When creating an estate plan, one of the most critical questions our clients ask is about taxes. Among the common concerns, the topic of capital gains tax often stands out, particularly for trusts. If you’re considering setting up a trust in Maryland or you already have one, you might be wondering, “Do trusts pay capital gains tax in Maryland?” The answer isn’t always straightforward as it depends on a variety of factors. At Frame & Frame Attorneys at Law, we aim to break down the complexities for you, ensuring your trust works in your best interest and aligns with Maryland’s tax regulations.

Understanding Trusts and Capital Gains Tax

To address whether trusts pay capital gains tax in Maryland, we must first define two key concepts.

What is a Trust?

A trust is a legal arrangement in which one party (the trustee) holds and manages property for the benefit of another (the beneficiary). Trusts are commonly used in estate planning to protect assets, reduce probate costs, and manage tax liabilities.

Trusts can broadly be divided into two main categories:

• Revocable Trusts (or Living Trusts): You retain control over the assets and income. Taxes are typically handled as if you still directly own the assets.
• Irrevocable Trusts: Once established, you relinquish certain rights to the trust. These trusts carry independent tax rules.

What Are Capital Gains Taxes?

A capital gains tax is a levy on the profit realized from the sale of an asset, such as real estate, stocks, or valuable collectibles. The tax rate can differ based on whether the gain is considered short-term (held for less than a year) or long-term (held for more than a year).

For trusts, how capital gains are assessed often depends on the trust type and how income—and gains—are distributed to beneficiaries.

When Do Trusts Pay Capital Gains Tax in Maryland?

Taxation rules for trusts often vary at the federal, state, and local levels. While Maryland does not have a specific capital gains tax, such gains are included in regular income for both individuals and trusts and are taxed accordingly.

1. Revocable Trusts

A revocable trust is treated as an extension of the grantor (the person creating the trust) for tax purposes. Therefore, capital gains earned by the trust are reported on the grantor’s individual tax return. The trust itself does not directly pay capital gains tax.

Example Scenario:

John sets up a revocable trust in Maryland and transfers a vacation property into the trust. When the property is sold, the capital gains are reported on John’s personal tax return.

2. Irrevocable Trusts

Irrevocable trusts are considered separate legal entities, which means they have their own tax identification number and file their own tax returns.

• If the trust retains the capital gains as part of its income, the trust is responsible for paying any applicable capital gains tax.
• If the capital gains are distributed to beneficiaries, the beneficiaries are responsible for paying taxes on those gains, not the trust.

Tax Rates for Irrevocable Trusts

For irrevocable trusts, federal tax rates on income and capital gains are typically more compressed than individual rates, meaning higher taxes can apply at lower income thresholds.

Example Scenario:

Mary establishes an irrevocable trust for her heirs, including investments that generate capital gains. If the trust sells an asset and keeps the profits, it must file taxes accordingly. However, if the trustee distributes the capital gains to the heirs, the beneficiaries will need to report those gains on their personal tax returns.

Key Consideration for Maryland Trusts

Maryland applies personal income tax rules to capital gains, whether individuals or trusts generate them. Therefore, for irrevocable trusts, any undistributed capital gains retained by the trust will be taxed at Maryland’s state income tax rates for trusts. However, if distributed, the beneficiaries will report the gains at their applicable personal income tax rates.

Strategies to Minimize Capital Gains Tax for Trusts

Careful planning with a knowledgeable attorney can help minimize the tax burden for your trust. Here are a few strategies the team at Frame & Frame Attorneys at Law often explores with our clients.

1. Distribute Income and Gains to Beneficiaries

For irrevocable trusts, distributing income and gains to beneficiaries can often reduce the trust’s tax liability. Beneficiaries may also fall into lower tax brackets, resulting in overall savings.

Caution: Timing and structuring of distributions is critical to ensure compliance with Maryland state and federal regulations.

2. Use the Step-Up in Basis Rule

For assets like real estate or stock held in a trust, beneficiaries may receive a “step-up” in tax basis at the time of the grantor’s death. This means they pay capital gains tax only on the increase in value from the time of inheritance to the time they sell the asset—potentially reducing the taxable gains significantly.

3. Consider Tax-Efficient Transactions

For grantors actively managing revocable trusts, it may be beneficial to defer sales of highly appreciated assets to minimize gains or use loss-harvesting techniques to offset taxable gains. A qualified estate planning professional can explore these options further.

4. Explore Charitable Trusts

Certain irrevocable trusts, such as charitable remainder trusts, provide opportunities to donate assets to a charitable cause while also providing tax benefits. These trusts can significantly reduce exposure to capital gains tax.

Common Questions About Trusts and Capital Gains Tax in Maryland

1. Does Maryland Ever Waive Capital Gains for Certain Assets?

No, Maryland does not waive capital gains tax. However, certain federally recognized exemptions, such as the sale of a primary residence (up to $250,000 for individuals and $500,000 for married couples), still apply within Maryland.

2. What Happens If a Trust Has Out-of-State Beneficiaries?

If a Maryland trust distributes capital gains to beneficiaries residing in other states, those beneficiaries may still owe taxes in their home states. This can create tax complications, making professional advice essential.

3. Are There Federal Considerations?

Yes. While we’ve focused primarily on Maryland regulations, federal tax laws play a significant role in how trusts are taxed. Trusts must adhere to IRS requirements when reporting capital gains, whether gains are retained by the trust or distributed to beneficiaries.

Build a Tax-Efficient Trust with Frame & Frame

Trusts can be powerful tools for protecting your assets and supporting your loved ones. However, the tax implications for trusts, particularly around capital gains, require careful consideration. With the right strategy, you can secure your financial future, minimize tax burdens, and ensure your legacy is carried out according to your wishes.

At Frame & Frame Attorneys at Law, we’ve spent decades guiding clients through every step of the estate planning process. Our expertise helps Maryland families and individuals establish trusts that maximize benefits and minimize risk. We tailor every plan to meet your unique financial and familial goals.

Schedule a consultation today and see how our team can help you create a tax-efficient estate plan or trust. Together, we’ll set the strongest foundation for your financial future.