Swapping Trust Assets to Achieve a Step-Up in Tax Basis at Death
By: Morris Law Group - June 12, 2013
Traditionally, a primary concern in estate planning has been the minimization of estate taxes. However, after the passage of the American Taxpayer Relief Act of 2012 ("ATRA"), for many individuals, the focus has been shifted to reducing future income taxes tax planning.. Even for high net worth individuals, the increase in income taxes discussed below make income taxes a significant factor in estate.
ATRA provides for a $5 million estate tax exemption, increased for inflation, and provides for the permanent enactment of portability, enabling a surviving spouse to utilize the first deceased spouse's unused exemption amount. This means that most individuals and married couples are now safely outside the realm of estate taxation, having combined assets under $5.25 and $10.5 million, respectively (estate tax exemptions for 2013). Along with the changes to the estate tax laws came increased income and capital gains rates and a new 3.8% Medicare tax. These tax increases make it important to ensure that the assets owned at death will receive a step-up in tax basis.
For example, if an individual were to purchase a piece of real estate for $100,000 and sell it prior to death when it is valued at $1 million, $900,000 would be subject to capital gains taxes, resulting in $180,000 in tax ($900,000 * 20% capital gains tax rate). If depreciation was taken, even more of the sales price would be subject to capital gains taxes. State and local taxes may increase the taxes due even further. However, if the property was held until death, =A71014(a) of the Internal Revenue Code would permit the asset a stepped-up basis to the fair market value of $1 million. Thus, if the property was sold after death, no capital gains taxes would be due and the full $1 million would be available for distribution to heirs.
In order to avoid estate taxes, property can be gifted to an irrevocable trust to remove the value of the asset from the grantor's gross estate. However, if this property is left within the trust, it will not be entitled to a step-up in basis at death. However, irrevocable trusts can be specially drafted to grant an individual the power to swap the assets of the trust with assets the grantor still holds individually. If done properly, the assets can be swapped prior to death so that the assets held in the trust with a low basis can be substituted for assets held by the grantor with high basis. After substitution, the assets with a low basis (i.e. a high amount of accumulated gain) are back in the grantor's hands and will be eligible for the =A71014(a) step-up in basis on the grantor's death. The high basis assets will no longer be in the grantor's gross estate and the exchange of assets is not a taxable event. Alternatively, if the grantor owns a loss asset (basis greater than the fair market value), 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.
To illustrate the benefits of substitution, assume that real estate purchased for $100,000 (basis) and valued at $1,000,000 was transferred into an irrevocable trust in an effort to remove the $1,000,000 value from the value of the grantor's gross estate for estate tax purposes. While this will allow for significant estate tax savings, if the asset is left in the trust and sold after the grantor's death, $900,000 of the sales price will be subject to capital gains taxes. However, using the power of substitution prior to the grantor's death, he or she can substitute $1,000,000 in cash, or other property with no inherent gain, for the real estate. When the grantor dies, his estate will be able to sell the real estate for the date of death value, with no capital gains taxes being due.
The substitution power held by the grantor or anyone in a non-fiduciary capacity should not cause inclusion of the trust assets in the grantor's gross estate because the right to swap assets does not allow the grantor to make additional wealth transfers or to diminish the value of the trust's assets. For example, in order for the grantor to remove the piece of real estate valued at $1 million from the trust, the grantor would need to transfer $1 million in assets to the trust in exchange.
While asset swaps can provide significant income taxes savings, if not done properly, adverse tax consequences can result. Many times, written agreements between the grantor and the trustee can be entered into, providing that if the finally-determined values are not equal, cash or other assets would be transferred to the under-compensated party to equalize the transfers.
We are able to assist you in structuring a strategic asset swap to allow for a full basis step-up of the assets held in trusts you have established. Please contact our office for additional information.
** Disclaimer Required by IRS Circular 230** Unless otherwise expressly approved in advance by the undersigned, any discussion of federal tax matters herein is not intended and cannot be used 1) to avoid penalties under the Federal tax laws, or 2) to promote, market or recommend to another party any transaction or tax-related matter addressed.