In our last article, we discussed the powerful “step-up in basis” rule, which can eliminate capital gains taxes for heirs who inherit appreciated assets. However, we noted a potential conflict: keeping assets in your name until death to get the step-up means they count towards your estate tax calculation. For those with estates potentially exceeding the federal exemption ($13.99 million per person in 2025, but potentially much lower in the future), this can be a costly trade-off.

So, how can you remove assets – especially those you expect to appreciate significantly – from your taxable estate before you pass away? One popular and powerful tool is an Irrevocable Trust. And a specific type, the Intentionally Defective Grantor Trust (IDGT), offers unique advantages.

Trust Basics: Getting Assets Out of Your Estate

An irrevocable trust is a legal arrangement where you (the “Grantor”) transfer assets to a trustee, who manages them for the benefit of others (the “Beneficiaries,” typically your children or grandchildren). Once you create an irrevocable trust and transfer assets to it, you generally give up control and ownership. The key benefit? Assets properly transferred to a well-drafted irrevocable trust are typically removed from your taxable estate. They can grow and eventually pass to your beneficiaries without being subject to estate tax upon your death.  

What Makes an IDGT “Defective”? (And Why It’s a Good Thing!)

An IDGT is a specific type of irrevocable trust designed with intentional “flaws” or “defects” from an income tax perspective, but not from an estate tax perspective.

• Estate Tax View: The assets and critically their future appreciation are OUT of your estate. Mission accomplished for estate tax reduction.
• Income Tax View: Due to the intentional “defects” (often related to certain powers the Grantor retains, like the power to substitute assets), the IRS considers the Grantor (you) the owner of the trust assets for income tax purposes only.

This means you, the Grantor, are responsible for paying the income taxes generated by the trust’s assets (like interest, dividends, or capital gains if the trust sells something).

Why Paying the Trust’s Income Tax is a Superpower

At first glance, paying taxes on assets you don’t technically “own” anymore might seem like a raw deal. But it’s actually a hidden superpower for transferring wealth:

1. Tax-Free Gift: When you pay the income tax liability generated by the IDGT, the IRS views this as fulfilling your own tax obligation, not as making an additional gift to the trust beneficiaries.
2. Turbocharged Growth: Because the trust’s assets aren’t being diminished each year by income taxes (you’re covering that bill!), the trust can grow faster. It’s like making additional, tax-free contributions to the trust year after year.

IDGT vs. Non-Grantor Trust (NGT): A Quick Comparison

An alternative is a Non-Grantor Trust (NGT), where the trust itself (or sometimes the beneficiaries) pays its own income taxes. While NGTs also remove assets from your estate, they don’t benefit from the Grantor paying the taxes. Furthermore, trusts often hit the highest income tax brackets at much lower income levels than individuals, potentially leading to a greater tax drag on growth within an NGT compared to an IDGT.  

Example: The Power of IDGT Growth

Let’s say Clara has an estate well over the exemption limit. She transfers $2 million worth of stock she expects to appreciate rapidly into an IDGT for her children.

• Assume: The stock grows at 8% per year and generates a 2% dividend (taxable income). Let’s also assume a combined federal/state income tax rate of 40% on that income.
• Year 1 Growth: The IDGT assets grow by $160,000 (8% of $2M) and produce $40,000 in dividends (2% of $2M).
• Tax Impact: The trust owes income tax on the $40,000 dividend. That’s $16,000 (40% of $40k).
  • In an IDGT: Clara pays the $16,000 income tax bill from her personal funds. The trust assets remain at roughly $2,200,000 ($2M + $200k growth). Clara has effectively made an additional $16,000 tax-free transfer to the beneficiaries.
  • In an NGT: The trust itself pays the $16,000 tax bill. The trust assets are reduced to roughly $2,184,000 ($2M + $160k growth – $16k tax).
• Long Term: Over many years, this difference compounds significantly. The IDGT grows much larger because it isn’t burdened by income taxes, and those assets (including all the growth) are outside Clara’s taxable estate.

