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George F. Bearup, J.D. Senior Legal Trust Advisor

14-Oct-19

Low Interest Rates Encourage Some Estate Planning Strategies

Take-Away: The current low interest rates, as reported in October’s IRC 7520’s rates, are attractive for may estate planning strategies like intra-family loans, grantor retained annuity trusts (GRATs), charitable lead annuity trusts (CLATs), and charitable gifts of remainder interests in homes and farms. These same low interest rates have an opposite effect, however, on qualified personal residence trusts (QPRTs), charitable remainder annuity trusts (CRATs), and charitable gift annuities (CGAs.)

Background: In January of this year the IRC 7520 rate that is used to value ‘split interests’ was 3.4%. This month the same IRC 7520 rate is 1.8%. This drop in the IRC 7520 interest rate used to value retained interests in transferred assets has a dramatic impact on the value of the gift of the fractional interest in an asset. The IRC 7520 rate is published by the IRS each month, around the 15th to the 20th, and it is used to value fractional interests, usually in the transfer of assets where the transferor retains an interest in the transferred asset, or in the trust to which the asset is transferred.

Mortality Tables: The other factor used in these valuations with retained interests, which in turn impacts the size of the transferor’s taxable gift, is the life expectancy or projected mortality of the life or ‘income’ interest-holder. These mortality table factors were supposed to have changed last May, when they were to have been updated using the 2010 U.S. Census, but that publication  date with the new mortality figures has been pushed back to later this calendar year.

Generalizations: As broad generalizations with respect to the impact of monthly changing interest rates on estate planning strategies, when the interest rates used to value fractional interests are lower:

  • The lower the assumed interest rate, the less an ‘income’ interest is worth;
  • When assumed interest rates fall, a remainder interest that follows the ‘income’ interest is worth more, as the remainder interest is being discounted less; and
  • An annuity, unlike an ‘income’ interest, becomes worth more as interest rates fall; a series of retained annuity payments is thus worth more when interest rates are low.

Strategies Favored by Low IRC 7520 Rates: How the drop in this month’s IRC 7520 rate can be explained with a few examples, which follow.

Grantor Retained Annuity Trusts (GRATs): Because the grantor’s retained annuity is being valued with a low interest rate, it is undervalued as an economic matter if the transferred assets are expected to produce a return in excess of the IRC 7520 rate used when the GRAT is funded. Since a GRAT produces a benefit to the grantor’s family only if its assets produce a total return in excess of the relevant IRC 7520 rate, the GRAT is an excellent device for an individual to use in a low interest rate environment.

  • Example: Grantor transfers $1.0 million to a 10-year GRAT, which has its remainder interest ‘zeroed out’ (meaning the value of the gifted remainder interest is $0.00.) If the IRC 7520 rate is 8%, the annual annuity payment that is required to be paid to the grantor to ‘zero out’ [$0.00] the value of the gifted remainder interest in the GRAT is $149,029. Using this month’s 1.8% 7520 rate, the amount of the annual annuity payment required to ‘zero out’ the remainder interest is $110,165. So long as the GRAT produces a return greater than 1.8% a year, it will work to shift wealth to the remainder beneficiaries of the GRAT gift-tax-free.

Sales to an ‘Intentionally Defective’ Grantor Trusts (IDGTs): A sale of an appreciated asset by the grantor to a grantor trust for income tax reporting purposes produces the same result as with the GRAT. The note that the trust gives to the grantor in exchange for his/her sale of the appreciated assets must carry a minimum applicable federal rate (AFR) of interest to avoid a gift or imputed interest. The long-term AFR rate for October 2019, i.e. longer than 8 years, is 1.86%. Thus, if the appreciated asset sold to the IDGT grows at a rate of more than 1.86% a year, the grantor will have shifted wealth to the beneficiaries of the IDGT gift-tax-free. In addition, since the IDGT is a grantor trust, the grantor will pay the income taxes on the IDGT’s income, which increases the amount of the wealth shifted to the IDGT’s beneficiaries.

