4 trust strategies that use volatility to cut taxes

The turbulent stock market is creating significant tax-saving opportunities for wealthy individuals through the often-overlooked strategy of asset swapping within irrevocable grantor trusts, a move that can reduce capital gains and estate tax liabilities by more than 40 percent.

"Asset swapping often falls between the cracks,” says Edward 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.”

The strategy allows a grantor to exchange assets of equal value between their personal estate and an irrevocable trust. This can be particularly powerful when considering the different tax rules; the top 37 percent income tax rate applies to trust income over $16,000, a threshold individuals only reach at $640,600.

For investors, this means a well-timed swap can preserve wealth for the next generation by maximizing the current $15 million per-person estate tax exemption, ensuring heirs receive a stepped-up cost basis on appreciated assets, and securing gains in popular trust vehicles before a market downturn.

Lock in a Step-Up in Cost Basis

One of the most powerful uses of an asset swap is to prepare assets for inheritance. When heirs inherit assets held within an irrevocable trust, they do not receive a “step-up” in cost basis, meaning they could face significant capital gains taxes. By contrast, assets inherited directly from an individual’s estate get their cost basis reset to the market value at the time of death.

“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. An individual can swap high-basis assets like cash into the trust in exchange for low-basis, highly appreciated stock. The stock then becomes part of the estate, and upon inheritance, the heirs receive it with a new, higher cost basis, effectively erasing the embedded capital gain.

This is especially advantageous given that the 20 percent top capital gains tax rate kicks in for trusts with income over just $16,250, compared to $533,400 for single filers.

Generate Cash or Meet Liquidity Needs

Asset swaps can also serve as a creative source of liquidity. An individual holding illiquid assets like private equity or real estate in their personal portfolio can swap them for cash held within their trust.

“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. This allows the grantor to access cash without having to sell other, more desirable assets in their personal accounts. For the swap to be valid, the assets exchanged must have an equivalent, justifiable value.

Minimize Estate and Gift Taxes

Market downturns offer a unique opportunity to transfer wealth more efficiently and minimize future estate taxes, which currently stand at a 40 percent rate above the exemption. The lifetime gift and estate tax exemption is a generous $15 million per person, but strategic gifting can make it go further.

Sara Wells, a partner at Morgan Lewis, suggests gifting shares to a trust after their value has dropped. “If they’ve gone down in value, get them and their future appreciation out of your estate,” she says. For example, if a $1 million stock position falls to $500,000, gifting it to the trust uses only $500,000 of the lifetime exemption. When the stock recovers to $1 million or more, that appreciation occurs inside the trust, shielded from future estate taxes.

Preserve Gains in a GRAT

For those using a Grantor Retained Annuity Trust (GRAT), a popular short-term trust vehicle, asset swaps can be crucial for locking in success. A GRAT allows appreciation above a rate set by the IRS to pass to heirs tax-free. However, the assets must outperform that hurdle rate over the trust's term, typically two to three years.

In a market with high volatility, a highly appreciated asset could quickly lose its value. “You could take chips off the table by swapping out a highly appreciated asset for cash or a more stable asset,” says Pam Lucina, head of family office solutions at Northern Trust Wealth Management. This immunizes the GRAT from a potential downdraft, preserving the gains that will ultimately pass to beneficiaries free of estate and gift tax.

This article is for informational purposes only and does not constitute investment advice.