Is it possible to place assets in an irrevocable grantor trust and swap said assets out for other property at a later date? Believe it or not, this is not a trick question. With the right planning in place, the answer is yes!
Also known as an intentionally defective grantor trust, an irrevocable grantor trust with swap power means the grantor retains one or more powers over the trust. Consequently, the grantor may be able to change a trust asset for a non-trust asset of equal value with no income or estate tax consequences.
The property that comes out of the trust can then be bequeathed outside the trust. That makes swap powers quite valuable. However, it’s important to recognize that various other rules and regulations may apply. For example, you cannot use IRAs or 401(k) plans for this purpose.
How swap power and taxes work
Let’s take a look at how taxation of the assets in the trust are affected when swap power is at play. Essentially, it’s important for the grantor’s individual tax return to include the income, losses, credits, and deductions of the trust.
Furthermore, the grantor is responsible for paying any tax liabilities that result from the assets in the trust. However, paying income tax isn’t all bad because the grantor will be regarded as having made an additional tax-free gift to the trust.
Meanwhile, the assets transferred out of the trust will continue growing outside the grantor’s estate. At the same time, assets that are gifted by way of an irrevocable trust will not receive a step-up in basis at the time of the grantor’s death. Instead, the assets have a carryover basis that is equal to the grantor’s basis at the time of the gift.
That said, this basis is adjusted for any gift tax that is paid by the grantor. It is also intended to remove any and all capital loss that goes unrealized by the grantor. As a result, the trust — as well as the beneficiaries of said trust — might be left with a potentially high capital gains tax bill upon selling the assets.
Estate taxes on the trust’s assets are treated differently as well. In general, assets in a decedent’s taxable estate receive a step-up in basis equal to the asset’s fair market value on the date of the grantor’s death. This, in turn, lowers their exposure to the capital gains tax.
However, in terms of irrevocable trusts, the assets have a carryover basis that is equal to the grantor’s basis at the time of the gift. For beneficiaries, this means they may be left with a potentially high capital gains tax liability.
Now, by putting their swap power into effect, the grantor can help mitigate this high capital gains tax liability by swapping out the assets in the trust.
Requirements for exercising the swap power in your trust
There are some requirements related to exercising the swap power, including the following:
- Only the grantor or those who are named in the trust in a non-fiduciary capacity can apply the swap power.
- There must be written proof that the swapped assets are of equal value. That way, the value of the trust assets will remain the same, and no additional wealth will be transferred into the trust as a result.
- Benefits that are listed within the trust cannot be shifted or exchanged amongst beneficiaries of said trust.
- The swap must not be made at the discretion of anyone with a fiduciary capacity.
- To prevent unintended taxable events, valuations of the assets in the swap should be documented whenever they are performed.
The bottom line of an irrevocable trust strategy
The bottom line is that most of the time, an irrevocable trust is just that — irrevocable. This foundational truth cannot be altered with ease, if at all. When you choose to include swap power as part of your trust, you can provide grantors with a certain level of flexibility as long as they meet all of the requirements prior to using the power.
At the end of the day, there’s no question that this area of tax law is rather complicated. Taxpayers who wish to create — or in some instances, those who have already created — an irrevocable trust should consult with tax and estate planning experts who can help them make sure their estate plans will result in their desired outcomes.
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