Intentionally Defective Grantor Trusts (IDGT) are when a grantor transfers an asset, or assets, into a trust where the asset and any growth are effectively removed from the estate, but the grantor still pays income tax. Effectively, the grantor’s purpose is to potentially grow the inheritance “income tax-free” for their heirs by paying the income taxes as the asset grows while they are still alive. By setting up an IDGT the grantor is “intentionally” triggering the need to pay income tax on the asset.
An IDGT is an irrevocable trust, where the grantor cannot be a beneficiary or a trustee. If it was a revocable trust, the property would stay within the estate. Separating the asset from the estate can also lower the taxable value of the state. If an estate is over $12 million in 2022, any amount over that threshold is subject to the federal estate tax.
Because the asset is removed from the estate, when the beneficiaries, usually children or a spouse, inherit the asset after the grantor’s death, they might be able to avoid estate taxes.
For example, if the grantor puts a building worth $10 million into the IDGT, and it appreciates to a value of $13 million at the time of death. While the grantor is alive, they paid any applicable income taxes for the building and its income. Upon their death, the beneficiaries inherit the building at its current value. Because the building was separated from the estate into the trust, there is the potential for both the estate and the beneficiary to avoid estate taxes.
The grantor can sell or gift assets into the trust at any time. When they do this, no capital gain is realized, and so they might avoid paying capital gains tax on the transfer. However, if the grantor gifts an asset to the trust, it might count towards the grantor’s lifetime gift exemption.
When a grantor isolates an asset into an IDGT with the hope of leaving the funds to relatives in their will without estate and gift tax implications, it can be complex. It is always a good idea to consult with a qualified estate planner or attorney when setting up an IDGT.