Charitable Lead Annuity Trusts (CLATs): If an individual is charitably inclined, a CLAT produces as similar benefit when the IRC 7520 interest rates is low. Any growth in the CLAT’s assets in excess of the IRC 7520 rate passes to the non-charitable remainder beneficiaries of the CLAT at the termination of the CLAT free of any gift or estate tax.

Private Annuities: For those interested in aggressive estate planning strategies, a private annuity can also benefit from the currently low interest rates. Payments on a private annuity will drop as interest rates fall. Private annuities are often used when a parent sells a business to a child in exchange for stream a lifetime annuity payments; on the parent’s death, the annuity stream stops, so there is no residual asset to include in the parent’s taxable estate for federal estate tax purposes.

  • Example: Father, age 70, purchases a $1.0 million private annuity from his son, in exchange for Father’s business interest. If the IRC 7520 rate is 6%, the amount of the annual annuity payment Father is to receive is $115,413. With this month’s 1.8% IRC 7520 rate, the amount of the annual annuity payment to Father would be only $82,780.

Note, however, that under proposed IRS Regulations the purchase of a private annuity using appreciated property results in an immediate recognition of gain by the seller, which means the gain can no longer be spread out over the purchaser/annuitant’s life expectancy as annuity payments are received.

Charitable Gift of Remainder Interest in Home or Farm: If an individual is charitably inclined, a gift to a charity of a remainder interest in a personal residence or farm will work well, because the retained use of the residence is equivalent to a retained ‘income’ interest. Consequently, the lower the interest rate, the less the retained residential interest is deemed to be worth, and the value of the remainder interest given to the charity is deemed to be worth more, i.e. the larger the donor’s charitable income tax deduction.

  • Example: Donor, age 70, wants to transfer the remainder interest in her $1.0 million home to her favorite charity: $800,000 is the value of her home, $200,000 is the value of the land on which the donor’s home sits, i.e. its salvage value. If the current IRC 7520 rate was 6%, the charitable deduction for the donor’s gift of the remainder interest in her home to the charity would be $386,194. If the gift of the remainder interest in the home was made this month, when the IRC 7520 rate is 1.8%, the donor’s charitable income tax deduction for the gift of the remainder interest in her home would increase to $598,584.

Note, this strategy involves no trust, just a deed, and the home will completely avoid probate on the donor’s death. Moreover, in a period where the large standard deduction makes many charitable gifts unavailable for income tax charitable deductions, the large gift of the remainder interest in the home bunches a large tax deductible charitable gift into one tax year, thus enabling the donor to actually claim and use the charitable income tax deduction associated with the gift of the remainder interest in her home since it greatly exceeds her standard deduction amount for the year.

Strategies Not Favored by Low IRC 7520 Rates: Other popular estate planning strategies that do not fare so well when the IRC 7520 interest rate drops include-

Qualified Personal Residence Trust (QPRT): Retaining the use of a residence is the equivalent to retaining an ‘income’ stream. By the donor retaining less means that more is given by a parent to a child, when the title to the parent’s home is transferred to the QPRT. Consequently, if a home is transferred to a QPRT this month, the value of the remainder interest in the QPRT will be larger, and the parent will have to use more of the parent’s federal gift tax exemption amount to ‘shield’ the gift of that remainder interest.

