Are Capital Gains Subject to the 65-Day Rule?

No, but you would not know that from reading the statute. 

The 65-day rule is a taxpayer-friendly provision involving the income taxation of trusts and estates. It allows the trustee of a trust or executor of an estate to treat certain distributions made in one tax year as if they were made on the last day of the previous tax year.  The rule is found in IRC § 663(b)(1), which states:

If within the first 65 days of any taxable year of an estate or a trust, an amount is properly paid or credited, such amount shall be considered paid or credited on the last day of the preceding taxable year.

Only distributions made within the first 65 days of the trust or estate’s taxable year are eligible, and the fiduciary must make the appropriate election on the trust or estate’s income tax return, Form 1041.

Why is this necessary? As a general rule, income generated by a trust or estate is taxed to either the entity or the beneficiaries. If the fiduciary distributes the income to the beneficiaries before the end of the entity’s taxable year, the beneficiaries will normally include the income on their personal income tax returns for the year in which the income is received. On the other hand, if the fiduciary retains the income, it will normally be taxed to the trust or estate.

The tax brackets for trusts and estate are greatly compressed relative to the tax brackets for individuals. For tax year 2018, it takes $500,000 of taxable income for an individual to reach the highest income tax bracket (see Rev. Proc. 2018-18). By contrast, trusts and estates are subject to the highest tax rate after $12,500 of taxable income (see tax table here). Accordingly, unless there are significant non-tax reasons for doing otherwise, fiduciaries generally want to distribute net income to the beneficiaries of the trust or estate. 

Unfortunately, fiduciaries do not always know by year end how much income is attributable to a trust or estate. They may not know the exact amount until January or February of the following year, when they receive tax statements. Thereafter, if they make income distributions to the beneficiaries by March 5 (March 4 in the case of a leap year), the IRS will treat the income as being distributed to the beneficiaries on December 31 of the preceding year. In that case, the beneficiaries would include the distribution in their personal income, rather than the income being taxable to the trust or estate.

On its face, this rule should apply to capital gains. Section 663(b) simply refers to amounts credited or paid. Nonetheless, the regulation “interpreting” this rule add a limitation not found in the statute. Treas. Reg. § 1.663(b)-1(a)(2) says:

In the case of distributions made after May 8, 1972, the amount to which the election applies shall not exceed:

(a) The amount of income of the trust (as defined in § 1.643(b)-1) for the taxable year for which the election is made, or

(b) The amount of distributable net income of the trust (as defined in §§ 1.643(a)-1 through 1.643(a)-7) for such taxable year, if greater,

reduced by any amounts paid, credited, or required to be distributed in such taxable year other than those amounts considered paid or credited in a preceding taxable year by reason of section 663(b) and this section.

In other words, the amount treated as incurred on the last day of the prior year cannot exceed the estate’s distributable net income (DNI). Under IRC § 643(a)(3), capital gains are normally not included in DNI. Therefore, the regulation effectively prevents capital gains incurred in the first 65 days of the tax year from being recognized at the end of the prior year.

Posted by Joel D. Roettger, JD, LLM, EPLS

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