Planning for 2026: Opportunities and Drafting Guide

In 2024, the federal lifetime gift, estate and generation-skipping transfer (GST) tax exemptions are $13.61 million for individuals and $27.22 million for married couples through the “pooling” of their exemptions, which are subject to annual inflation adjustments. Absent new legislation, the current exemption laws will sunset on Jan. 1, 2026, and the exemption amounts will drop to an estimated $6 million to $7 million per individual (reflecting a base $5 million exemption, inflation adjusted from 2010 to 2026). 

The following provides a general overview of two planning opportunities for individuals who want to use all or part of their exemptions before 2026: (1) a gift and/or sale to a grantor trust and (2) the creation of a spousal lifetime access trust. Each strategy takes time to implement, and individuals must select the assets they plan to transfer with care, taking into account expected income and appreciation, applicable federal and state income and transfer tax rates, state property taxes and personal circumstances. As 2026 nears, implementing these transactions may become increasingly difficult, due to heightened demands on advisors and potential trustees. Accordingly, individuals with sufficient wealth should consider planning now to maximize the benefits of their currently higher exemptions.

Foundational Tax Concepts

Income Tax Basis. A lifetime gift carries over the donor’s income tax basis to the recipient. Accordingly, if a donor makes a lifetime taxable gift of appreciated property that the recipient subsequently sells, not only does the donor use gift tax exemption and/or pay gift tax (40%) based on the gift’s fair market value, but the recipient also may pay capital gains tax (20% to 37% plus applicable state taxes) on the difference between the property’s tax basis and its fair market value when sold.

In contrast, property inherited from a donor’s estate typically receives either a “step up” or a “step down” in tax basis to the property’s fair market value as of the donor’s death. For spouses with community property, this basis adjustment is made to both the deceased spouse’s half and the surviving spouse’s half of the community property assets at the first spouse’s death, whereas separate property assets receive a basis adjustment only with respect to the deceased spouse’s separate property.

For these reasons, deciding whether to make a lifetime transfer of an asset that will carry over its tax basis depends in part on the spread between the projected income or capital gains taxes resulting from a future sale of that transferred property compared to the estate tax exposure applicable to inherited property. A lifetime gift of property with substantial appreciation or potential for growth in value may not generate the greatest overall tax savings.

Retained Interests or Powers. If an individual makes a lifetime transfer of property and retains an interest in or certain powers over that property, it can trigger inclusion in the individual’s taxable estate at death. For example:

• If an individual makes a lifetime transfer of a partnership interest and retains the right to receive the income attributable to that interest, the value of the entire partnership interest is considered a part of the individual’s taxable estate at death.
• If an individual makes a lifetime transfer of a house and then continues to use the house without paying fair market rent for the usage, the value of the house will be included in the individual’s taxable estate at death.
• If an individual makes a gift to an irrevocable trust benefiting descendants but retains the right to receive income from the trust or to control the distribution of trust assets, the value of the trust will be included in the individual’s taxable estate.

GST Tax. GST tax applies to transfers to grandchildren (or more remote descendants) and to non-relatives who are more than 37.5 years younger than the donor. As a result, GST tax can apply to a transfer to such a person in addition to any gift or estate tax. For example, if a donor creates a trust for her child for the child’s lifetime, after which the donor’s grandchild will become the beneficiary, the donor’s gift to the trust is subject to gift tax and, at the child’s death, may be subject to GST tax.

State Property Taxes. Individuals with real property holdings should consider any relevant state property tax laws when making a transfer of real property interests. For example, with certain exceptions, a transfer of California real property is generally considered a change in ownership for property tax purposes that “resets” the property’s assessed value based on its then fair market value. Notably, a transfer of California real property between spouses does not trigger such a reset. Special rules apply with respect to transfers of interests in an entity (such as a limited liability company, partnership or corporation) that owns California real property and whether such a transfer triggers reassessment of the real property held within the entity.

Grantor and Non-Grantor Trusts. A donor can structure an irrevocable trust as a non-grantor trust, so that the trust itself is responsible for the payment of its own income tax liability. If trust income is distributed to a trust beneficiary, the beneficiary, rather than the trust, may be responsible for payment of any income tax. For estate tax purposes, assets held in the non-grantor trust remain outside of the donor’s and beneficiaries’ taxable estates (absent the retention of certain powers by the donor).

In contrast, a donor may establish an irrevocable trust as a grantor trust by holding certain powers or interests in the trust. The donor, as grantor, is treated as the owner of the trust assets for income tax purposes and must pay the trust’s income tax liability. The grantor’s income tax payments are not taxed as gifts, even though they could be viewed as constructive additions to the trust. The grantor also can enter into transactions with the trust, such as sales or loans to or from the trust, which are disregarded for income tax purposes. With proper structuring, the grantor will not be treated as the owner of the grantor trust assets for estate tax purposes at death, so any property gifted or transferred to the trust (and any appreciation) will be removed from the grantor’s taxable estate.

If the income tax burden of a grantor trust becomes too onerous for the grantor, the trust can include a mechanism to convert to non-grantor trust status, although this conversion typically cannot be reversed. Alternatively, it may be possible for the trust to grant an independent person the authority, on a year-by-year basis, to reimburse the grantor for income taxes paid by the grantor on the trust’s income. Such a power should not be exercised with regularity in order to avoid the risk of inclusion of the trust assets in the grantor’s estate.

Opportunity 1: Gift and/or Sale to a Grantor Trust

An individual can fund a grantor trust via a gift and/or a sale, which can take advantage of the transferor’s available exemption amounts, shift appreciating assets to beneficiaries and remove the value of the assets and future appreciation from the transferor’s taxable estate. Thereafter, the trust assets will grow free of additional income, gift or estate tax (and, if applicable, GST tax).