  • Example: Mother, age 70, creates a 10-year QPRT using her $1.0 million cottage. If the IRC 7520 rate is 8% when the title to the cottage is transferred to the QPRT, the taxable gift of the remainder interest in the QPRT to Mother’s children is $314,710. If the QPRT received the title to the cottage this month, using the 1.8% IRC 7520 rate would lead to a taxable gift of the remainder interest in the QPRT of $568,430. While that larger taxable gift might be a disincentive to place the cottage in a QPRT, remember that if Mother survives the full 10-year QPRT exclusive use term, she will have removed a $1.0 million cottage, or even more assuming the cottage appreciates during her 10-year exclusive use period, from her taxable estate at a gift tax cost of $568,430 when her federal gift tax exemption amount is $11.4 million. The primary drawback to the use of a QPRT is that the children, when they take title to the cottage after the 10-year exclusive use period ends, will have taken title to the cottage as a lifetime gift, which means that they will have a ‘carry-over’ income tax basis, so if the children sell the cottage, they will recognize capital gains. If a legacy-type cottage is the subject of the QPRT, which means that it is highly unlikely the children will ever sell the home, then the ‘carry-over’ basis issue will not be a problem for the children.

Charitable Remainder Annuity Trusts (CRATs): As noted above, since annuities are worth more when the IRC 7520 rate is low, the income tax deduction for the donor’s contribution of assets to a CRAT will be less. The donor’s income tax deduction is the value of the property or cash transferred to the CRAT less the value of the donor’s retained interest. The result will be a small charitable income tax deduction when the IRC 7520 rates are low.

  • Example: Father, 70 years old, contributes $100,000 to a CRAT. If, at the time of Father’s transfer of property to the CRAT, the IRC 7520 interest rate is 6%, the CRAT will be obligated to pay to Father, each year, an annuity payment of $6,000. This will produce for Father a current income tax charitable deduction (of the transferred remainder interest in the CRAT) of $46,859. If Father funded the same CRAT this month, (but he used the more favorable September, 2019 IRC 7520 rate of 2.2%- with CRTs you get to use the month of the transfer or the prior two-month’s IRC 7520 interest rates) Father’s deductible gift of the CRAT’s remainder interest to the charity is $29,431.

However, there is an even bigger problem caused by the lower IRC 7520 rate. The CRAT will ‘flunk’ the IRS’ 5% probability of exhaustion test- that the CRAT will theoretically run out of money before the donor dies, and if that probability exceeds 5% the test is ‘flunked’ and no charitable income tax deduction will be allowed. [Revenue Ruling 77-374.] What this ‘5% exhaustion test’ means, when the 70 year old donor uses even a 2.2% IRC 7520 rate,  is that he/she cannot obtain any charitable income tax deduction at all if a CRAT is created, because even with a minimum 5% annuity payout rate, the CRAT will ‘flunk’ the ‘5% exhaustion test.’

Charitable Gift Annuities (CGA): The same concerns that are associated with the transfer of assets to a CRAT apply to the purchase of a CGA. While a CGA does not have to pass the CRAT’s  ‘5% exhaustion test’, the American Council on Gift Annuities recommends a maximum annuity rate to assure that the charity will receive at least 10% of the value of the lifetime gift. [These new CGA rates were adopted as of July 1, 2018 to reflect this new 10% ‘minimum charitable deduction’ rule.] Translating all of this, charities will probably lower their annuity rates to meet the 10% ‘minimum charitable income tax deduction’ requirement. On the positive side,  although the charitable deduction on the purchase of a CGA is lower when the IRC 7520 rate is lower, the amount of each annuity payment that is excluded from the donor’s taxable income [under IRC 72] will be higher. Consequently, the purchaser of a CGA who is a non-itemizer due to their larger standard deduction amount, who is focused more about how much of their annuity payment is taxable income than the size of their ‘up front’ charitable income tax deduction, may find CGA’s a more attractive way to fund their retirement years and assist their favorite charity.

Conclusion: This month’s low IRC 7520 rate should encourage some individuals to consider some of the planning strategies just outlined, including GRATs, intra-family loans, and gifts of remainder interests in homes and farms. Other strategies, like QPRTs, might be placed on a ‘back-burner’ until interest rates increase. Any projections that rely on October’s 1.8% 7520 interest rate should also factor in the probability that soon the IRS will publish its updated mortality tables that will probably reflect longer life expectancies, which will also influence the value of fractional interests in assets that are transferred by gift.