Jay D. Waxenberg and Nathan R. Brown briefly discuss the idea of post-gift asset exchanges in the July 2014 issue of Trusts & Estates, in an article entitled, The Narrowing “Tax Efficiency Gap”. The concept surprised me. It reflects the need for yet another shift in the focus of estate planning. With the current large exemption from gift and estate tax ($5.34 million in 2014), it is no longer enough to get assets out of an estate in order to keep them from being estate-taxed at the older generation’s death. We also have to attempt to do it in a way that minimizes the income tax consequences for the younger generation.
Traditionally, we would advise our clients to keep assets that are already highly appreciated in value, in order to take advantage of the step up in basis to date of death value when they pass away. We would select assets for giving that have a high expectation of future appreciation. This strategy usually enables the client to leverage his available exclusion, to make it go farther and cover more value.
For example, if an asset worth $1 million today is given to a family member in a younger generation, it may be worth, say, $3 million at the time our donor passes away. That saves the inclusion of the extra $2 million in value from being taxed in the estate of the older generation. The drawback to this strategy is that the younger generation is sitting on that extra $2 million of appreciation and would have to pay a significant amount of income tax to turn that asset into cash. Assuming a 20% capital gains rate, a 3.8% net investment income tax, and, if our client is an Ohio resident, about a 5% Ohio income tax, a sale of this asset would incur tax of about 28.8% of the gain realized. So, depending on what other characteristics appear in the tax return, the $2 million of appreciation may require the payment of about $576,000 of income tax.
The technique of a post-gift asset exchange may be used to avoid this income tax. It involves having the donor, shortly before his death, swapping out the original gift asset with another asset of equal value whose basis is close to its fair market value, such as cash. That way, the donor passes away with the $3 million highly appreciated asset and the asset receives a step up in basis to date of death value in his hands. The younger generation family member walks away with cash. He also possibly stands to inherit the other $3 million asset, depending on the rest of the donor’s estate plan, and can now liquidate it with no income tax consequence.
To make this work, the original gift must be made to a trust and the donor must have the right to substitute assets. We commonly see this right to substitute assets in a planning technique that involves intentionally defective grantor trusts. The “defect,” the right to substitute assets, is what makes this type of trust a grantor trust for income tax purposes and allows the grantor to continue to be taxed on the income earned in the trust. The defect is ignored for gift tax purposes. Such a gift is considered a completed gift that is out of the donor’s estate for estate tax purposes.
In a Journal of Accountancy article in November 2008, Alistair M. Nevius discusses two strategies for reacquiring appreciated assets. The first is merely to swap out the appreciated asset for an equal value in cash. The second is to have the trust sell the appreciated asset to the grantor for cash. Because the transaction is between a grantor and his grantor trust, it is disregarded for income tax purposes. This sounds plausible and familiar because sales of assets to intentionally defective grantor trusts have long been ignored for income tax purposes.
Waxenberg and Brown have promised a follow-up article on the techniques post-gift asset exchanges. I will be very interested to learn more about this.
Karen S. Cohen, CPA
Principal – Packer Thomas
Feel free to contact Karen with your questions: firstname.lastname@example.org