Now is the Time to Put your Swap Powers to Use by Jeffrey M. Mutnik, CPA/PFS
Posted on April 12, 2023
A key element of estate planning involves the creation of trusts to protect assets from creditors and provide financial security for beneficiaries. Over time, and especially as tax laws change, individuals must reassess existing plans and consider making changes or taking other actions to improve tax efficiency and wealth preservation for themselves and future generations.
One of the more tax-efficient tools individuals can use to pass wealth to heirs is an irrevocable grantor trust. The popular nomenclature of such a trust is to call it an intentionally defective grantor trust (IDGT), for which the person creating the trust, the grantor, retains one or more powers over the trust and is responsible for paying taxes on the trust’s income. The transfer of assets to the IDGT is considered a completed gift for gift-tax purposes, and the IDGT is not included in the grantor’s estate for estate tax purposes. However, because grantors retain certain powers, they are responsible for reporting all trust income, losses, credits and deductions on their individual income tax returns and paying any related tax liabilities. By paying a trust’s income tax liabilities, grantors essentially make an additional tax-free gift to the trust while allowing the transferred assets to continue growing outside of their estates for the benefit of named trust beneficiaries.
Generally, asset ownership for income-tax purposes differs from ownership for estate-tax purposes. Under U.S. tax laws, assets included in an individual’s taxable estate upon death are passed to beneficiaries with a stepped-up cost basis equal to the fair market value (FMV) on the date of the owner’s passing. While this basis adjustment eliminates all asset appreciation and unrealized gains during the owner’s life and allows beneficiaries to sell inherited assets with less exposure to capital gains tax, it does not apply to assets held in an IDGT.
Assets gifted to an IDGT do not receive a step-up in basis at the time of the grantor’s death. Instead, the assets receive a “carryover” basis equal to the grantor’s basis at the time of the gift (adjusted for any gift tax paid by the grantor and to remove any capital loss unrealized by the grantor). As a result, IDGTs and/or their beneficiaries can be left with a potentially substantial capital gains tax on any sale of appreciated trust assets. There is, however, a way to mitigate this: swap powers.
One of the methods frequently used to trigger grantor trust status is to give the grantor the power to reacquire an IDGT’s assets by substituting or swapping assets of equivalent value. Swapping low-basis assets out of a trust and into their taxable estates allows a grantor to ensure beneficiaries receive a step-up in basis to the FMV of the assets on the date of the grantor’s death. By contrast, the high-basis assets owned by the grantor and swapped into the trust are no longer included in the grantor’s estate and will receive the benefit of the higher basis and hence lower capital gains in the future.
Grantors may also use swap powers to maximize the use of unrealized capital losses. While the basis adjustment to the FMV at the date of death is often referred to as a “step-up” in basis, if the FMV of an asset is worth less than the basis as of the date of death, then there will be a “step-down” in basis. If the grantor owns a loss asset for which the basis is greater than the FMV, he or she should consider taking back the low-basis assets held by the trust by substituting the loss asset. This way, the loss is preserved in the trust.
While swaps are not taxable events, grantors and trustees approving a swap should properly document all exchanges and ensure that the value of the substituted property is equivalent. This may require the expertise of professional appraisers or other valuation specialists. A failure to properly substantiate values can result in unintended and significant tax liabilities.
Now is the time to speak with your trusted advisors to explore how you may use swap power to your advantage. If you have an existing trust that does not include the power to substitute assets, you are not out of luck. There are some strategies you can employ to modify trust instruments.
About the Author: Jeffrey M. Mutnik, CPA/PFS, is a director of Taxation and Financial Services with Berkowitz Pollack Brant Advisors + CPAs, where he provides tax- and estate-planning counsel to high-net-worth families, closely held businesses and professional services firms. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at info@bpbcpa.com.
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