The Estate Tax, also known as the “death tax,” is going to be a reality for many more individuals once the estate tax threshold lowers automatically in 2025.
One strategy for avoiding the estate tax is to take advantage of the high exemption now. Currently, the exemption for an individual is $12.06 million. This exemption will sunset back to the previous $5 million amount in 2025 (with a likely adjustment for inflation).
The method to take advantage of the current exemption amount (without dying) is to transfer assets to an irrevocable trust. However, it is crucial to have a proper plan in place to avoid estate tax without leaving behind a huge tax advantage: the step-up in basis.
A Grantor trust is one where the trust maker (the “grantor”) retains power over the trust. Since the grantor still has power over the trust, the assets transferred to the trust are still considered to be owned by the Grantor. Because the assets are still technically owned by the Grantor, the assets will be included in the Grantor’s gross estate for estate tax purposes.
For example, George creates a grantor trust and puts all of his assets, worth $12 million, into the trust. George, in 2030, dies and his beneficiaries are trying to determine whether his estate will be subject to the federal estate tax. Because the trust is considered a “grantor” trust, the assets will all be included in George’s gross estate, which is what is examined to determine whether the estate is taxable. Because George’s gross estate is $7 million above the estate tax exemption ($5 million), that $7 million will be subject to the maximum federal estate tax rate of 40%.
There is an important caveat to this scenario however. While the Grantor trust failed to exempt the assets from the estate tax, it did preserve the step up in basis for the assets.
Step up in Basis
Basis in an asset is the basis by which a capital gain is determined. Basis is typically determined based on how much you paid for an asset (“cost basis”). Alternatively, if you were given an asset, you get the basis that the donor had (“carry over basis”).
Let’s say George buys a home for $100k in 2022. In 2030, George decides to sell the home, which has appreciated to $300k. George’s basis in the property is what he paid, $100k. To calculate capital gain, he looks at the difference between what he paid and what it’s selling for. Here, the gain is $200k. Even at the lowest applicable capital gain rate (above 0%), that’s a $30k tax bill.
A step-up in basis serves to eliminate or reduce capital gain and is available if an asset is received by virtue of someone’s death (inheritance). Let’s say that George bought the same property in 2022. In 2030, he dies and leaves his property to Bill. Bill’s basis in the property is stepped up because he received the property as an inheritance. Bill’s basis is now equal to the fair market value at the date of George’s death. If Bill turns around and sells it the next day for $300k, he will have virtually no capital gain. Alternatively, if Bill hangs on to the property and lets it appreciate in value, he will have less capital gain than he would have had he received the property as a gift (with carryover basis).
In a grantor trust, the grantor still owns the trust assets. A transfer of an asset to the trust is not a completed gift to the beneficiary. Therefore, the beneficiary receives the asset only by virtue of the grantor’s death and, in turn, receives a step-up in basis.
Intentionally Defective Grantor Trust (IDGT)
In an IDGT, the trust assets are considered to be owned by the trust and not the Grantor. A transfer of assets to the trust constitutes a complete gift to the beneficiaries. This means that the assets will not be included in the grantor’s gross estate. However, this sacrifices the step up in basis because the beneficiaries are not receiving the assets by virtue of the grantor’s death (since the gift to them is completed during the grantor’s life).
IDGT and Swap Powers
Let’s pause for a second to talk about strategy. To get the benefit of estate tax avoidance, one does not need to put all assets into the IDGT, just that amount which is above the estate tax exemption. In fact, leaving some assets out will give you some flexibility in planning, as we will see below.
An IDGT gives you estate tax benefits but not the step up in basis. So, some creativity is required to get the best of both worlds. If the IDGT doesn’t give the step-up, then we want to put “high basis” assets into the IDGT. These would be assets that have either not significantly appreciated in value nor have been intentionally depreciated for tax purposes.
But this begs the question, what if the basis changes? Let’s say George put a high basis home in the trust, then a golf course gets built next door and the value of the home skyrockets. If something like this happens, George has the option to “swap” a high basis asset for the home. This allows George to take the home out of the trust and put in a high basis asset of equal/similar value. George would then ensure that the home was in a grantor trust which preserves the step-up.
What if you do not have a high basis asset to swap? You could borrow money and swap the cash out for the asset. Let’s say George doesn’t have a high basis asset to swap. He bought the home at $1m and it has appreciated to $5m. He could borrow the $5m and swap out the cash for the home. When he dies, the home gets a step up in basis and is sold immediately with no capital gain. Then the home proceeds pay off the outstanding $5 million loan.
This is where the utilization of an insurance product can be incredibly helpful. Instead of borrowing from a bank, with applicable interest rates, one could instead borrow the cash from an insurance policy to perform this swap.
In conclusion, the use of an IDGT can save you and your loved ones from unnecessary taxation as long as you have the proper plan in place.