Borrow, Swap and Step-Up: A Trust Move, Not a Dance Move

A look at the use of credit in estate planning.

Among the most popular estate planning strategies is an intentionally defective grantor trust (IDGT). Not only can an IDGT protect family assets for multiple generations by not subjecting them to gift, estate or generation-skipping transfer (GST) taxes, but the grantor is also able to pay the income taxes for the IDGT, which allows the trust assets to grow for the benefit of future generations unencumbered by federal and state income taxes.1 A key trust provision most often used to obtain “grantor trust status” for income tax purposes is commonly referred to as a power of substitution—or “swap power.” Under section 675(4) of the Internal Revenue Code, if the grantor has the power to reacquire any property held in an irrevocable trust by substituting other property of equivalent value, then the trust will have all the income tax advantages of a grantor trust, without any negative impact from a gift, estate or GST tax perspective.

A potential disadvantage of an IDGT is that the assets owned by the IDGT will not receive a step-up in basis for income tax purposes upon the death of the grantor, as opposed to the step-up that generally would occur for non-retirement assets directly owned by an individual at death.Utilizing an IDGT’s swap power, however, can provide an optimum means for preserving all the gift, estate and GST tax benefits of an IDGT while also obtaining a step-up in basis at death. If an IDGT owns low-basis assets (such as appreciated stock or real estate) with significant built-in capital gains, the grantor could substitute high-basis assets or cash of equivalent value in exchange for the IDGT’s low-basis assets. By so doing, the low-basis assets would receive a step-up in basis upon the grantor’s death, and the IDGT would continue to own the same fair market value of assets without the need for a stepped-up basis. In a community property state, a full 100% step-up in basis can occur following the death of either the IDGT’s grantor or the grantor’s spouse 

Often, individuals with effectively and efficiently managed investment portfolios do not have significant cash available or investment assets with a high cost basis. For those IDGT grantors who do not hold sufficient cash or high basis assets to take advantage of the swap power, a creative solution could involve the grantor strategically using tax-efficient leverage by borrowing the cash with a secured line of credit, which is especially effective and efficient in the current low-interest rate environment. Borrowing while rates are historically low reduces the cost to the grantor and increases the likelihood that swapping cash for appreciated assets will result in a net positive for the grantor’s family. That is, the low-interest rate paid to facilitate the swap could be more than offset by the substantial savings from eliminating capital gains tax liability with respect to the appreciated assets obtaining a step-up in basis.

As an example, assume an IDGT created by John Smith originally owned a $5 million apartment building with a $5 million basis.3 After $4.5 million in depreciation deductions, the basis is now $500,000, but the fair market value of the building has appreciated to $20 million. If the property is sold after John’s death later this year, the gain would be subject to federal income tax at rates as high as 28.8% (25% plus the 3.8% net investment income tax) on $4.5 million—as the recapture of the previous depreciation deductions—and long-term capital gains taxes at rates as high as 23.8% (20% plus the 3.8% net investment tax) on the $15 million of appreciation. Depending on the state of residence, there also could be state income taxes on the sale of the property—for example, up to a 13.3% state income tax in California. On the other hand, if John had borrowed $20 million and then substituted/swapped the cash for the apartment building in the IDGT before he died, the apartment building would receive a new $20 million stepped-up tax basis after his death equal to the fair market value. The property could then be re-depreciated based on the new $20 million tax basis, even though the IDGT already had fully depreciated the property. Alternatively, John’s estate or testamentary trust could sell the property after his death for the $20 million fair market value without any federal or state income taxes. Moreover, since the fair market value of the apartment building would be approximately equal to the outstanding $20 million loan amount, there would be no additional gift, estate or generation skipping transfer (GST) tax owed after John’s death.

There are, however, certain risks and other potential disadvantages of this strategy. Chief among these is that, after the swap, the asset reacquired by the grantor may continue to appreciate in value. Such appreciation will, of course, be eliminated along with all other appreciation at the grantor’s death for capital gain tax purposes via the step-up in basis, but the continued appreciation will add to the size of the grantor’s taxable estate. The uncertainty of both how long the grantor may continue to live, and how much continued appreciation will occur as to the reacquired assets, are risks to be understood in considering this strategy.

An additional downside is the interest paid on the third-party loan. Depending upon how the loan is structured, this can potentially impact the benefit of the strategy more than intended. For example, if the loan is structured as interest-only with intention to pay off the loan upon the grantor’s death, the mortality risk of the grantor living too long would again be a factor for consideration.

Also, IRS challenge of the strategy as a step-transaction or lacking economic substance is a possibility with tax mitigation strategies like this one. Such a risk would seemingly be relatively low other than with respect to swaps that could be challenged as “death bed” type planning, such as, for example, in the case of a swap by a 95-year old grantor suffering from late-stage terminal cancer.

An additional potential risk is that the trustee could determine that the fair market value of the appreciated trust asset is not the equivalent value of the property being offered by the grantor as part of the swap. From a fiduciary duty perspective, the trustee likely will need to satisfy itself that the substituted property from the grantor is of equivalent value to the property being swapped out of the grantor trust so that the swap will not diminish the value of the trust’s assets. That fiduciary burden will be much easier to overcome if the grantor is using borrowed cash for the swap as opposed to property with a less clear value, such as a promissory note.4

In conclusion, by swapping cash for low basis trust assets to return them to the grantor’s ownership, those low basis assets will receive a step-up in basis. Consequently, capital gains would be eliminated upon the grantor’s death, and the IDGT can continue to grow free of gift, estate and GST taxes for future generations. A loan to provide cash for the swap, such as through a flexible, cost-effective line of credit, particularly in the current low interest rate environment, could facilitate this strategy.  In such cases, the amount outstanding on the line of credit upon the grantor’s death will be a liability of his or her estate and further reduce the value of the taxable estate for estate tax purposes. Ultimately, the above borrow, swap and step-up strategy should, at a minimum, be considered by grantors of IDGTs holding appreciated assets.

  • 1 Rev. Rul. 2011-28, 2008-22, 2004-64, and 85-13.
    2 Note that Presidents Biden, Trump and Obama all have proposed eliminating the tax benefit of a step-up in basis at death. However, as of March 2021, there is no current congressional bill or legislative proposal to address changes to the step-up in basis rules in the near future.
    3 Unless otherwise provided, the names, characters, businesses, places, and events discussed in the hypothetical examples in this paper are fictitious. Any resemblance to actual persons, living or dead, or actual events is purely coincidental.
    4 See, e.g., Manatt v. Manatt, 2018 WL 3154461 (S.D. Iowa May 2, 2018); Schinazi v. Eden, 338 Ga. App. 793 S.E.2d 94 (Ga. App. 2016); Benson v. Rosenthal, No. 15-782, 2016 WL 2855456 (E.D. La. 2016); In re Dino Rigoni International Grantor Trust for the Benefit of Christopher Rajzer, 2015 WL 4255417 (Ct. App. Mi. July 14, 2015); In re the Matter of the Mark Vance Condiotti Irrevocable GST Trust, No. 14CA0969, Col. App. July 9, 2015).

  • Reprinted with permission from Leimberg Information Services, Inc. (LISI).This material is provided for illustrative/educational purposes only.

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