In the sleepy world of trust planning, the topsy-turvy stock market is creating big tax-savings opportunities.
While irrevocable trusts are permanent structures, the assets within them are flexible and can be swapped at any time with different similarly valued assets—a strategy worth considering during times of extreme swings in market values.
“Asset swapping often falls between the cracks,” says Ed Renn, of counsel on the private client and tax team at Withers. “Some people are knocking around with trust structures from years back and may not be proactive when it comes to managing assets in the trusts.”
Swapping assets is often part of estate planning for wealthy taxpayers aiming to minimize exposure to the 50% estate tax rate. But the strategy can also have significant benefits for people who aren’t worried about the estate tax now that the estate tax exemption is at $15 million per person or $30 million for couples.
To swap assets, a trust must be an irrevocable grantor trust. These are generally the most popular kinds of trusts in which the person setting it up is responsible for paying the trust’s taxes.
For a swap to be valid, any assets you take out of the trust must be replaced with assets of the same value.
“You can swap one security for another, or cash for private equity or real estate,” Renn says. “You can swap anything for anything, but you have to know what the assets are worth and be able to justify your numbers.”
The objective of swaps is to leverage tax advantages given the different tax rules that apply for assets owned by a trust versus an individual taxpayer.
Lock in a step-up in cost basis
When heirs inherit assets in an irrevocable trust, they don’t get the benefit of a step-up in cost basis that they get on assets inherited outside the trust.
“To set the kids up to get the advantage of the step-up in basis, a lot of times the substitution power is exercised when someone is closer to passing away,” says Jere Doyle, senior estate planning strategist at BNY Wealth.
You can pull stock with a low cost basis out of your trust and into your estate, and swap in cash or an asset with a high cost basis, Doyle says.
That way, when the heirs inherit the highly appreciated stock, the cost basis will get reset to the current market value, effectively wiping out any capital-gains tax obligation on the assets up to that point.
A swap for cost basis planning looks even more advantageous when considering onerous tax rules for trust assets.
The top income and long-term capital-gains tax rates for trusts and individuals are the same, at 37% and 20% respectively, but the top rates kick in on trust income and gains at a much lower level.
Annual income exceeding $16,000 in a trust is taxed at the 37% rate, while the thresholds are $640,600 for individuals filing as singles and $768,700 for couples who file taxes jointly.
The 20% tax on capital gains on assets held at least 12 months applies when income hits $16,250 in trusts. For individuals, the threshold is $533,400 for singles and $600,050 for joint filers.
Meet liquidity needs
A swap can be a way to generate cash.
If you have liquidity needs you can’t easily meet, you can transfer assets to your trust and take out the equivalent value in cash, says Robert Westley, regional wealth advisor at Northern Trust. “You may feel constrained because you don’t want to sell stock or have illiquid assets. If the trust holds cash, you can swap those assets to solve your problem.”
Minimize the estate tax
If you are worried about estate taxes and want to maximize the $15 million per person estate tax exemption, it can make sense to gift shares of stock to a trust during a market downswing, assuming you expect them to rise in value again, says Sara Wells, a partner at Morgan Lewis. “If they’ve gone down in value, get them and their future appreciation out of your estate.”
Consider a $1 million stockholding in your taxable account that halves in value. “You can take that $500,000 of stock and swap it for $500,000 in cash in a trust,” Wells says. “Later that $500,000 may rise back to $1 million or more but you only used up $500,000 of your estate tax exemption to gift it to your trust.”
Part or all of the exemption can be used during your lifetime to avoid gift taxes.
Preserve growth in GRATs
When stock values swing high, it may be a good time to swap assets out of a common type of trust called grantor retained annuit trust (GRAT).
GRATs are typically set up for two to three years, during which the grantor—the person who sets up the trust—receives an annuity payment and is responsible for the paying the trust taxes.
At the end of the trust’s term, any appreciation that is above a hurdle rate set by the Internal Revenue Service goes to heirs free of gift and estate taxes.
A GRAT is only successful if the assets within it appreciate. If the value doesn’t rise above the hurdle rate, the assets return to the grantor’s estate and the trust is dissolved.
In this kind of market environment where stock values are high but extremely volatile, it may make sense to immunize your GRAT from any big downdrafts, says Pam Lucina, chief fiduciary officer at Northern Trust. “You could take chips off the table by swapping out a highly appreciated asset for cash or a more stable asset.”
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