Estate Planning Techniques To Consider If Interest Rates Rise
By: Randall A. Denha, J.D., LL.M.
The Federal Reserve continues to slowly increase the federal funds rate. That is the rate banks charge each other. The federal funds rate has an indirect effect on many other interest rates such as the rate banks charge for loans or the amount banks pay on savings. The rates can impact your estate planning because many of the planning techniques used to transfer wealth are interest rate sensitive. The IRS publishes each month a table of rates (AFRs or Applicable Federal Rates) required to be used for many different estate and gift transfer transactions. This is the minimum interest rate that must be charged to avoid a gift loan under Internal Revenue Code Section 7872.
Given the historically low interest rates, two planning techniques which have been out of favor during times of low interest rates should be reconsidered if interest rates begin to rise.
Qualified Personal Residence Trusts.
A qualified personal residence trust, or QPRT, is a gifting technique where an individual transfers an interest in a personal residence to a trust, making a gift of the remainder interest while retaining the exclusive use of the residence for a term of years. Vacation homes as well as primary residences can be used. A QPRT is most advantageous where a residence is likely to appreciate in value. Because the gifted remainder interest in the residence has a carryover basis for income tax purposes (rather than a stepped-up basis which would occur if the residence passed at death), it is also a better technique for a residence which an individual anticipates his or her children (or other heirs) will retain rather than sell. When a personal residence is transferred to the QPRT, the value of the gift is the value of the remainder interest. The value of the remainder is based on the length of the grantor’s retained interest – i.e., the right of the grantor to reside in the home (the longer the term of the retained interest, the less the value of the remainder interest). The value of the grantor’s retained interest (which is his or her retention of the right to live in the residence) is measured by the term of the trust and the §7520 rate on the date of the creation of the trust. Therefore, as the §7520 rate increases, the value of the retained interest is deemed to be higher and the gift of remainder interest less.
For example, assume that a 50-year-old individual transfers a residence worth $1.5 million to a QPRT with a 20-year term. Under the §7520 rate for April 2019, the amount of the gift would be $663,705 (and not $1.5 million). In this example, if the residence appreciates at 4% per year, a 20-year QPRT could result in an estate tax savings of approximately $1.049 million (assuming a 40% estate tax rate). As in the case of a GRAT, using a QPRT involves mortality risk. If the grantor dies during the term of the QPRT, the entire value of the property is brought back into his or her estate. For many clients, using a QPRT can result in the removal of valuable residential real estate from the client’s taxable estate at very little gift tax cost.
Charitable Remainder Trusts.
A charitable remainder trust, or CRT, essentially is the reverse of a charitable lead trust. A CRT is an irrevocable trust that pays an amount annually to an individual or individuals for a specified term and, at the end of the term, pays the remainder interest to qualified charitable organizations. In order to qualify as a CRT, the annual income interest must be in the form of either an annuity payment (an annual payment fixed as a percentage of the amount contributed, known as a charitable remainder annuity trust) or a unitrust payment (a percentage of the fair market value of the assets of the trust valued each year, known as a charitable remainder unitrust). The percentage of the annuity or unitrust payment amount must be fixed between 5% and 50%, and the remainder interest must equal at least 10% of the fair market value of the assets contributed to the trust. The CRT itself is a tax-exempt entity. As a consequence, none of the transactions entered into by the CRT will be subject to income taxes at the trust level. However, upon receipt of the annuity or unitrust payment each year, the designated recipient may have taxable income. So in effect, this may be an income tax deferral strategy. Each year the annuity or unitrust payment is deemed to consist of assets from the CRT that are first, ordinary income, second, capital gain property, and finally, tax-exempt income or principal. The character of the assets remains the same in the hands of the recipient as in the CRT. Therefore, the recipient of the annuity or unitrust payment must report either the ordinary or capital gain income on his or her individual income tax return in the year of the receipt. As in the case of a QPRT, the value of the retained and remainder interests are measured by taking into account