Intentionally defective grantor trust

An Intentionally defective grantor trust is sometimes used to reduce estate taxes. It works as follows:

1. The grantor creates the trust
2. The grantor transfers investment assets into the trust, but retains the power to "reacquire the trust corpus by substituting other property of equivalent value". The transfer is valid (complete) for estate tax purposes but is incomplete for income tax purposes.
3. The grantor pays gift tax on the transfer
4. During the grantor's lifetime, he pays income taxes any increase in value of the assets in the trust. The trust grows, but its "value" for estate tax purposes is "frozen" at the time of the transfer. If the trust grows substantially, the increase is not subject to estate tax (which is usually at a higher rate than the grantor's marginal income tax rate).
5. If the assets decrease in value, the grantor can sell them (leaving the sales price in the trust, or using it to acquire other assets for the trust). He can then apply that loss to decrease the taxes he will pay on other assets that have increased in value, but the value for estate tax purposes will not decrease.