Interest rates are at the heart of many estate planning strategies. Given the recent downward trend, families should evaluate which opportunities are best suited for today’s declining rate environment and which strategies may become advantageous if rates reverse and begin to rise.
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’re 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, such as two years. They’re commonly funded with marketable securities, but they can also be funded with other assets that are expected to appreciate significantly. Using nonmarketable or hard to value assets can work but may introduce additional complexity to the structure.
Because a GRAT is treated as a grantor trust for income tax purposes, there are no income tax consequences to the donor when it’s funded. In many cases, the trust is formed in a way so that it doesn’t have to file its own income tax return. Instead, all tax items are reported on the grantor’s individual income tax return (Form 1040).
A GRAT requires the donor to receive annuity payments from the trust based on IRS-published monthly interest rates (specifically the IRS published minimum Section 7520 rate) that are in effect at the time of funding. These interest rates are important because they’re the rates that invested securities in the trust need to outperform to realize a benefit for the beneficiaries of the GRAT. For example, if the Section 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 is unsuccessful, 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 a good strategy for those with a taxable estate in times of falling interest rates. The strategy benefits by shifting 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 instance, if you were to loan your child $1 million today, you would charge them 4.0% (an example AFR for a short-term loan), and any appreciation of the $1 million above 4.0% 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. It’s important to follow the terms of the loan and document all payments.
Planning strategies in a rising interest rate environment
While interest rates are currently falling, the future of further rate cuts is unclear. Therefore, it may be viable to consider two options that work well in higher interest rate environments: the charitable remainder trust (CRT) and the qualified personal residence trust (QPRT).
CRT
A CRT is a trust when 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. Therefore, the annual payment will change each year throughout the term of the trust.
Upon creation of the CRT, you can 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). 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 that the tax liabilities flow back to you as the grantor, essentially you’re paying rent to yourself and the rental payments are therefore income tax-free.
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.
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. For example, GRATs and intrafamily loans are strategies that are especially helpful when interest rates are decreasing. If you’re interested in utilizing them, you should do so before interest rates increase again. If you 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 now as a result of falling interest rates.
