Estate Planning in Low and High Interest Rate Environments

Some estate planning or wealth transfer strategies work well in a low interest rate environment, like the one we are in now, while others are more effective when rates are higher. It may be advantageous to implement those strategies that are most effective in a low interest rate environment now while preparing to implement other strategies when rates rise.

Each month, the Internal Revenue Service publishes short-, mid- and long-term rates (Applicable Federal Rates (AFRs)) and the §7520 rate. The AFRs reflect the minimum interest rate that must be charged for loans between related parties to avoid triggering imputed income or gift taxes. The §7520 rate, named after a section of the tax code, is 120% of the mid-term AFR, and is used to calculate annual payments for certain estate planning techniques. It is often referred to as the “hurdle rate” because certain strategies depend on investments returning more than the current §7520 rate to be successful.

This fall, the IRS lowered the mid-term (3 to 9 years), long-term (over 9 years) and §7520 rates to their lowest levels in three years. Loans originated within a particular month, with very few exceptions, keep the same rate throughout the lifetime of the loan. While not at the levels of the historically low 2012–2013 rates, the current low rates present timely opportunities for those looking to transfer assets to their heirs tax-free. The §7520 rate, for example, in November 2019 was 2.0%, roughly one-third of its average rate over the last 30 years.

Estate planning strategies which work well while interest rates are low include, intra-family loans, grantor retained annuity trusts (GRATs), sales to intentionally defective grantor trusts (IDGTs) and charitable lead annuity trusts (CLATs). When rates are higher, more efficient and commonly deployed strategies include charitable remainder annuity trusts (CRATs) and qualified personal residence trusts (QPRTs). If you are thinking about estate planning, in the midst of such planning, or even if your wealth transfers are complete, prevailing interest rates can have a significant impact on the effectiveness of your planning. Below, we will discuss some common estate planning strategies and how they are favored when interest rates are either low or high.

Effective Strategies in a Low Interest Rate Environment

Planning when interest rates are low often involves one or more lending strategies that leverage low interest rates to transfer wealth with little or no gift tax. Typically, parents and grandparents make such loans to children and grandchildren at the appropriate AFR for the desired loan term with the loan proceeds invested by the younger generation. If the investment gains exceed the interest (hurdle) rate, the excess value is transferred to the borrower.

INTRA-FAMILY LOANS: Intra-family lending can be a good way to assist family members without incurring gift tax or using up any estate and gift tax exclusion. In addition to the benefits of a low interest rate (currently around 1.6% for a three-to-nine-year loan term), the interest is paid to a family member instead of a bank and, if used for the purchase of a home, may allow the borrower to avoid administrative loan costs and allow a child with poor or no credit history to buy a home. The lender can also forgive all or part of the loan each year up to the annual gift tax exclusion amount (currently $15,000 to any individual), without a gift tax consequence.

While intra-family loans are most often used in connection with a home purchase, in a low interest rate environment such loans can be a useful strategy in other contexts. If the borrower is able to earn a rate of return on the borrowed funds in excess of the loan interest rate, the borrower keeps the excess without any transfer tax cost.

INSTALLMENT SALE TO AN INTENTIONALLY DEFECTIVE GRANTOR TRUST (IDGT): This strategy is similar to an intra-family loan, the principal features of which are that the borrower is a trust created by the lender and the borrower trust is a “grantor trust,” which means the lender/grantor is responsible for the payment of any income and capital gains taxes incurred by the trust. This allows the assets to grow inside the trust on a tax-free basis. Another feature is that the assets sold to the trust or into which the loan proceeds are invested are often non-cash assets. The interest rate is the relevant AFR, so any appreciation of the assets, over and above the currently low interest rate, accrues to the beneficiaries free of gift tax.

GRANTOR RETAINED ANNUITY TRUST (GRAT): A grantor retained annuity trust, known in estate planning circles as a GRAT, is another wealth transfer technique that allows for the transfer of significant assets to the next generation with little or no gift or estate tax consequences. The grantor first establishes the trust and funds it with assets with appreciation potential that the grantor wants to pass on to the beneficiaries. The grantor receives annuity payments for period of years, usually two to five years (the GRAT term). The total value of all annuity payments is more than or equal to the initial value plus interest based on the §7520 rate. So, as you can see, the lower the “hurdle rate,” the more likely the assets are to appreciate above their value at the funding of the trust plus the interest payments. The assets remaining in the trust at the end of the term are passed on to the beneficiaries gift tax-free.

If the assets in the GRAT fail to outperform the §7520 rate, the assets are returned to the grantor. The grantor would have paid little to no gift tax and only incurred the legal and administrative costs to establish and maintain the GRAT. There are no other adverse tax consequences of a “failed” GRAT.

CHARITABLE LEAD ANNUITY TRUST(CLAT): A charitable lead annuity trust (CLAT) is similar to a GRAT, except the annuity payments for a term of years are made to a charity and the grantor is entitled to a charitable deduction for the amounts passing to charity. Only the assets calculated to remain at the end of the term are subject to gift tax. If the trust is structured to “zero out” at the end of the term, there will be little or no gift tax. The trust is said to zero out when the annuity payments are at least as high as the AFR over a sufficient number of years leading to the actuarial value of the remainder interest to be zero at the end of the term.

Like a GRAT, a CLAT works best in a low interest rate environment because any investment performance in excess of the hurdle rate passes tax free to the beneficiary or beneficiaries at the end of the trust’s term. The lower the rate, the larger the potential tax free transfer.

Effective Strategies in a High Interest Rate Environment

Estate planning strategies that work well in higher interest rate environments are those where the benefits hinge on using higher rates to reduce the actuarial value of a taxable gift or to increase the value of a charitable remainder interest.

CHARITABLE REMAINDER ANNUITY TRUST (CRAT): With a charitable remainder annuity trust (CRAT), the donor places an asset in a charitable trust with the annuity payments made to one or more persons (which may include the donor) for a term of years or a lifetime. The value of the annuity is calculated as a fixed percentage of the initial value of the trust’s assets, but the amount must be no less than 5%. The charity receives whatever remains at the end of the term. The value of the remainder interest is calculated at the time of the trust’s creation and the donor receives an income tax charitable deduction. The value of the remainder (the amount going to the charity) must meet a minimum threshold to pass IRS muster. When the §7520 rate is higher, the value of the charitable interest is higher and the more likely the trust will pass IRS review.

QUALIFIED PERSONAL RESIDENCE TRUST(QPRT): A qualified personal residence trust (QPRT) is a trust used to transfer a personal residence to trust beneficiaries. The homeowner places the residence in trust but retains the right to use it rent free for a number of years. At the end of the term, the residence passes to the beneficiaries. If the grantor wishes to continue to live in the home at the end of the term, the beneficiaries can rent it to the grantor. The initial transfer to the QPRT is a taxable gift of the remainder interest, calculated using the §7520 rate. The higher the rate, the higher the value of the grantor’s right to use the residence during the term and the lower the future remainder interest. So as the §7520 rate increases, the taxable gift decreases. This makes the QPRT a more appropriate strategy at higher interest rates.

If you are considering one or more wealth transfer strategies, we encourage you to visit with your Greenleaf Trust client centric team or other financial and legal advisors to assist you in implementing strategies consistent with your overall goals and objectives.