The IDGT Downside (So Far): No Step-Up

While IDGTs are fantastic for reducing estate taxes and enhancing growth, there’s a catch we alluded to earlier. Because the assets are legally owned by the trust, not by you at death, your beneficiaries do not receive a step-up in basis on the assets inside the IDGT when you pass away. They inherit the trust’s basis (often the original low basis you had when you transferred the assets in).

So, we’ve solved the estate tax problem for those assets, but we seem to have lost the capital gains tax benefit for the heirs. Is there a way to have your cake and eat it too?

The Magic Wand: The Power of Substitution

Many IDGTs are drafted to include a provision granting the Grantor (you) the power, acting in a non-fiduciary capacity, to “swap” or “substitute” assets of equivalent value between yourself personally and the trust. This means you can pull assets out of the trust and replace them with other assets you own personally, as long as the assets exchanged have the same fair market value at the time of the swap.

The Strategy: Bringing Low-Basis Assets Home for the Step-Up

Here’s how the strategy works, combining the benefits of an IDGT with the power of substitution to ultimately achieve a step-up in basis:

1. Fund the IDGT: Transfer highly appreciating, low-basis assets (like rapidly growing stock or pre-IPO shares) into the IDGT early on. These assets are now removed from your taxable estate.
2. Let it Grow: The assets grow inside the IDGT. You pay the income taxes generated by the trust from your personal funds, further boosting the trust’s value without using your gift tax exemption. The growth occurs outside your taxable estate.
3. Monitor and Prepare: As you get older, or if health concerns arise, you identify the low-basis, highly appreciated assets within the IDGT.
4. Execute the Swap: Using the Power of Substitution, you swap high-basis assets (like cash, bonds, or recently purchased stocks with little appreciation) from your personal ownership into the IDGT. In exchange, you take back the low-basis, highly appreciated assets out of the IDGT and into your personal name. Crucially, the swap must be for assets of equivalent fair market value. (e.g., swap $5M cash for $5M worth of the appreciated stock).
5. Hold Until Death: You now personally own the highly appreciated, low-basis assets again. You hold these until you pass away.
6. The Payoff:
   • Step-Up Achieved: Your heirs inherit the highly appreciated assets directly from you (or your revocable trust). Their basis steps up to the fair market value at your death, wiping out the built-in capital gain.
   • Estate Tax Minimized: The high-basis assets (like the cash you swapped in) remain in the IDGT, passing to your beneficiaries free of estate tax. The appreciation that occurred while the assets were in the IDGT also escaped estate taxation.

Example: Putting it All Together

Let’s revisit Clara from Article 2. Years ago, she put $2M of stock (basis $200k) into an IDGT. She paid the income taxes annually. Her estate is potentially taxable.

• Now: Clara is elderly. The stock in the IDGT is now worth $10M (still has a low basis, close to the original $200k carried over). Clara has $10M in cash/high-basis assets personally.
• The Swap: Clara uses her Power of Substitution. She transfers $10M cash into the IDGT. In return, she takes the $10M worth of appreciated stock out of the IDGT and holds it personally. The swap is value-for-value.
• Clara Passes Away:
  • Her heirs inherit the $10M stock directly. Their basis steps up to $10M. They can sell it with zero capital gains tax.
  • The IDGT, holding $10M cash (or whatever high-basis assets were swapped in), passes to the beneficiaries completely outside of Clara’s taxable estate. No estate tax is due on the IDGT assets.  

Result: Clara successfully removed the $8M+ of appreciation from her taxable estate and provided her heirs with a full step-up in basis on the appreciated stock, eliminating a significant capital gains tax burden for them.

Conclusion:

For individuals with significant wealth facing potential estate taxes and holding low-basis, high-growth assets, the combination of an IDGT and the strategic use of the Power of Substitution can be an incredibly powerful tool. It offers a potential pathway to minimize estate taxes while preserving the valuable step-up in basis for heirs, truly aiming for the best of both tax worlds.

About Valur

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From selecting the right strategy to handling setup, administration, and ongoing optimization, we take care of the hard work so you don’t have to. The results speak for themselves: our customers have generated over $3 billion in additional wealth through our platform.

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