How Are Capital Losses Handled in a Trust? (w/Examples) + FAQs

Can a Trust’s Capital Losses Lower My Personal Taxes?

No, not during the trust’s normal operation. When a trust sells an asset like a stock for less than its purchase price, that capital loss belongs to the trust itself, not to you as a beneficiary. The loss is effectively “trapped” inside the trust and cannot be passed out to you to offset your personal capital gains in a typical year.

The primary conflict arises from a specific rule in the U.S. tax code: Internal Revenue Code § 643(a). This section defines a trust’s “Distributable Net Income” (DNI), which is the pipeline that carries taxable income from the trust to its beneficiaries. The law explicitly excludes capital gains and losses from this DNI calculation.

The immediate negative consequence is that a trust can have a massive capital loss on paper, yet beneficiaries with their own significant capital gains receive no tax benefit from it. This valuable tax asset can be wasted, year after year, simply because it’s locked inside the trust’s legal structure. This issue is magnified by the reality of trust tax rates; for 2025, a trust hits the highest federal income tax bracket of 37% at just $15,650 of retained income.

This article will demystify the entire process. You will learn how to navigate these complex rules to preserve asset value and ensure tax efficiency.

Understand the Core Problem 🧐: We’ll break down exactly why capital losses get “trapped” inside a trust and the specific tax code that creates this frustrating situation.
Identify Your Trust Type 🗂️: Learn the critical differences between Grantor, Non-Grantor, Simple, and Complex trusts, and see how this classification completely changes who is responsible for taxes.
Unlock Trapped Losses 🔑: Discover the single most important exception—the “final year” rule under IRC § 642(h)—that allows a trust’s accumulated losses to finally pass through to beneficiaries.
Master Proactive Strategies 📈: Go beyond basic compliance and learn how trustees can use tax-loss harvesting to actively manage the trust’s tax liability and fulfill their fiduciary duties.
Avoid Costly Mistakes ❌: We will detail the most common and damaging errors trustees make, from improper record-keeping to misunderstanding state tax laws, and show you how to avoid them.

Deconstructing the Trust: A Universe of Its Own

A trust is a distinct legal and financial universe with its own set of players and rules. To understand how losses are handled, you must first understand its core components.

Who Are the Key Players in a Trust?

The Grantor is the person who creates the trust and funds it with assets. Their intent, documented in the trust agreement, guides all trust activities.

The Trustee is the manager of the trust universe. The trustee has a legal and ethical obligation, known as a fiduciary duty, to manage the trust’s assets solely for the benefit of the beneficiaries. This includes making prudent investments, keeping meticulous records, and filing the trust’s taxes.

The Beneficiary is the person or entity for whom the trust was created. There are often two types: an Income Beneficiary, who receives income generated by the trust, and a Principal Beneficiary, who receives the trust’s core assets when the trust terminates.

The Two Worlds of Trust Assets: Principal vs. Income

Imagine a trust is an apple orchard. The land and the apple trees are the principal. The apples harvested each year are the income.

The principal, also known as the corpus, is the core property of the trust—stocks, bonds, or real estate. When a trustee sells one of these core assets, any resulting profit or loss is a capital gain or capital loss. By default, all capital gains and losses are allocated to the trust’s principal.

Income is what the principal generates, such as stock dividends or bond interest. This is the “fruit” that is typically distributed to the income beneficiaries. This distinction is the absolute key to understanding trapped losses.

The Core Problem: Why Your Trust’s Losses Are Not Your Own

When a person sells a stock at a loss, they can use that loss to lower their taxes. When a trust does the exact same thing, a completely different set of rules applies.

Your Trust Is Its Own Taxpayer

A non-grantor trust is viewed by the IRS as a brand-new, separate taxpayer. It must get its own Taxpayer Identification Number (TIN) and file its own annual tax return, Form 1041.

Because the trust is its own taxpayer, the financial events that happen inside it belong to the trust entity itself. A capital loss is an asset on the trust’s books, not the beneficiary’s.

The Tax Code’s Choke Point: Distributable Net Income (DNI)

The IRS keeps that loss locked inside the trust using a formula called Distributable Net Income (DNI). Think of DNI as a filter that determines which types of income can pass through to the beneficiaries. The DNI calculation, defined by Internal Revenue Code § 643(a), is specifically designed to exclude capital gains and losses allocated to the trust’s principal.

Since the capital loss is not included in DNI, it cannot be distributed to a beneficiary. Even if the trustee gives a beneficiary cash from the principal, that distribution is a non-taxable transfer. The capital loss remains behind, “trapped” within the trust’s tax return.

Inside the trust, this trapped loss is used to offset the trust’s own capital gains. If losses remain, the trust can deduct up to $3,000 against its ordinary income. Any remaining loss is then carried forward indefinitely for the trust to use in future years.

The Great Divide: Is Your Trust a Grantor or Non-Grantor Type?

Not all trusts are created equal. The most important question you must ask is whether the trust is a grantor or non-grantor type. The answer completely changes the tax implications.