the §7520 rate at the time of creation of the trust (or at the grantor’s option in either of the preceding two months). The assets contributed are assumed to have the §7520 rate of return over the term of the trust. Thus, a higher rate of return will provide more income to pay the retained annuity or unitrust amount, thereby increasing the value of the assets remaining for the charitable remainder interest. The remainder value determines the charitable income, estate and gift tax deduction available to the grantor. The CRT is especially beneficial for highly appreciated assets owned by an individual. The individual would transfer the appreciated assets to the CRT and then the CRT would sell the assets. Once sold, the full value of the assets can be used to produce an income stream (in the form of the annuity or unitrust payment) for the grantor or another designated individual during the CRT term. Only as the grantor or other designated individual actually receives the annuity or unitrust payment will he or she recognize the capital gain which occurred when the CRT sold the assets. For example, if an individual contributes $1 million of low basis stock into a charitable remainder annuity trust paying him or her $50,000 a year for 20 years, the income tax charitable deduction in the year the trust is created would be $269,695 based on a §7520 rate of 3.20%. If the Trustees, after the trust was created, sold the low basis stock, there would be no capital gain realized by the trust. Additionally, if the individual creates a charitable remainder unitrust (where the annuity retained is a percentage of the fair market value of the assets of the trust valued each year) and the trust assets grow at a rate more than the §7520 rate, it creates the possibility for an increased annuity payable to the annuitant. This is not available in a charitable remainder annuity trust where the annuity payments are fixed at the trust’s inception.
Loan Based Options
Loan-based options Low interest rate environments can also be advantageous for loan-based options where you lend money to your beneficiaries at below-commercial rates.
Intra-family loans
Typically, an intra-family loan involves a parent or grandparent lending money to a child or grandchild at the Applicable Federal Rates, which are lower than what commercial lenders charge. The loan is often used to facilitate a large purchase, like a home, but may also be made to fund an investment or business opportunity. This can be beneficial when the borrower can invest the loaned funds and earn a higher rate of return than the interest being paid-the difference being basically a tax-free gift from the grandparent or parent to the child. This strategy also could provide some additional monetary benefits for the family, such as the interest paid on the loan remaining in the family and avoiding any additional loan costs associated with borrowing from, for example, a bank. Unless a grantor trust is used (discussed below), interest received by the parent must be recognized as income for income tax purposes. In fact, financial modeling would demonstrate that there is a potential economic benefit lost to a family as interest rates rise. The longer the term of repayment, the more significant the economic impact would be to the child over the term of the loan if, in fact, interest rates rise.
Sale to an intentionally defective grantor trust
Another loan-based estate planning technique is a sale to an intentionally defective grantor trust (IDGT), also commonly referred to as an intentionally defective irrevocable trust (IDIT). An IDGT is an irrevocable trust set up for the benefit of individual’s heirs and-if the sale is structured properly-the grantor can transfer a significant portion of assets in a tax-efficient manner, thereby reducing the taxable estate. On its own, an IDGT can be a very powerful wealth-transfer technique. In many instances, the seller can discount the asset’s sale price to below its fair market value. An IDGT is treated differently for income tax and transfer tax purposes. For income tax purposes, this trust is a “grantor” trust, which means that the trust is not a separate income-tax-paying entity. The trust’s income and deductions are taxable to the grantor, and sales (or other transactions) that occur between the grantor and the trust are not recognized or taxable. However, for transfer tax purposes, the IDGT is a separate entity. While the initial transfer is taxable for gift, estate, or generation skipping transfer tax purposes, when properly structured, the value of the trust is not included in the grantor’s estate.
In summary, we are in or going to be in a period of rising interest rates and this will affect many wealth-transfer strategies that are most effective in a low-interest-rate environment.
The type of entity or structure you employ will require careful consideration and time with your professional advisors. The best time to begin this process is now.
