If you reside in a high-tax state, you may want to consider using non-grantor trusts to soften the blow of the new $10,000 federal limit on state and local tax (SALT) deductions. The limit, which was added by last year’s Tax Cuts and Jobs Act (TCJA), can significantly reduce itemized deductions if your state income and property taxes are well over $10,000. A potential strategy for avoiding the limit is to transfer interests in real estate into several non-grantor trusts, each of which enjoys its own $10,000 SALT deduction.
Grantor vs. Non-Grantor Trusts: What’s the Difference?
The main difference between a grantor and non-grantor trust is that a grantor trust is treated as your alter ego for tax purposes, while a non-grantor trust is treated as a separate entity. Traditionally, grantor trusts have been the vehicle of choice for estate planning purposes because the trust’s income is passed through to you, as grantor, and reported on your tax return. That’s an advantage, because it allows the trust assets to grow tax-free, leaving more for your heirs. By paying the tax, you essentially provide an additional, tax-free gift to your loved ones that’s not limited by your gift tax exemption or annual gift tax exclusion. In addition, because the trust is an extension of you for tax purposes, you have the flexibility to sell property to the trust without triggering taxable gain.
Now that the TCJA has doubled the federal gift and estate tax exemption, fewer families are subject to gift taxes, so grantor trusts enjoy less of an advantage over non-grantor trusts. This creates an opportunity to employ non-grantor trusts to boost income tax deductions.
Non-Grantor Trust in Action
A non-grantor trust is a discrete legal entity, which files its own tax returns and claims its own deductions. The idea behind the strategy is to divide real estate that’s subject to more than $10,000 in property taxes among several trusts, each of which enjoys its own SALT deduction up to $10,000. Each trust must also generate sufficient income against which to offset the deduction.
Here’s an example:
Diane pays a total of $30,000 in property taxes each year, but can deduct only $10,000 of that amount under the new limit. She transfers her real estate to a limited liability company (LLC) and then gifts one-third interests in the LLC to three non-grantor trusts. She also ensures that each trust holds sufficient assets to produce approximately $10,000 of income per year. The result: Each trust reports around $10,000 in income, which is offset by a $10,000 property tax deduction, so the trusts have no taxable income. This strategy essentially allows Diane to deduct her entire $30,000 property tax bill.
Beware the Multiple Trust Rule
Before you attempt this strategy, be sure to consider the multiple trust rule of Internal Revenue Code Section 643(f). That section provides that, under regulations prescribed by the U.S. Treasury Department, multiple trusts may be treated as a single trust if they have “substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries” and a principal purpose of the arrangement is tax avoidance.
In the past, the multiple trust rule wasn’t really a concern, because the required regulations hadn’t been issued. In August 2018, however, the Treasury issued proposed regulations implementing the rule. To preserve the benefits of multiple trusts, therefore, it’s important to designate a different beneficiary for each trust.
Pass the SALT
If you’re losing valuable tax deductions because of the SALT limit, consider using a non-grantor trust to pass those deductions on to one or more trusts. Consult us before taking action, because these trusts must be structured carefully to ensure that they qualify as non-grantor trusts and don’t run afoul of the multiple trust rule.