A grantor trust is typically a trust where the creator keeps a certain level of control, like a revocable living trust. The IRS “looks through” the trust and treats the grantor as the direct owner of the assets for tax purposes. The concept of “trapped losses” does not exist here.

A non-grantor trust is typically an irrevocable trust where the creator has given up control. This is the default type of trust where the entity is its own taxpayer. All the rules about trapped losses, DNI, and carryovers are in full force.

A Deeper Distinction: Simple vs. Complex Trusts

Non-grantor trusts are further broken down into “simple” and “complex” trusts. A simple trust must distribute all its income annually, cannot distribute principal, and cannot make charitable donations. Because capital losses are part of the principal, they are automatically trapped in a simple trust by its definition.

A complex trust is any trust that is not a simple trust and has more flexibility. While a complex trust can distribute principal, this action does not carry the capital loss with it for tax purposes due to the DNI rules. In any year other than the final year, both trust types will trap capital losses inside the entity.

The Great Escape: Freeing Losses in the Trust’s Final Year

There is one powerful, legally defined moment when the walls of the trust come down. When a trust terminates, its trapped losses can finally escape to the beneficiaries.

How IRC § 642(h) Unlocks the Value

This specific section of the tax code provides the exception. Upon the final termination of a trust, any unused short-term or long-term capital loss carryovers are allowed to be distributed to the beneficiaries. The law recognizes that the beneficiaries who inherit the assets should also inherit the trust’s final tax attributes.

The Step-by-Step Process for Releasing Losses

The process is precise. The trustee must check the “Final return” box on the trust’s Form 1041. This is the official signal to the IRS that the special rules of § 642(h) are now in play.

The trustee reports these distributable losses on Schedule K-1 (Form 1041). This is the form that tells each beneficiary their share of the trust’s tax items. The losses appear in Box 11, “Final year deductions”, using specific codes.

Code B: Short-Term Capital Loss Carryover
Code C: Long-Term Capital Loss Carryover

Once you receive a final Schedule K-1 with a loss in Box 11, that loss is now yours. You report it on your personal Form 1040, using Schedule D (Capital Gains and Losses). The character of the loss is preserved; a long-term loss from the trust remains a long-term loss for you.

Real-World Scenarios: How Trust Losses Play Out

Let’s move from theory to practice with three common scenarios.

Scenario 1: The Trapped Stock Loss

The Miller Family Irrevocable Trust has $10,000 in dividend income. The trustee sells a stock at a $20,000 long-term capital loss. The beneficiary, Sarah, has her own $15,000 capital gain.

Trust’s Action	Tax Consequence
Realizes $20,000 Capital Loss	The loss belongs to the trust, not Sarah. It is “trapped” inside the trust’s tax return.
Applies Loss to Trust’s Income	The trust uses $3,000 of the loss to offset its dividend income. The trust’s taxable income is reduced to $7,000.
Carries Forward Remaining Loss	The trust carries forward the remaining $17,000 long-term capital loss to use in future years.
Sarah’s Tax Situation	Sarah receives no benefit from the trust’s loss. She must pay capital gains tax on her full $15,000 personal gain.

Scenario 2: The Final Year Windfall

The Davis Trust is terminating. It has a $100,000 unused long-term capital loss carryover. The assets are distributed equally to two beneficiaries, Tom and Maria.

Trustee’s Final-Year Action	Consequence for Beneficiaries
Files Final Form 1041	The trustee checks the “Final return” box, triggering the IRC § 642(h) pass-through rules.
Issues Final Schedule K-1s	Tom and Maria each receive a Schedule K-1 showing a $50,000 long-term capital loss carryover in Box 11, Code C.
Tom’s Situation (Has Gains)	Tom has a $40,000 personal capital gain. He uses the distributed loss to wipe out his gain, deducts $3,000 from his salary, and carries forward the remaining $7,000 loss.
Maria’s Situation (No Gains)	Maria has no capital gains. She uses $3,000 of her distributed loss to reduce her taxable income and carries forward the remaining $47,000 loss.

Scenario 3: The Inherited Home Sale

A home is held in an irrevocable trust for two children, Ben and Chloe. Neither has used the home personally. The trustee sells the home for $50,000 less than its value on their father’s date of death.

Trustee’s Decision	Tax Outcome
Sells Home at a Loss	Because the home was not used for personal purposes, it is treated as investment property. The $50,000 loss is a deductible capital loss.
Loss is Trapped	The loss belongs to the trust. It cannot pass to Ben and Chloe unless the trust terminates.
Hypothetical: Ben Lives in Home	If Ben had lived in the home, the property would be reclassified as personal-use property.
Consequence of Personal Use	Losses on the sale of personal-use property are *not deductible*. The entire $50,000 tax deduction would be permanently forfeited.

Proactive Management: The Art of Tax-Loss Harvesting

A trustee’s job is to actively manage the trust’s assets, which includes smart tax management. The most powerful tool for this is tax-loss harvesting. This is the practice of strategically selling investments at a loss to realize that loss for tax purposes, which can then offset realized capital gains.

