Capital gains in an irrevocable trust are taxed in one of two ways: if the trust is a grantor trust, the gains flow through to the person who created it and are taxed at that individual’s rates; if it is a non-grantor trust, the trust itself pays the tax at sharply compressed brackets unless the gains are distributed to beneficiaries under specific rules. For 2026, a non-grantor trust hits the top 37% ordinary rate at just $16,000 of taxable income and the top 20% long-term capital gains rate above $16,250.1IRS. Rev. Proc. 2025-32 The 3.8% Net Investment Income Tax stacks on top of that. Getting the classification and the distribution mechanics right is what keeps a routine sale from turning into a punishing tax bill.
Grantor Trust or Non-Grantor Trust
Everything starts with whether the IRS treats the trust as a separate taxpayer. Under IRC Sections 671 through 679, an irrevocable trust is classified as a grantor trust when the person who created it kept certain powers over the property. Common triggers include the power to swap assets of equal value, the power to control who benefits from the trust, or the right to borrow from the trust without adequate security. Any one of these retained powers causes the entire trust to be ignored for income tax purposes.
In a grantor trust, all income, including capital gains, flows through to the grantor’s personal return. The grantor pays the tax at individual rates even if the trust distributed nothing. The trust still files Form 1041, but only as an informational return pointing back to the grantor’s Social Security number. Because individual brackets are much wider than trust brackets, this can be favorable. The grantor’s payment of the trust’s tax bill also effectively transfers value to the beneficiaries without using gift tax exemption.
A non-grantor trust is what you get when the grantor gave up all of those retained powers. The trust has its own taxpayer identification number, files its own Form 1041, and pays its own tax on gains it retains. The planning question becomes whether gains stay inside the trust at compressed rates or get pushed to beneficiaries at their typically lower rates.
Trust Tax Brackets for 2026
The rate compression is severe. For 2026, a non-grantor trust’s ordinary income is taxed at:1IRS. Rev. Proc. 2025-32
- 10% on taxable income up to $3,300
- 24% from $3,301 to $11,700
- 35% from $11,701 to $16,000
- 37% above $16,000
A married couple filing jointly does not reach the 37% bracket until taxable income exceeds $768,700.1IRS. Rev. Proc. 2025-32 A trust pays the same top rate on income the couple wouldn’t touch until nearly $769,000. Short-term capital gains, on assets held one year or less, use these ordinary rates and hit the ceiling almost immediately.
Long-term capital gains get preferential rates but face the same compressed thresholds. For a 2026 trust, gains up to $3,300 qualify for the 0% rate, gains between $3,300 and $16,250 are taxed at 15%, and anything above $16,250 is taxed at 20%.1IRS. Rev. Proc. 2025-32
The 3.8% Net Investment Income Tax
A non-grantor trust also owes the 3.8% Net Investment Income Tax on the lesser of its undistributed net investment income or the amount by which its adjusted gross income exceeds the threshold where the highest ordinary bracket begins.2Internal Revenue Service. Questions and Answers on the Net Investment Income Tax For 2026 that threshold is $16,000.3Internal Revenue Service. Topic No. 559, Net Investment Income Tax Capital gains, dividends, interest, and rental income all count as net investment income.
The combined federal picture: a non-grantor trust retaining long-term capital gains above $16,250 faces a top rate of 23.8%. On short-term gains above $16,000, the combined rate reaches 40.8%. Those numbers explain why trustees push capital gains out to beneficiaries whenever the trust instrument and local law allow it.
Cost Basis: What the Trust Starts With
Before calculating a gain, you need the trust’s basis in the asset. The rule depends on how the asset got there.
Assets Transferred During Life
When someone transfers an asset to an irrevocable trust while alive, the trust takes the transferor’s original basis. Stock bought for $50,000 and transferred to the trust keeps a $50,000 basis in the trust’s hands, and any eventual sale measures gain from that figure.4Office of the Law Revision Counsel. 26 USC 1015 – Basis of Property Acquired by Gifts and Transfers in Trust Decades of appreciation carry over with the asset.
If the asset’s fair market value on the transfer date is below the transferor’s basis, the trust’s basis for calculating a loss is capped at that fair market value. This blocks anyone from shifting a built-in loss into the trust.4Office of the Law Revision Counsel. 26 USC 1015 – Basis of Property Acquired by Gifts and Transfers in Trust
Step-Up at the Grantor’s Death
Property passing from a decedent generally receives a basis stepped up to its fair market value on the date of death, which can eliminate the tax on years of appreciation. For an irrevocable trust, the question is whether the assets are included in the grantor’s gross estate. Under Section 1014(b)(9), property required to be included in the decedent’s gross estate qualifies for the step-up whether or not it sits in a trust.5Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
That creates a trade-off built into most estate plans. Structuring a trust so its assets are included in the estate qualifies them for a step-up but exposes them to estate tax; structuring it so the assets are outside the estate avoids estate tax but forfeits the step-up.
The IRS closed a long-open question in 2023 with Revenue Ruling 2023-2: assets in an irrevocable grantor trust that are not included in the grantor’s gross estate do not receive a step-up when the grantor dies. If the trust was designed to keep property out of the taxable estate, that property keeps its carryover basis.
