust, often called a “Nevada Incomplete Gift Non-Grantor Trust” (NING) or a “Delaware Incomplete Gift Non-Grantor Trust” (DING). When structured correctly, the trust can sell an asset and, while federal capital gains tax would still be due, it may be possible to legally avoid the state-level capital gains tax. ⁴⁷ This strategy is highly complex and is under scrutiny by high-tax states, but it has become a primary driver for sophisticated trust planning.

Staying Legal: How to Avoid IRS Scrutiny

The IRS is well aware that trusts can be used for both legitimate tax planning and illegal tax evasion. They actively investigate and prosecute what they deem to be “abusive trust tax evasion schemes.” ⁴⁸ It is absolutely critical that your strategy is structured to be fully compliant with the law.

The guiding legal principle the IRS uses is “substance over form.” This means they look at the economic reality of a transaction, not just the fancy legal documents. ⁴⁹ If you set up a trust that looks good on paper but in reality, you still retain full control and benefit of the assets, the IRS will disregard the trust and tax you directly.

Warning Signs of an Abusive Trust Scheme

Promoters of illegal schemes often make promises that are too good to be true. Be extremely wary of anyone who makes the following claims: ⁴⁸

“You can eliminate all taxes on your income.”
“You can still maintain complete control over your assets.”
“You can deduct personal living expenses through the trust.”
“This is a secret strategy the IRS doesn’t want you to know about.”

Legitimate tax planning, like the strategies discussed in this article, involves a real and permanent change in your legal relationship to your assets. You are genuinely giving up control to an independent trustee in an irrevocable trust. ⁴⁸

The Consequences of Getting It Wrong

Participating in an abusive tax scheme can lead to severe civil and criminal penalties. This is not a risk worth taking. The potential consequences include: ⁴⁸

Payment of all back taxes, plus interest.
A civil fraud penalty of up to 75% of the underpaid tax.
Criminal prosecution, which can result in fines up to $250,000 and up to five years in prison for each offense.

The key to staying on the right side of the law is to work with a reputable team of experienced legal and tax professionals. Do not rely on promoters selling a one-size-fits-all “magic bullet” solution.

Frequently Asked Questions (FAQs)

Can I be the trustee of my own irrevocable trust?

No, not if the goal is tax reduction or asset protection. Serving as your own trustee gives you control that would cause the IRS to disregard the trust and include the assets in your estate.

If my trust avoids probate, does it also avoid estate tax?

No, this is a common and critical misunderstanding. A standard revocable living trust avoids probate but does not avoid estate tax. Only certain types of irrevocable trusts can remove assets from your taxable estate. 12

What is a “step-up in basis” and do trusts get it?

Yes, but it depends. A step-up in basis resets an asset’s cost basis to its market value at death, eliminating capital gains for heirs. Assets in a revocable trust get this step-up. Assets gifted to an irrevocable trust generally do not. 11

Can I put a mortgaged property into one of these trusts?

No, not easily. Transferring mortgaged property into a Charitable Remainder Trust can disqualify it. For other trusts, it can trigger a “due-on-sale” clause from your lender and creates complex gift tax issues. These strategies work best for debt-free properties. 18

Is it too late to set up a trust if I already have a buyer?

Yes, it is likely too late. The trust must be established and the property transferred into it before you enter into a binding sales contract. Doing it after can be seen by the IRS as a sham transaction. 13

What’s the difference between a Delaware Statutory Trust and a Deferred Sales Trust?

They are completely different. A Delaware Statutory Trust is a real estate ownership structure used for 1031 exchanges. A Deferred Sales Trust is a tax strategy that uses an installment sale to defer capital gains.