Several of our clients who have used the 1031 exchange previously to sell investment property and exchange into a DST, have asked if a “Trust” can be used to avoid estate taxes. The answer to that question depends on the type of trust the client is establishing.
Two of the most common trust structures individuals use to facilitate the transfer of wealth to heirs are 1) revocable and 2) irrevocable trusts. A revocable trust, sometimes called a living trust, can be changed by the creator of the trust at any time. An irrevocable trust however has very limited options to make changes as compared to a revocable trust.1 However, only irrevocable trusts allow you to potentially shelter assets from estate taxes. While revocable trusts are frequently used to help avoid probate issues, they don’t allow you to pass assets to avoid estate taxes.
How Does an Irrevocable Trust Help Avoid Estate Taxes?
First, it’s important to know there are generally three parties involved in an irrevocable trust:
- Grantor (sometimes called a settler) who creates the trust
- Trustee who administers the trust
- Beneficiary who receives the trust assets upon the grantor’s death
Once an irrevocable trust has been created and the grantor’s assets have been placed into the trust, the trustee assumes control of the trust. The grantor no longer has ownership rights to any of the assets. Since ownership of the assets has been legally transferred to the trust, the grantor has no tax liability created by the assets. The value of the assets has now been removed from the grantor’s estate.
The trust acquires its own tax filing number and, from this point forward, files income taxes and other reporting requirements on behalf of the trust. The grantor can continue contributing assets to the trust but relinquishes ownership rights as those assets are added.
While the grantor may avoid taxation on the assets in the trust, the trust would be responsible for paying income tax on any undistributed gains. Or if the beneficiary receives income from the trust, they would pay income tax on the money received.
Real Assets and Using an Irrevocable Trust Conduct a 1031 Exchange
Real property and other assets can be held in a trust. That includes any tax-deferred real estate replacement property the grantor may want to pass to heirs. Any appreciation of that property, while held in the trust, remains tax-deferred until the property is sold.
And if the trustee determines it’s in the trusts and the beneficiary’s best interest to sell the tax-deferred real estate in the trust using another 1031 exchange, they may do so. The rules that apply to conducting an exchange within a trust are basically the same as a traditional exchange.
The replacement property must be of equal or greater value than the relinquished property and must meet like-kind property requirements.
The 45-day replacement property identification rule applies, as does the 180-day transaction completion rule. Since the trust is now the taxpayer, the important factor to remember is that each side of the 1031 exchange transaction must occur within the trust.
Trusts and Accreditation
Securities including Delaware Statutory Trust DSTs that may be used as replacement properties in a 1031 exchange require that investors must be accredited i.e., meet at least one of the following requirements:
- Earns sustained annual income of at least $200,000 if single, or $300,000 if combined with their spouse’s income.
- Has a net worth of $1 million or more—either individually or in combination with a spouse’s net worth, but excluding the equity value of a primary residence
These same requirements apply when determining if a revocable trust is accredited and thus permitted to invest in securities.
To qualify for accreditation, an irrevocable trust is required to meet the following general standards:
- Must have more than $5 million in assets or
- The trustee or co-trustee is a bank, insurance company, or a qualified registered investment company
Since qualifying for accreditation status is often done on a case-by-case basis, it is best to consult a qualified attorney to assess specific situations.
If you are considering a 1031 exchange or evaluating moving exchange property into an irrevocable trust, we encourage you to contact our professionals at FGG1031 | First Guardian Group, as well as your tax and legal advisors to help you achieve your overall objectives.
For more information, contact us.
1. Changes to irrevocable trusts usually require approval by all the beneficiaries and/or a court to that may be granted if beneficiaries can prove that significant changes occurred requiring a change e.g., changed tax laws.