Substitution Power: The Best Kept Secrets of the Rich (part 2 of 3)

In last week’s article we talked about how the rich used the stepped up basis rule to maximize after-tax returns for their children (or whoever they leave their property to).

In this article we are going to take that one step further with a specific grantor trust rule called the swap out or “substitution power” clause. 

Some background information on “grantor” trust rules:

For those of you who don’t know (because you are a normal person that doesn’t read estate tax laws for a living) - trusts are typically structured for tax purposes as one of two ways: (1) grantor trusts or (2) non-grantor trusts.

It’s important to know whether your trust is a grantor trust or a non-grantor trust because that directly impacts your tax situation. In other words, if you have a grantor trust then nothing should change with regards to your income taxes (everything still gets reported on your own individual income tax return - your 1040). However, if you have a non-grantor trust then you generally have to file a tax return for the trust (known as a fiduciary tax return or 1041) to figure out your income tax situation.

Why is this important for my estate planning?

Well first let me state that if you have a revocable trust (meaning a trust you have control over and can change/amend), then you can rest easy knowing that it’s generally a grantor trust and no income tax complications arise (everything is taxed on your personal return and nothing should really change from an income tax perspective).

But, if you have an irrevocable trust then this can be very important because it can allow you to have the best of both worlds.

What I mean by that is: What if you could remove an asset or its capital appreciation from your estate for estate tax purposes, but also have the ability to get a stepped-up basis in that asset for income tax purposes?

That is what the power of substitution or swap power is all about and below I’m going to show you how the rich use it to maximize their children’s after-tax inheritance.

Power of Substitution Clause:

The power of substitution clause is written in Section 675(4)(C) of the Internal Revenue Code, which states:

“A power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity. For purposes of this paragraph, the term “power of administration” means any one or more of the following powers:…. (C) a power to reacquire the trust corpus by substituting other property of an equivalent value.” (https://www.law.cornell.edu/uscode/text/26/675)

And then there’s the revenue ruling, which shows this technique has been tested and validated:

“Rev. Rul. 2008-22 was the first ruling to outline how a grantor trust with a Section 675(4)(C) “power of substitution” clause could be used so that a grantor could substitute assets of equal value for assets already held by the grantor’s irrevocable trust. The ruling stated that the trust assets would NOT be included in the grantor’s gross estate as a retained life interest under IRC Section 2036 and NOT be included as a power to alter, amend, or revoke under IRC Section 2038.” (https://denhalaw.com/the-power-of-substitution-and-life-insurance/)

So let’s put this into English for you by applying the substitution power to the example given in the previous article - with a twist:

1. In 1985, you bought a 2-family investment property in Somerville for $100,000.

2. You immediately transferred that property to an irrevocable trust that included the power of substitution.

3. Since the irrevocable trust is properly structured and has the power of substitution, it is a grantor trust for tax purposes - therefore, the rental income flows to your individual tax return for income tax purposes.

4. The property is now worth $1 million, however, the asset is considered out of your estate for estate tax purposes because it is in a properly structured irrevocable trust.

5. If you were to sell the property today or leave it to you children through the trust, then you (or your children) would pay a large capital gains tax, but after being reminded of the stepped up basis rule, you decide it would be better to take advantage of the substitution power.

6. Following the terms of the trust, you swap your $1 million investment property with a high cost-basis asset (could be recently purchased stocks, bonds, or even cash).

7. So long as the asset being swapped into the trust is equivalent to the value of the investment property being swapped out, you’ve now successfully substituted the asset.

8. Now the $1 million assets transferred to trust will still avoid estate taxes, but the investment property swapped out of the trust will get the benefit of a stepped up basis at your death.

The net result being that you not only shielded $1 million from estate taxes, but also shielded your family from about $900,000 in capital gains. That’s the power of the substitution clause.

Now, some of you might be thinking - that sounds great, but I don’t have $1 million dollars lying around that I can swap into trust like that.

Well, the good news is that there’s a strategy for that too - stay tuned for my next article to be published on 2/14.

Interested in updating your estate plan? Give me a call at 781 202 6368, email jlento@perennialtrust.com, or click here to schedule your free personal consultation.

I’m always happy to help,

Joseph M. Lento, J.D.

Your Local Estate Planning Attorney

For client testimonials, please visit: www.PerennialEstatePlanning.com

Conveniently located at 477 Main Street, Stoneham, MA 02180