With possible estate tax changes on the horizon, now’s a good time to reassess your estate plan. Here are 4 tax-friendly strategies for changing interest rate environments.
With the stock market hovering near all-time highs and the potential for estate tax law changes, estate planning is back in the spotlight. Alongside this fluid economic environment, current levels of estate tax exemptions are scheduled to be cut in half at the end of 2025, prompting some high-net-worth individuals and families to consider bringing estate planning activities forward.
With interest rates at the heart of many estate planning strategies, families should consider a variety of scenarios during this period of uncertainty — some that are ideal for a rising interest rate environment, and some that are preferable in a declining environment.
Planning strategies in a low interest rate environment
There are a variety of wealth transfer strategies to consider in a low interest rate environment, with two in particular that stand out because they tend to use little to no estate tax exemption. They are the grantor retained annuity trust (GRAT) and the intrafamily loan.
GRAT
A GRAT is an irrevocable trust that’s funded for a specific period of time, for example two years. They’re commonly funded with marketable securities. There are no income tax consequences to the donor for funding a GRAT due to its classification as a grantor trust (this type of trust doesn’t have its own income tax return — everything flows through on the donor’s 1040).
A GRAT requires that the donor receive annuity payments from the trust based on IRS-published monthly interest rates (specifically the Section 7520 rate) that’s in effect at the time of funding. This interest rate is important because it’s the rate that invested securities in the trust need to outperform to realize a benefit for the beneficiaries of the GRAT. For example, if the 7520 rate is 5%, the rate of return produced by the invested assets would have to exceed 5% in order for the GRAT to be successful.
At the end of the GRAT period, the trust ends, and the assets pass to the remainder beneficiaries named in the trust (commonly the donor’s children).
During periods of high returns in the stock market the GRAT can be an excellent tool for wealth transfer, enabling appreciated assets to be passed to your beneficiaries tax-free. A successful GRAT can use little to no gift tax exemption, whereas, many other estate planning strategies result in a gift to beneficiaries requiring the use of the exemption. This strategy is particularly attractive if you’re nearing the estate tax exemption amount.
If the GRAT fails, the only downside is the cost associated with creating the GRAT. GRATs can be complex to administer, so it’s important to work with advisors who have experience with this strategy.
Intrafamily loan example/benefit
Intrafamily loans are another strategy that can shift asset appreciation outside of your taxable estate while minimizing the use of your gift tax exemption.
In this scenario, you can make a loan to a family member at a rate of interest based on the applicable federal rate (AFR), which is published monthly by the IRS. This rate is typically lower than what a borrower would pay on a loan from a financial institution. Any appreciation on the assets loaned to the family member that exceeds the AFR rate will fall outside of the lender’s taxable estate. For example, if you were to loan your child $1 million today, you would charge them 4.5% (the applicable AFR on a short-term loan for January 2025), and any appreciation of the $1 million above 4.5% could be retained by the borrower/beneficiary. Put another way, at the end of the loan period, the amount included in your estate would be the $1 million loaned plus the interest earned, but any excess appreciation in the assets wouldn’t be included in your taxable estate. If interest rates decrease at any point during the loan, the note could be refinanced to a lower rate.
Planning strategies in a rising interest rate environment
There are two popular strategies that are typically more effective in higher interest rate environments. Two options to consider are the charitable remainder trust (CRT) and the qualified personal residence trust (QPRT).
CRT
A CRT is a trust where you fund a trust and then begin to receive an annual payment for a term of years. Upon the termination of the trust, the remaining assets are distributed to a designated charity. There are two types of CRTs to consider: the charitable remainder annuity trust (CRAT) and the charitable remainder unitrust (CRUT).
The CRAT pays a fixed income stream to you that’s based on a chosen percentage of the initial fair market value of the assets gifted to the CRAT. The annual payment doesn’t change during the term of the CRAT.
The CRUT pays an income stream to you that’s a fixed percentage based on the balance of the trust assets, which are revalued annually. So, the annual payment will change each year throughout the term of the trust.
Upon creation of the CRT, you claim an income tax deduction for the charitable portion of the transfer. The charity must receive at least 10% of the initial contribution upon the expiration of the trust.
When interest rates are higher, there’s a higher charitable deduction upon creation of the CRT. In this case, it’s assumed the assets in the CRT will grow quickly, meaning there will be a larger amount left for the charity when the annuity payment ends.
QPRT
A QPRT is an irrevocable trust that reduces your taxable estate by transferring a residence into a trust for a period of time (known as term interest), usually 7–12 years. Upon expiration of the term interest, the residence is transferred to remainder beneficiaries — oftentimes your children or trusts for the benefit of your children.
A QPRT can be an effective estate tax minimization tool because it allows you to continue enjoying the benefit of using your home while removing it from your estate. It’s important to note that a limit of two residences may be transferred to a QPRT — a primary residence and a secondary residence.
Upon the expiration of the term interest, you can continue to live in the residence by paying rent at fair market value to the remainder beneficiaries. This provides an additional way to transfer wealth since it’s not considered a gift. Additionally, the QPRT is generally structured so the tax liabilities flow back to you as the grantor, so you’re essentially paying rent to yourself and the rental payments are therefore income tax-free and may be used to pay for any liabilities, such as property taxes, for the home.
The initial transfer to the QPRT is a taxable gift of the value of the remainder interest that’s calculated using the 7520 rate. The higher the interest rate, the higher the value of your right to use the residence as your own during the term interest, and the lower the value of the gift of the future remainder interest. Therefore, as interest rates increase, the taxable gift decreases, which makes a QPRT an effective wealth transfer strategy with higher interest rates.
If you have a house that you’re confident is going to increase in value this can be an attractive strategy. On the downside, a QPRT can be administratively burdensome, because at the end of the term period, you have to transfer it to the beneficiaries. And, if you want to retain the residence or remain in the residence, you have to pay fair market rent to the beneficiaries, usually your children.
Timing is critical
Fluctuating interest rates are a reminder to review your estate plan and implement the most favorable estate planning strategies for the environment. If you have a taxable estate or haven’t looked at your estate plan recently, now’s a good time to meet with your advisor to determine if there’s any planning that should take place in the near term.
