Swapping Assets Can Be Tax-Friendly Move For Some Trusts

The IRS has ruled that a long-used basis adjustment under Sec. 1014 generally doesn’t apply to the assets of an irrevocable grantor trust that aren’t included in the deceased grantor’s gross estate.

“This ruling will have almost no impact because most practitioners didn’t believe that assets in an irrevocable grantor trust that wasn’t includible in a grantor’s estate, commonly referred to as [an] ‘intentionally defective grantor trust,’ were subject to a basis adjustment at death,” said Karen Goldberg, partner-in-charge in the trusts and estates practice of the Eisner Advisory Group in New York. “Most believed that taking a contrary position was very aggressive.”

In that case, what tax-savings moves are left for grantor trusts with appreciated assets?

One popular technique is giving the grantor the power to substitute their own assets for trust assets with equivalent value to receive better basis treatment.

“This power is found in Sec. 675(4) of the Internal Revenue Code and is commonly referred to as a ‘swap power,’” said Azriel J. Baer, partner in the trusts and estates group at the law firm Farrell Fritz P.C., in Uniondale, N.Y. “This transfer is not a gift since the assets need to be of equivalent value and the decedent’s heirs will receive a full basis adjustment for the property owned by the decedent outright at death.”

With this technique, the trust’s settlor (aka, the grantor) retains the right to substitute assets of equivalent value with the trustee. That is sufficient for the settlor to be treated as the owner of the trust’s assets for income tax reporting purposes but not estate tax purposes.

“The grantor could swap cash or high-basis assets with the trust before death so that the appreciated assets received from the trust will receive a step-up in basis,” said Frank Corrado, managing director and principal at Robertson Stephens Wealth Management in Holmdel, N.J., adding that this could also be accomplished by borrowing money from a third party or the trust and purchasing the low-basis trust assets.

“This way, the basis of those appreciated trust assets would be stepped up to fair market value at the client’s death,” Goldberg said. “Because the trust is a grantor trust, no gain or loss would be triggered by the exchange.”

The ruling applies to irrevocable grantor trusts like grantor retained annuity trusts and intentionally defective grantor trusts, which are often used by wealthy clients. “Individuals should understand that, according to the IRS position, assets transferred into an irrevocable grantor trust will pass to the beneficiaries at carryover basis,” said Sophia Duffy, a CPA and associate professor of business planning at The American College of Financial Services in King of Prussia, Pa.

“If the beneficiaries sell the assets, they’ll recognize the difference between the carryover basis and fair market value as capital gain, and likely pay capital gains tax on that amount,” she said. “If step-up basis were applied, the amount of capital gain recognized would be much lower or eliminated entirely.”

Assets’ appreciation rate is also important. If original assets are falling short in appreciation in some way, perhaps by not delivering anticipated returns or beginning to level off in returns, swapping more promising assets into the trust might be a good move-bearing in mind the possible 2026 sunset of the Tax Cuts and Job Act’s larger estate tax inclusion.

Reviewing trusts can also unearth swap provisions, which may be buried in the documentation.

“The first point to consider is whether these types of trusts still make sense for the client,” Duffy added. “Grantor retained annuity trusts and intentionally defective grantor trusts have many favorable tax effects that may outweigh the basis issues. For example, paying the income tax on the trust income allows the grantor to further reduce the estate without incurring more gift tax since the payment is not considered a gift.”

Need for such tactics and the recent IRS ruling also don’t mean that these trusts shouldn’t be used. “There are many other benefits of these trusts that may outweigh the potential higher tax bill,” Duffy said.

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