A popular trust strategy, the sale of an asset to an Intentionally Defective Grantor Trust (IDGT), is also complex and expensive to set up. However, because the payoff is potentially greater than with other trusts that pass your money to the next generation while minimizing taxes, "everyone out there is talking about it," says Evelyn Capassakis, a partner at PricewaterhouseCoopers.
The idea is to set up a trust and then sell it stock, real estate, or another asset in exchange for an interest-bearing I.O.U. If you sell the asset to the trust for a profit, you don't need to pay taxes on the gain, since you're essentially selling something to yourself. The goal is for the trust's assets to appreciate enough to cover the I.O.U., while leaving something more for your heirs. Today, that's easier than ever, since IDGTs must pay interest of only 1.23% to 4.17%, depending on the I.O.U.'s maturity.
There are several caveats. Because the tax code doesn't specifically authorize IDGTs, the Internal Revenue Service has been known to challenge them, says Capassakis. Another complication is that if you die before the I.O.U. is paid, it's not clear what kind of income-tax liability your estate will incur, says Don Weigandt, managing director at J.P. Morgan Private Bank in Los Angeles. In a worst-case scenario, he says, your estate might owe tax on any gain you realized when you sold your asset to the trust.
IT'S A GIFT. In order to purchase your asset, your IDGT needs some cash. So you'll have to fork over at least 10% -- and some advisers suggest more -- of the asset's purchase price and pay gift taxes on that amount. A big risk is that if your asset declines in value, the trust will have to use the money you gave it to repay its debt. Of course, if that occurs, you won't be able to recoup the gift taxes you paid.
Worse, the IRS might consider a defaulted loan a gift -- obligating you to pay even more in gift taxes, says Joanne Johnson, managing director at JPMorgan Private Bank. "If the trust has no money, does that mean the grantor has made a gift of the balance of what's left on the loan?" Like many things about these trusts, the answer is unclear. By Anne Tergesen in New York