When a step-up does apply, the trustee needs documentation for the new basis, typically a qualified appraisal for real estate or closely held business interests. If the estate filed Form 706 and the beneficiary received a Schedule A to Form 8971, the basis reported must be consistent with the estate tax value or an accuracy-related penalty can apply.6Internal Revenue Service. Gifts and Inheritances
Pushing Gains Out to Beneficiaries
Because trust brackets are so compressed, the standard planning move is to shift capital gains onto beneficiaries’ personal returns. The mechanism is Distributable Net Income, or DNI.
Why Capital Gains Usually Stay Inside the Trust
DNI limits how much of a distribution the beneficiary must report as taxable income. Capital gains are generally excluded from DNI because they are allocated to trust principal rather than income. Under IRC Section 643(a)(3), gains stay out of DNI to the extent they are allocated to corpus and not distributed or set aside for charitable purposes.7Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D When gains sit outside DNI, the trust pays the tax at its own rates.
Three Ways to Get Gains Into DNI
Capital gains are included in DNI, and therefore taxed to the beneficiary, when any of the following applies: the trust document specifically requires capital gains to be distributed; the trustee has and exercises a power under local law to allocate gains to income; or the trust is terminating and all assets are being distributed. In the termination year, everything flows to the beneficiaries, tax liability included.
When a gain is properly distributed and included in DNI, the trust claims a distribution deduction on Form 1041 and the beneficiary receives a Schedule K-1 showing the amount and character.8Internal Revenue Service. Instructions for Form 1041 and Schedules A, B, G, J, and K-1 The character carries over, so a long-term gain distributed from the trust is a long-term gain on the beneficiary’s return.
The 65-Day Rule
Trustees rarely know exact income figures before year-end. Section 663(b) lets a trustee elect to treat distributions made within 65 days after the close of the tax year as if made on the last day of that year. For a calendar-year trust, distributions made by March 6 can count for the prior year. The election is irrevocable for that year and is made by checking a box on page 3 of Form 1041. It is where most of the after-the-fact planning value sits: the trustee can see the final numbers and then decide how much to send out.
Selling a Home Held in an Irrevocable Trust
The Section 121 exclusion lets an individual exclude up to $250,000 of gain ($500,000 for a married couple) on the sale of a principal residence, provided they owned and used the home for at least two of the five years before the sale. Whether a trust can claim it depends on classification.
In a grantor trust, the grantor is treated as the owner of the residence for tax purposes. If the grantor meets the two-year ownership and use tests, the exclusion applies to a sale by the trust as if the grantor sold personally.9eCFR. 26 CFR 1.121-1 – Exclusion of Gain From Sale or Exchange of a Principal Residence
A non-grantor irrevocable trust generally cannot claim the exclusion, even if a beneficiary lives in the home. The exclusion requires ownership by the taxpayer, and the trust, not the beneficiary, is the legal owner. The IRS has recognized a narrow exception where a beneficiary holds a withdrawal power over trust corpus that makes them a deemed owner of a portion of the trust under the grantor trust rules, and in that case the exclusion is limited to the portion the beneficiary is treated as owning. For most non-grantor trusts holding a residence, the full gain is taxable. This surprises many families who transferred a home into an irrevocable trust years earlier expecting the exclusion to still be available.
Capital Losses and What Happens When the Trust Ends
Losses inside a trust follow rules similar to those for individuals. They offset gains dollar for dollar, and up to $3,000 of any excess can offset other income each year. Unused net losses carry forward and keep their short-term or long-term character.
When the trust terminates, Section 642(h) sends any capital loss carryover that would have been available in a future year through to the beneficiaries who receive the remaining property. The losses keep their character, and the first year a beneficiary can use them is the year the trust terminates. With multiple beneficiaries, losses are split in proportion to each one’s share of the distributed property. The carryover period does not reset: the trust’s final year and the beneficiary’s first year each count toward it, so beneficiaries should use these losses promptly rather than assume they will sit indefinitely.10eCFR. 26 CFR 1.642(h)-1 – Unused Loss Carryovers on Termination of an Estate or Trust
Filing, Estimated Payments, and Penalties
A calendar-year trust must file Form 1041 and deliver Schedule K-1 to each beneficiary by April 15 of the following year.11Internal Revenue Service. Forms 1041 and 1041-A: When to File Extensions extend the filing deadline, not the payment deadline. If the trust expects to owe $1,000 or more after withholding and credits, the trustee must make quarterly estimated payments on Form 1041-ES.12IRS. 2026 Form 1041-ES – Estimated Income Tax for Estates and Trusts Given how fast trust income climbs the brackets, most non-grantor trusts with any investment activity clear that threshold.
Miss the deadline without an extension and the late-filing penalty runs at 5% of unpaid tax per month or partial month, capped at 25%. If the return is more than 60 days late, the minimum penalty is the lesser of $525 or the total tax due. A separate late-payment penalty of 0.5% per month runs on any unpaid balance, also capped at 25%, and interest accrues on top of both.8Internal Revenue Service. Instructions for Form 1041 and Schedules A, B, G, J, and K-1
One boundary worth flagging: state income tax on trusts is a separate exercise. States use different rules to decide when a trust is subject to their tax, some looking at where the trust was created, others at where the trustee sits, others at where beneficiaries live. A trust with connections to more than one state can owe tax in more than one. Any trust selling appreciated property should account for state liability alongside the federal figures.