When it comes to estate planning in Orange County, California, living trusts are often touted as a powerful tool for avoiding probate and ensuring your assets pass seamlessly to your heirs. However, the question many people don't ask—and should—is whether living trusts create additional tax concerns. While a living trust can provide incredible benefits, there are some critical tax implications you need to understand to avoid costly mistakes. Let's explore the potential pitfalls and why not having a properly structured trust might be even riskier.

For a deeper understanding of living trusts and their benefits, read our article on How a Living Trust Works to Protect Your Home in California.

What is a Living Trust?

A living trust is a legal entity created to hold your assets during your lifetime and distribute them upon your death, bypassing probate court. While it's often marketed as a simple solution, the tax ramifications of creating and maintaining a living trust are anything but straightforward. The good news is that with proper planning, you can navigate these challenges—but ignoring them could spell disaster.

Income Taxes and Living Trusts

For most people, a revocable living trust does not create any additional income tax concerns. Here's why:

1. Tax Identification Number (TIN): As long as the trust is revocable, it uses your Social Security Number as its TIN. This means there's no need for a separate tax return while you're alive. The income generated by trust assets is reported on your personal tax return, just as it would be if the assets were held in your name.

2. Revocable vs. Irrevocable Trusts: A revocable trust allows you to maintain control over the assets and amend the trust as needed, so it's considered a “pass-through” entity for tax purposes. By contrast, an irrevocable trust—often created for advanced estate tax planning—may require a separate tax ID and its own tax filings, which can complicate matters.

Example: John, a resident of Newport Beach, places his rental property in a revocable living trust. The rental income is reported on his personal tax return. However, if John converts the trust to irrevocable status, the trust may need to file its own tax return, and any income retained in the trust could be taxed at much higher rates (with the top federal rate kicking in at just $14,450 in 2024).

Capital Gains Tax Concerns

One common myth is that placing real estate or other assets in a living trust triggers capital gains taxes. This is not true for revocable living trusts. Since you maintain control over the trust and are still considered the owner for tax purposes, transferring assets into the trust does not result in a taxable event.

However, problems can arise in poorly executed plans:

• Step-Up in Basis: If the trust is not properly structured, your heirs may lose the benefit of a step-up in basis at your death. This could lead to significant capital gains taxes when they sell inherited property.

Example: Susan owns a home in Laguna Beach worth $2 million, with an original purchase price of $500,000. Upon her death, the home's value would typically be stepped up to $2 million, eliminating any capital gains if her heirs sell immediately. But if the home is in an improperly structured trust, they might lose this benefit and face $1.5 million in taxable gains.

Property Taxes and Proposition 19

In California, Proposition 19 has introduced a new layer of complexity to property tax reassessments when transferring property to heirs. While a living trust can protect against probate, it does not inherently shield you from property tax reassessments.

• Parent-to-Child Exclusion: Before Prop 19, parents could transfer their primary residence to their children without reassessment, regardless of its value. However, Prop 19 limits this exclusion to situations where the child also uses the property as their primary residence.

• Special Considerations for Trusts: If your property is held in a trust, it's critical to ensure the trust's terms align with Prop 19's requirements. Failure to do so can result in a reassessment at current market value, leading to a significant tax increase.

Example: The Smith family's Irvine home has been in their revocable living trust for decades. When the parents pass, their children plan to rent it out. Under Prop 19, the property will be reassessed to its full market value, resulting in a massive property tax hike unless careful planning is in place.

To learn more about how Proposition 19 impacts living trusts, see our post Does Your Living Trust Protect Your Family from Proposition 19 Pitfalls? Here's What You Need to Know.

Estate Taxes and the Federal Threshold

For most Orange County residents, federal estate taxes may not be an immediate concern, given the current exemption of $12.92 million per individual (as of 2023). However, this exemption is set to drop significantly in 2026, unless Congress acts.

If your estate approaches or exceeds the threshold, an irrevocable trust might be necessary to minimize estate tax exposure. A poorly executed estate plan, however, can leave your heirs facing a hefty tax bill.

Case Reference: The landmark California case Estate of Powell (2014) underscores the importance of proper trust planning. In this case, the mishandling of a trust resulted in unnecessary estate taxes, demonstrating how small errors can lead to significant financial consequences.

Avoiding Costly Pitfalls

Not having a living trust—or having an improperly structured one—can lead to:

• Unnecessary probate costs and delays.
• Exposure to audits or challenges from the Franchise Tax Board.
• Loss of key tax benefits, including the step-up in basis.
• Significant property tax increases under Prop 19.

These are not hypothetical risks. Every year, countless Californians face avoidable financial and legal troubles because their estate plan was inadequate, outdated, or nonexistent.

For insights into common estate planning mistakes and how to avoid them, consider reading Will Power: Demystifying Estate Planning in Orange County.

What Should You Do?

1. Review Your Current Estate Plan: If your living trust was created years ago, it may not account for recent changes in California law, including Prop 19.
2. Consult an Expert: DIY solutions or generic plans often overlook nuanced tax implications, leaving you or your heirs exposed to unnecessary liabilities.
3. Plan for the Future: With the federal estate tax exemption set to shrink, now is the time to ensure your trust is structured to maximize tax efficiency and protect your legacy.

Take Action Today

The risks of not having a properly structured living trust are far too great to ignore. Whether you're concerned about income taxes, property taxes, or long-term estate planning, our firm is here to help. With years of experience serving clients in Orange County, we specialize in creating tailored solutions that protect your assets and give you peace of mind.

Contact us today at (949) 305-8642 or visit www.jamesburnslaw.com to schedule a consultation. Don't leave your legacy to chance—let us help you secure it.

• Do living trusts affect taxes in California?
• Tax concerns with living trusts in Orange County
• How Proposition 19 impacts property taxes in a trust
• Do you need a trust for estate planning in California?
• Living trust tax implications
• Avoiding property tax reassessment with a trust
• Does a living trust trigger capital gains tax?
• Estate planning in Orange County
• Legal tips for trusts and taxes in California