When you sell or exchange your interest in a unit investment trust that holds Connecticut state or local bonds, how is the gain or loss treated for Connecticut income tax?

Plain-English summary

Two individuals, H and G, each held an interest in a unit investment trust (UIT) (as defined in 26 C.F.R. § 1.851-7(d)) whose assets were obligations of the State of Connecticut and its political subdivisions, authorities, and public instrumentalities. H sold her UIT interest to a third party at a gain; the UIT's custodian sold G's proportionate share of the trust assets and distributed the proceeds to him, also at a gain. They asked DRS how that gain (or a corresponding loss) is treated for Connecticut income tax.

The starting point for the Connecticut income tax is your federal adjusted gross income (AGI), which is then adjusted by the additions in Conn. Gen. Stat. § 12-701(a)(20)(A) and the subtractions in § 12-701(a)(20)(B). Two of those adjustments matter here:

• Gain — subtract it. Section 12-701(a)(20)(B)(vii) requires you to subtract from federal AGI any gain from the sale or exchange of Connecticut state or local obligations, to the extent properly includable in your federal capital gain/loss. So the gain is effectively not taxed by Connecticut.
• Loss — add it back. Section 12-701(a)(20)(A)(v) requires you to add to federal AGI any loss from the sale or exchange of those same Connecticut obligations — so the loss is effectively not deductible for Connecticut.

The link to a UIT interest is the pass-through rule: a UIT holder is treated as directly owning a proportionate share of the trust's assets (26 C.F.R. § 1.851-7(a), (c)(1)), and the UIT itself is not a taxpayer, so gain or loss is taxed to the holders as if they had received it directly (§ 1.851-7(b)). Thus, whether you sell your UIT interest to a third party (H's situation) or the custodian sells your share of the trust assets and pays you out (G's situation), the portion of the gain or loss attributable to the underlying Connecticut obligations gets the subtract-the-gain / add-back-the-loss treatment.

If the UIT holder is a trust or estate rather than an individual, the same items don't go through the (a)(20) AGI modifications; instead they flow through the Connecticut fiduciary adjustment under § 12-701(a)(10) — netting the additions in subparagraph (A) against the subtractions in subparagraph (B). If the (A) items exceed the (B) items, the trust/estate's share of the fiduciary adjustment is added to federal taxable income; if the (B) items exceed the (A) items, it is subtracted.

What this means for you

Individual investors in Connecticut-bond UITs

If you sell your interest in a UIT that holds Connecticut state or municipal bonds, the gain attributable to those bonds is backed out of your Connecticut income — a Connecticut benefit consistent with Connecticut not taxing interest on its own obligations. The flip side: a loss on those bonds is added back, so you can't use it to reduce Connecticut income. It applies whether you sell the interest yourself or the custodian liquidates your share and pays you.

Trustees and estate fiduciaries

If a trust or estate holds the UIT interest, run the Connecticut-obligation gain or loss through the fiduciary adjustment (§ 12-701(a)(10)) rather than the individual AGI modifications — gains as subtraction items, losses as addition items — and net them to determine whether the fiduciary adjustment increases or decreases Connecticut taxable income.

Accountants and tax professionals

Track the portion of gain/loss attributable to Connecticut obligations inside the UIT; only that portion gets modified. Because the holder is deemed to directly own a pro-rata slice of the trust assets (26 C.F.R. § 1.851-7), the character flows through. Basis is the holder's basis in the trust interest (§ 1.851-7(c)(2)). Match the correct vehicle: individuals use § 12-701(a)(20)(B)(vii)/(A)(v); trusts and estates use § 12-701(a)(10).

Common questions

Q: I sold my Connecticut-bond UIT interest at a gain. Does Connecticut tax it?
A: Not to the extent the gain is attributable to Connecticut state or local obligations — that portion is subtracted from your Connecticut AGI under § 12-701(a)(20)(B)(vii).

Q: What if I had a loss instead?
A: A loss attributable to Connecticut obligations is added back to your Connecticut AGI under § 12-701(a)(20)(A)(v), so it doesn't reduce your Connecticut income.

Q: Does it matter whether I sell my interest or the custodian sells my share of the bonds?
A: No. Because a UIT holder is treated as directly owning a proportionate share of the trust assets, both routes produce the same Connecticut treatment of the gain or loss attributable to the underlying Connecticut obligations.

Q: I hold the UIT interest through a trust or estate — same rules?
A: The result is parallel, but a trust or estate runs the items through the Connecticut fiduciary adjustment (§ 12-701(a)(10)) instead of the individual AGI modifications.

