Swap powers are an important but often overlooked opportunity in estate planning. Understanding what allowances swap powers provide can result in significant tax liability reductions. Attorneys working with clients to preserve assets should be aware of the potential benefits of swap powers and work them into estate planning strategies.
What are swap powers?
Swap powers grant the right to substitute—or swap—property of equal value in a trust. This causes a change in the cost basis of the property. Since the new basis will reduce capital gains, tax liability should be minimized when the asset is transferred.
Swap powers provide the ability to move a highly appreciated, low basis asset from an irrevocable trust into a grantor's estate. This means that the low basis is “stepped up” to the fair market value on the date of death of the grantor.
What makes swap powers important?
Many clients have assets in irrevocable trusts to protect themselves from estate taxes. Estate tax thresholds have been raised significantly. At the same time, income tax rates have been increased. These new income tax thresholds have been labeled as the new “death tax”. With this “death tax,” an important estate plan strategy is to make sure that heirs can take advantage of the step-up in basis when grantors pass away.
Under IRC 1014, one can receive a step-up in basis for assets held in one’s estate at death. This means that assets are reappraised at the fair market value at the date of death of the grantor. Heirs inherit the asset under this new cost basis, usually minimizing capital gains taxes if they sell the appreciated asset at a later date.
What’s important to note is that this step up provision does not apply to irrevocable trusts, since these are not considered part of the grantor’s estate. Without the provisions of IRC 1014, assets in the trust would be subject to higher capital gains taxes when sold.
If the grantor possesses a highly appreciated asset in the trust and wants to receive a step up in basis when passing this asset to heirs at death, it may be best to use swap powers in order to take advantage of the provisions applicable to estates.
Part II will look at how swap powers can be used in this way to reduce liability and help in estate planning.
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