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Irrevocable Trusts and the Sec 121 Home Gain Exclusion

The Sec 121 gain exclusion can apply to a home held in an irrevocable trust, but there are specific conditions that must be met for the exclusion to apply. The key factor is whether the beneficiary of the trust (or the person with the beneficial interest in the home) meets the ownership and use tests outlined in IRC Sec 121.

For an individual to qualify for the Sec 121 exclusion, they must have owned and used the property as their principal residence for at least two out of the five years immediately preceding the sale. When a trust owns the property, the IRS looks at whether the beneficiary of the trust can be considered the owner for purposes of Sec 121 and whether they meet the use requirement. In most cases, when an irrevocable trust is the owner of the home, the Sec 121 exclusion won’t apply. But see the next paragraph for a potential narrow exception.

A private letter ruling (PLR 200104005) provides insight into how the IRS might apply these rules. In the scenario described in the ruling, a married couple transferred their residence to a revocable trust, which became irrevocable upon the death of the first spouse. The IRS concluded that the surviving spouse could use the Sec 121 exclusion, but only to the extent of their beneficial interest in the trust, which was determined by their power to withdraw principal from the trust. This indicates that the exclusion may be available on a limited basis depending on the terms of the trust and the beneficiary's rights under the trust.

It's important to note that private letter rulings are specific to the taxpayer who requested it and cannot be used or cited as precedent. However, they do provide insight into how the IRS might interpret the law in similar situations.

Therefore, whether the Sec 121 gain exclusion applies to a home in an irrevocable trust depends on the specific terms of the trust and the rights of the beneficiaries. To make this determination, the return preparer must read the trust document.

A moot point? - When a revocable trust becomes irrevocable due to the death of the grantor, the basis of the decedent’s personal residence is reset to the fair market value at the date of death. If the home is sold shortly thereafter, there will likely not be a taxable gain, especially when sales expenses are factored in. Thus, use of the Sec 121 exclusion becomes a moot point in that case.

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