Citations and references

Statutes:

• Conn. Gen. Stat. § 12-701(a)(20)(B)(vii) (subtract from federal AGI any gain from the sale or exchange of Connecticut state or local obligations)
• Conn. Gen. Stat. § 12-701(a)(20)(A)(v) (add to federal AGI any loss from the sale or exchange of Connecticut state or local obligations)
• Conn. Gen. Stat. § 12-701(a)(10) (Connecticut fiduciary adjustment — additions in subparagraph (A), including (A)(iv) for such losses; subtractions in subparagraph (B), including (B)(v) for such gains)

Regulations:

• 26 C.F.R. § 1.851-7 (federal treatment of unit investment trust holders as directly owning a proportionate share of the trust assets; UIT not itself a taxpayer)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 2004-1

Original ruling text

Ruling 2004-1, Income Tax / Unit Investment Trust

FACTS:

H, an individual, and G , an individual, are each holders of an interest in a unit investment trust, as defined in 26 C.F.R. §1.851-7(d).  The assets of the unit investment trust consist of obligations issued by or on behalf of the state of Connecticut or a political subdivision thereof, or a public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut.

H sells her interest in the unit investment trust to a third party.  H recognizes a gain for federal income tax purposes from the sale of her interest to the third party.

The custodian of the unit investment trust sells G ’s proportionate share of the trust assets and distributes the proceeds from such share to G in exchange for his interest in the unit investment trust.  G recognizes a gain for federal income tax purposes from the exchange of his interest in the unit investment trust for the proceeds from the custodian’s sale of his proportionate share of the trust assets.

ISSUES:

Is the holder of an interest in a unit investment trust, as defined in 26 C.F.R. §1.851-7(d), who recognizes a gain for federal income tax purposes from the sale or exchange of the holder’s interest in the unit investment trust, required under Conn. Gen. Stat. §12-701(a)(20)(B)(vii), in computing his or her Connecticut adjusted gross income, to subtract such gain from his or her federal adjusted gross income, to the extent such gain is attributable to the sale or exchange of obligations issued by or on behalf of the state of Connecticut or a political subdivision thereof, or a public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut?

Is the holder of an interest in a unit investment trust, as defined in 26 C.F.R. §1.851-7(d), who recognizes a loss for federal income tax purposes from the sale or exchange of the holder’s interest in the unit investment trust, required under Conn. Gen. Stat. §12-701(a)(20)(A)(v), in computing his or her Connecticut adjusted gross income, to add such loss to his or her federal adjusted gross income, to the extent such loss is attributable to the sale or exchange of obligations issued by or on behalf of the state of Connecticut or a political subdivision thereof, or a public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut?

RULING:

The holder of an interest in a unit investment trust, as defined in 26 C.F.R. §1.851-7(d), who recognizes a gain for federal income tax purposes from the sale or exchange of the holder’s interest in the unit investment trust, is required under Conn. Gen. Stat. §12-701(a)(20)(B)(vii), in computing his or her Connecticut adjusted gross income, to subtract such gain from his or her federal adjusted gross income, to the extent such gain is attributable to the sale or exchange of obligations issued by or on behalf of the state of Connecticut or a political subdivision thereof, or a public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut.

The holder of an interest in a unit investment trust, as defined in 26 C.F.R. §1.851-7(d), who recognizes a loss for federal income tax purposes from the sale or exchange of the holder’s interest in the unit investment trust, is required under Conn. Gen. Stat. §12-701(a)(20)(A)(v), in computing his or her Connecticut adjusted gross income, to add such loss to his or her federal adjusted gross income, to the extent such loss is attributable to the sale or exchange of obligations issued by or on behalf of the state of Connecticut or a political subdivision thereof, or a public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut.

DISCUSSION:

The starting point in computing an individual’s Connecticut income tax liability is his or her federal adjusted gross income.  In computing the individual’s Connecticut adjusted gross income, items expressly provided for in Conn. Gen. Stat. §12-701(a)(20)(A) are added to his or her federal adjusted gross income, and items expressly provided for in Conn. Gen. Stat. §12-701(a)(20)(B) are subtracted from his or her federal adjusted gross income.

Conn. Gen. Stat. §12-701(a)(20)(A)(v) expressly provides for “any loss from the sale or exchange of obligations issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut” to be added to an individual’s federal adjusted gross income, “to the extent properly includable in determining the net gain or loss from the sale or other disposition of capital assets for federal income tax purposes . . . .”  Conn. Gen. Stat. §12-701(a)(20)(B)(vii) expressly provides for “any gain from the sale or exchange of obligations issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut” to be subtracted from an individual’s federal adjusted gross income, “to the extent properly includable in determining the net gain or loss from the sale or other disposition of capital assets for federal income tax purposes . . . .”

Each holder of an interest in a unit investment trust, as defined in 26 C.F.R. §1.851-7(d), is treated (to the extent of such interest) as directly owning a proportionate share of the assets of the trust.  26 C.F.R. §1.851-7(a) and (c)(1).