This is especially critical in a trust because of its compressed tax brackets. A trustee cannot simply sell a stock to get the loss and then buy it right back. The IRS’s wash-sale rule disallows a loss deduction if you sell a security and buy the same or a “substantially identical” one within 30 days before or after the sale.

The Pros and Cons of Tax-Loss Harvesting in a Trust

Pros	Cons
Reduces High Trust Taxes: Directly offsets gains that would be taxed at punishingly high rates.	Increased Accounting Costs: Active trading generates more transactions, which can increase fees for trust accounting and tax preparation.
Fulfills Fiduciary Duty: Proactively managing tax liability is a key part of the duty to preserve trust principal.	Court Scrutiny: Frequent trading can be misconstrued as “churning” the account, requiring the trustee to defend their strategy.
Rebalances the Portfolio: Provides an opportunity to sell underperforming assets and reinvest in ones with better prospects.	“Carry Value” Confusion: Court reviewers often look at an asset’s value when the trustee took over, not its original cost basis, which can make a harvested loss look like poor performance.
Generates Carryover Losses: Unused losses can be carried forward to offset future gains within the trust.	Risk of Wash Sale Violation: A careless trustee could accidentally violate the wash-sale rule, negating the entire strategy.
Improves Long-Term Returns: The money saved on taxes can be reinvested, allowing it to compound over time.	Small Mismatches: The replacement investment may not perform identically to the one sold, creating a performance gap.

The Trustee’s Minefield: 7 Costly Mistakes to Avoid

A trustee’s failure to properly handle tax matters can lead to personal liability and erode the trust’s value.

Filing Late or Not at All
- The IRS imposes significant failure-to-file and failure-to-pay penalties, with compounding interest, which are paid from trust assets.
Misreporting the Schedule K-1
- This causes a mismatch with the IRS’s records, triggering audits for both the trust and the beneficiaries and forcing everyone to file amended returns.
Poor Record-Keeping
- It becomes impossible to accurately calculate gains and losses. If a beneficiary sues, the trustee cannot produce records to defend their actions and can be held personally liable.
Failing to Make Estimated Tax Payments
- If a trust has taxable income, it is required to make quarterly estimated tax payments. Failure to do so results in underpayment penalties and interest.
Ignoring State Tax Laws
- The trustee could miscalculate state tax liability or fail to file a required state return, leading to state-level penalties.
Misunderstanding Asset Characterization
- Allowing a beneficiary to use a trust asset personally can change its character from “investment” to “personal use,” causing a valuable capital loss deduction to be permanently forfeited.
Passive Management
- Simply holding assets without a proactive tax strategy, such as tax-loss harvesting, can lead to unnecessarily high taxes, violating the fiduciary duty to preserve the principal.

The State Law Maze: A Patchwork of Contradictory Rules

Federal tax law is only half the battle. State tax law is a completely different and often contradictory world. A trustee must be aware of the laws in the state where the trust is administered.

Pennsylvania: The state’s rules are particularly harsh. Pennsylvania law does not permit a loss from one class of income to offset gains in another, and it does not permit the carryforward of capital losses to other tax years.
Alabama: In a direct contradiction to federal law, an official FAQ from Alabama’s Department of Revenue states that an excess loss on the termination of an irrevocable trust may not be passed on to the beneficiary.
Washington: Washington has its own state-level capital gains tax and prohibits carrying forward any capital losses that occurred before January 1, 2022.
Illinois: Illinois requires trusts with any net income or loss to file a specific fiduciary return, Form IL-1041, and has its own form for amending returns to carry a net loss to another year.

Frequently Asked Questions (FAQs)

1. Can a trust’s capital loss offset my salary? Yes, but only if the loss is passed to you in the trust’s final year. You would first use it against capital gains, then deduct up to $3,000 of any remaining loss against your salary.

2. What happens if a trust terminates with both gains and losses? No, the trust first nets its own gains and losses. If a net loss remains, it can be passed to you. If a net gain remains, the trust or beneficiaries will be responsible for the tax.

3. Does the holding period matter when a loss is passed through? Yes, the character of the loss is preserved. A long-term capital loss from the trust is treated as a long-term loss on your personal tax return, and the same is true for short-term losses.

4. Can I refuse a capital loss distribution from a terminating trust? No. The distribution of tax attributes like a capital loss carryover under IRC § 642(h) is an automatic function of the law upon trust termination. It is allocated among the succeeding beneficiaries.

5. Who is responsible for tracking the carryover after it’s distributed? You are. Once the loss is reported on your Schedule K-1 and you claim it on your tax return, it becomes your personal capital loss carryover to track and use in future years.

6. If a trust sells my inherited home at a loss, can I deduct it? No, not directly. The loss belongs to the trust. You can only benefit if the trust terminates and passes the loss to you, and only if the home was not considered your personal-use property.

7. Does a revocable living trust trap capital losses? No. A revocable trust is a grantor trust. For tax purposes, it’s ignored, and all capital losses are reported directly on the grantor’s personal Form 1040 tax return as if they owned the assets personally.