In a typical gift and sale transaction, an individual makes an initial gift of property to the grantor trust, which can serve as “seed money” to support the trust’s purchase of additional assets from the transferor. As a general rule of thumb, the gifted property equals at least 10% – 20% of the value of the property to be sold to the trust. The transferor then sells property to the trust in exchange for a promissory note. The sale is not a taxable gift if the assets are accurately valued and the note bears interest at the appropriate interest rate. On a monthly basis, the IRS publishes applicable federal rates (AFRs), which are the threshold rates that these notes should charge. Because transactions between a grantor and a grantor trust are disregarded for income tax purposes, the sale does not trigger capital gains tax, and the tax basis of the property sold carries over to the trust.

The grantor trust should make periodic payments on the promissory note, such as debt servicing of the note interest. At the end of the note’s term (or earlier), the trust repays the note’s outstanding balance in cash or by transferring assets back to the transferor (valued at their then fair market value). Any appreciation in the assets sold in excess of the total note obligations is transferred to the trust gift-tax free. Further, grantor trust assets are not subject to estate tax at the deaths of the beneficiaries or to GST tax if GST tax exemption is allocated to the trust. This plan allows the transferor to retain access to the transferred assets through the trust’s payments on the note.

• Example. A transferor gives $1 million of interests in Realty LLC (or $1 million of cash) to a grantor trust and then sells an additional $4 million of interests in Realty LLC to the trust in exchange for a promissory note equal to the purchase price. The note has a nine-year term and bears interest annually at 5% (equal to $200,000 per year). The trust receives annual income from the Realty LLC interest of $1.14 million, which it can apply to the annual note payments.

The transferor receives an income stream through the annual note payments but does not recognize the interest payments as taxable income. Although the transferor must continue to pay the income tax on all income from the Realty LLC interest, he or she also can take any depreciation or other deductions allowable to the trust to offset that income. All appreciation remaining in the trust after repayment of the note is removed from the transferor’s taxable estate.

Opportunity 2: Spousal Lifetime Access Trust

A common hesitation for donors when considering sizable gifts is uncertainty as to whether they will need the gifted property in the future. Planning with a spousal lifetime access trust (SLAT) can help mitigate such apprehension.

A SLAT is a lifetime irrevocable trust created and funded with the separate property of one spouse (Grantor Spouse) to benefit the other spouse (Beneficiary Spouse) and/or descendants. To remove the transferred assets from Grantor Spouse’s estate, Grantor Spouse cannot retain an income interest in or direct access to the trust assets. Beneficiary Spouse, however, can receive trust distributions, which gives Grantor Spouse indirect access to the transferred property and trust income. Beneficiary Spouse also can act as a trustee, although his or her powers to make distributions should be limited to an “ascertainable standard,” such as distributions for health, education, maintenance or support.

The trust is a grantor trust due to Beneficiary Spouse’s interest, so Grantor Spouse remains responsible for payment of the trust’s income tax liability. Any assets remaining in the trust after Beneficiary Spouse’s death can pass to descendants or other beneficiaries free of gift or estate tax and GST tax, if GST tax exemption is allocated to the trust.

• Example. Grantor Spouse and Beneficiary Spouse, California residents, divide $26 million of community property into equal shares of separate property ($13 million per spouse). Grantor Spouse funds a SLAT for the benefit of Beneficiary Spouse with Grantor Spouse’s $13 million separate property. Following Beneficiary Spouse’s death, the remaining trust assets pass to trusts for Grantor Spouse’s descendants. Grantor Spouse files a gift tax return allocating her lifetime gift and GST tax exemptions to the gift to the trust. If California real property is part of the gift, the property’s assessed value will not be “reset” for California property tax purposes because Beneficiary Spouse is the trust’s initial beneficiary.

Each spouse may want to create a SLAT for the benefit of the other. If the IRS successfully asserts the “reciprocal trust doctrine,” however, both SLATs may be unwound, thus subjecting the spouses’ transferred assets to estate tax and defeating the planning. The more similar the terms of the two trusts, the greater the risk, although crafting effective differences intended to permit SLATs to benefit both spouses can be a complex exercise. Accordingly, careful planning and execution are essential in creating dual SLATs.

As noted, a Grantor Spouse generally should not retain a direct interest in the SLAT to prevent inclusion of the trust assets in his or her taxable estate. If Beneficiary Spouse predeceases or divorces Grantor Spouse, Grantor Spouse will lose indirect access to the trust assets. For example, if the SLAT holds a family home, Grantor Spouse would need to pay fair market rent to avoid possessing a retained interest in that asset following the divorce from or death of Beneficiary Spouse. 

While there are certain states that allow the creation of “self-settled” trusts with retained interests, known as Domestic Asset Protection Trusts (DAPTs), there are many risks, formalities and constraints that could make a DAPT an undesirable vehicle. Further, the effectiveness of a DAPT created in one state by a resident outside of that state will depend on applicable state law, and it may be unclear whether a DAPT is effective with respect to a non-DAPT state resident who creates a trust in a DAPT state. 

• Example. Beneficiary Spouse is able, under the terms of the trust, to add Grantor Spouse as a beneficiary of the SLAT at Beneficiary Spouse’s death. Under California law, Beneficiary Spouse’s power will be treated as a retained interest of Grantor Spouse. If the trust is created in a DAPT state, there should be no retained interest, but it is unclear whether that determination would govern with respect to California residents.

Key Takeaway

The above is only a sample of the planning strategies that may work for a particular individual’s circumstances. The most important takeaway is that, with 2026 around the corner, now is the right time for high net worth individuals to begin evaluating methods for optimizing the benefits of their increased exemptions.