A very popular estate planning tool is the Intentionally Defective Grantor Trust (IDGT). Despite the implication of the name, there is nothing defective about an IDGT. Rather, it is an extremely cunning tool for the avoidance of estate taxes. An IDGT is established with two opposing goals. The first goal of the trust is to insure that once assets are placed within, they are no longer part of the grantor’s estate. The second goal is to keep the assets within the grantor’s ownership for income tax purposes. This seemingly contradictory goal, is the “Intentionally Defective” element of the IDGT.
Perhaps the most common application of this technique, involves the transfer of a valuable piece of real estate. The grantor wishes to pass the real estate to his or her children, while minimizing gift and estate taxes. To do so the grantor establishes an IDGT. The grantor then sells the real estate to the IDGT for its full value. In exchange for the sale, the grantor receives an IOU from the trust for the full amount of the sale. This sale is the equivalent of selling your house to yourself, as the IDGT is ignored for income tax purposes. Therefore, no income tax is generated by the sale. However, for estate tax purposes, the sale is binding and the property is removed from the grantor’s estate. In its place there is now an IOU. Over time, the trust will pay down the IOU using income generated by the real estate. Income tax will be paid by the grantor, while the value of the trust increases! The grantor creates three channels of tax free gifting. 1. Income of the trust, 2. The income tax paid on this income and 3. The growth in the value of the building. All three of these are now transferred to the beneficiaries with no gift or estate tax.