Gain.   If an individual, such as H , is the holder of an interest in a unit investment trust, and the unit investment trust owns obligations issued by the state of Connecticut, the individual is treated as directly owning a proportionate share of those obligations.  If the individual sells his or her interest in the unit investment trust to a third party, and recognizes a gain for federal income tax purposes from the sale of his or her interest to the third party, then, to the extent that such gain is attributable to the sale of obligations issued by the state of Connecticut, the individual is treated as recognizing gain from the sale or exchange of obligations issued by the state of Connecticut.

Loss.   If the individual sells his or her interest in the unit investment trust to a third party, and recognizes a loss for federal income tax purposes from the sale of his or her interest to the third party, then, to the extent that such loss is attributable to the sale of obligations issued by the state of Connecticut, the individual is treated as recognizing loss from the sale or exchange of obligations issued by the state of Connecticut.

Because a unit investment trust is “not a taxpayer subject to taxation under the Internal Revenue Code,” the unit investment trust does not recognize gain or loss if it “distributes a holder’s proportionate share of the trust assets in exchange for his interest in the trust” or if it “sells the holder’s proportionate share of the trust assets and distributes the proceeds from such share to the holder in exchange for his interest in the trust.”  26 C.F.R. §1.851-7(b). “Items of income, gain, loss, deduction, or credit received by the trust or a custodian thereof shall be taxed to the holders of interests in the trust (and not to the trust) as though they had received their proportionate share of the items directly on the date such items were received by the trust or custodian.”  26 C.F.R. §1.851-7(c)(1).

Gain.   If an individual, such as G , is the holder of an interest in a unit investment trust, and the unit investment trust owns obligations issued by the state of Connecticut, the individual is treated as directly owning a proportionate share of those obligations.  If the custodian of the unit investment trust sells the holder’s proportionate share of the trust assets and distributes the proceeds from such share to the holder in exchange for his or her interest in the unit investment trust, items of gain received by the unit investment trust are taxed to the holder as if the holder had received his or her proportionate share of the items directly.  (The basis of a unit investment trust’s assets that are treated as “owned by the holder of an interest in such trust shall be the same as the basis of [the holder’s] interest in such trust.  Accordingly, the amount of the gain or loss recognized by the holder upon the sale by the unit investment trust of the holder’s pro rata share of the trust assets shall be determined with reference to the basis of [the holder’s] interest in the trust.”  26 C.F.R. §1.851-7(c)(2).)  To the extent that such gain is attributable to the sale of obligations issued by the state of Connecticut, the individual is treated as recognizing gain from the sale or exchange of obligations issued by the state of Connecticut.

Loss.   If the custodian of the unit investment trust sells the holder’s proportionate share of the trust assets and distributes the proceeds from such share to the holder in exchange for his or her interest in the unit investment trust, items of loss received by the unit investment trust are taxed to the holder as if the holder had received his or her proportionate share of the items directly.  To the extent that such loss is attributable to the sale of obligations issued by the state of Connecticut, the individual is treated as recognizing loss from the sale or exchange of obligations issued by the state of Connecticut.

If the holder of an interest in a unit investment trust is a trust or estate

Gain.   If the holder of an interest in a unit investment trust, as defined in 26 C.F.R. §1.851-7(d), is a trust or estate, and the holder recognizes a gain for federal income tax purposes from the sale or exchange of the holder’s interest in the unit investment trust, then, to the extent such gain is attributable to the sale or exchange of obligations issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut, the gain is required, under Conn. Gen. Stat. §12-701(a)(10)(B)(v), to be netted, along with other items enumerated in Conn. Gen. Stat. §12-701(a)(10)(B), against items enumerated in Conn. Gen. Stat. §12-701(a)(10)(A), in computing the Connecticut fiduciary adjustment.

Loss.   If the holder is a trust or estate, and the holder recognizes a loss for federal income tax purposes from the sale or exchange of the holder’s interest in the unit investment trust, then, to the extent such loss is attributable to the sale or exchange of obligations issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut, the loss is required, under Conn. Gen. Stat. §12-701(a)(10)(A)(iv), to be netted, along with other items enumerated in Conn. Gen. Stat. §12-701(a)(10)(A), against items enumerated in Conn. Gen. Stat. §12-701(a)(10)(B), in computing the Connecticut fiduciary adjustment.

If the total of the items enumerated in Conn. Gen. Stat. §12-701(a)(10)(A) exceeds the total of the items enumerated in Conn. Gen. Stat. §12-701(a)(10)(B), the trust or estate’s share of the Connecticut fiduciary adjustment is to be added to the trust or estate’s federal taxable income in computing its Connecticut taxable income.  If the total of the items enumerated in Conn. Gen. Stat. §12-701(a)(10)(B) exceeds the total of the items enumerated in Conn. Gen. Stat. §12-701(a)(10)(A), the trust or estate’s share of the Connecticut fiduciary adjustment is to be subtracted from the trust or estate’s federal taxable income in computing its Connecticut taxable income.

LEGAL DIVISION

March 2, 2004