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Now is the Time to Put your Swap Powers to Use by Chris Taarick, JD, LLM


Posted on August 19, 2020 by Christopher Taarick

A key element of estate planning involves the creation of trusts to protect assets from creditors and provide financially for beneficiaries. Over time, and especially as tax laws change, individuals must reassess exiting plans and consider making changes or taking other actions to improve tax efficiency and wealth preservation for themselves and for future generations.

One of the more tax-efficient tools individuals can use to pass wealth to heirs is 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 the grantor retains certain powers, he or she is responsible for reporting all trust income, losses, credits and deductions on his or her individual income tax return and paying any related tax liabilities. By paying the trust’s income tax liability, the grantor essentially makes an additional tax-free gift to the trust while allowing the assets transferred to the trust to continue growing outside his or her estate for the benefit of the named trust beneficiaries.

Generally, asset ownership for income-tax purposes is not the same as 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 death of the grantor. Instead, the assets receive a “carryover” basis, which is 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, beneficiaries of an IDGT 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 most frequently used by a grantor to trigger grantor trust status is to give the grantor the power to reacquire the IDGT’s assets by substituting, or swapping, assets of equivalent value. By swapping low-basis-assets out of a trust and into their taxable estates during life, grantors can 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 get 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 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 actually 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 take care to properly document all exchanges and ensure that the value of substituted property is equivalent. This may require the expertise of professional appraisers or other valuation specialists. 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: Christopher Taarick, JD, LLM, is a senior manager of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he helps private companies and high-net-worth families develop tax-efficient business and estate plans. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or info@bpbcpa.com.