by Philip D. W. Hodgen
Imagine this. You’re rich. Oh, come on. Not THAT rich. Say, $5M or so, all in—house, pension plans, life insurance, furniture, cars, and antique electric can opener.
Imagine that you have an apartment building worth $1.5M, that you’ve owned forever. It generates $150,000 a year of cash flow—nice to have, but you really don’t need it. And everything you don’t spend is just adding to your kids’ estate tax problem, anyway. (You won’t have a tax problem for obvious reasons).
You don’t want to sell because of a gigantic capital gain tax. You don’t want to keep it because you’re wealthy enough to create estate tax problems for your kids. You’re in a bind.
So let’s manufacture a solution. You create the buyer—your own trust, for the benefit of your kids. You provide 100% financing with an interest-only, 30 year note. You sell at fair market value and get interest payments every year.
- You pay no capital gains tax on the sale.
- You pay no income tax on the interest payments back to you.
- Future appreciation escapes estate tax.
- You pay no gift tax.
- Here’s the interesting one, though—you (not the trust) pay income taxes on the net income from the building and on the capital gains when it is sold.
What’s so %@#! interesting about paying income taxes on money you can’t have? It’s like a tax-free gift to your kids. More later.
Intentionally defective grantor trusts
This is all about one of the odd beasts of estate planning—the intentionally defective grantor trust.
Intentionally defective grantor trusts are not really defective. A normal irrevocable trust pays income tax on its earnings, and property in the trust escapes estate taxes when you die. The intentionally defective grantor trust is simply an irrevocable trust carefully crafted to change one or both of those tax results.
. . . defective for estate tax?
If you create a trust that is defective for estate tax purposes, its assets are included in your estate when you die. This is a good idea if you are fairly sure you won’t owe estate tax—your net worth is under $650,000 (for ’99). Then your heirs pay no estate tax and (because of a tax feature that Congress is sure to nuke sooner or later) they won’t pay capital gains tax, either.
. . . defective for income tax?
But usually, intentionally defective grantor trusts are designed to be defective for income tax treatment. You pay income tax on the trust’s income—not the trust, not the beneficiaries. And the trust assets are out of your estate for estate tax purposes.
How to do it
Making an irrevocable trust properly defective is easy—simply violate one of the "grantor trust rules" in the Internal Revenue Code. Intentionally making the "right mistake," of course, is hard. It’s like a golfer intentionally slicing the ball.
So you have this defective trust. Now what? You sell the building to the trust.
Give the trust an initial seed gift, in cash, of perhaps 10% of the building’s value. Then, sell the building to the trust at fair market value. ("Fair market value" can be manipulated for tax purposes through techniques like family limited partnerships.)You receive a interest-only note for the entire sale price, calling for a balloon payment far in the future—perhaps as long as 30 years.
What just happened?
You unloaded an asset that will generate increasing income and rise in value. You’ve replaced it with an asset with a fixed value and fixed income—the note.
When the building goes up from $1.5M to $2M in value, that extra $500,000 ends up with your kids via the trust, with NO gift tax and NO estate tax.
And the note you hold? Ask yourself—how much would you pay today for someone’s promise to pay you $1.5M in 2029, with modest interest until then? Not much. This means that the note can be valued at lower than face value for estate tax purposes.
If you sell at fair market value, and set the interest rate correctly, there is no taxable gift.
What about income tax? The IRS treats the sale to the trust as a non-event for income tax and capital gains purposes. There is no capital gain tax on the sale. And the interest payments you get on the note won’t be taxable income, either.
Here’s the kicker—a gift tax-free cash gift to your kids
The trust (not you) now gets the $150,000 of rental income every year, and pays you, let’s say, $100,000 of interest on the note you took back.
But you pay income tax on the entire $150,000, even though you’re only getting $100,000 cash. Look at it this way—you’re paying the income tax on that extra $50,000 that you don’t get. In a 40% tax bracket, that’s $20,000 of tax you pay.
With a regular irrevocable trust, the trust pays the $20,000 of income tax. That’s $20,000 your kids would eventually NOT inherit (Uncle Sam, of course, won’t include your kids in his will).
But with the defective trust, YOU’RE paying the $20,000. So the trust still has the $20,000 and it will go to your kids, not to Uncle Sam. This is the same as giving the trust $20,000 so it can pay the tax. And there is no gift tax when you do this.
With this modest example you might not even have a taxable gift (you can give $10,000 a year to as many people as you like, tax free). But imagine that over the years the building throws off more and more income. Now the numbers get bigger and the gift tax advantages get better.
Here’s the real payoff. When the trust sells the building there will be a whacking great capital gain tax. You pay a couple of hundred thousand dollars of tax, not the trust. You’ve left that much money in the trust for your kids. And there is no gift tax due when you do this.
Save state income taxes
This strategy can also avoid state income taxes. Set up your intentionally defective grantor trust in a state with no income tax. Do the sale. Pay 20% Federal capital gain tax, but no state income tax—the seller is the out-of-state defective trust, not you, the in-state human. (Sorry, won’t work for real estate).
Now be warned. The California tax authorities insist that if you live in California, the trust is taxable here. This will change—the Big California Banks are lobbying to change the law. But in the meantime, here’s the reality for California residents—it’s hard to escape the Franchise Tax Board.
Department of economics
This strategy only works when the return on the investment you stick into the trust is GREATER than the interest rate on the note you get back. And, like everything good in tax law, it ain’t black and white. You’ll need a good tax lawyer to make it work. And there will still be some income tax (for sure) and estate tax (probably) and gift tax (maybe) to pay. But you (oops, your kids) will probably save bundles in tax—20X, maybe more—than the legal fees it takes to set this up.
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