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

30-Jul-18

Rising Interest Rates: What Estate Planning Techniques Work Well

Take-Away: As we counsel clients about estate planning over the next few years, we do so with the expectation that interest rates will continue to rise. Some conventional estate planning strategies like qualified personal residence trusts (QPRTs), grantor retained income trusts (GRITs) and charitable remainder annuity trusts (CRATs) perform well as interest rates continue to climb.

Background: As was explained a few weeks ago, some estate planning strategies work well when interest rates are low. Those strategies include intra-family loans, sales to intentionally defective grantor trusts, and charitable lead annuity trusts (CLATs). Other conventional strategies work well when interest rates increase. Three examples of  strategies employed when interest rates are in an increasing environment are summarized below.

  • QPRT: IRC 2702 explicitly sanctions the use of a qualified personal residence trust (QPRT.) A QPRT is usually viewed as a very conservative planning strategy, as it seeks to shift future appreciation of the residence out of the grantor’s taxable estate, gift-tax free. The grantor’s retained use of the principal residence (or second home) for a set number of years, which is effectively treated as an income interest in the trust property, is determined using the IRC 7520 interest rate (120% of the then prevailing federal midterm rate of interest). The difference between the fair market value of the residence and the present value of the grantor’s retained interest in the QPRT is a taxable gift to  the remainder beneficiaries of the QPRT. In a high interest rate environment, the present value of the donor’s retained income interest will be higher, and thus the amount of the gift of the remainder interest in the QPRT will be lower. If the grantor expressly retains a reversionary interest in the QPRT should the grantor die before the retained exclusive use term of the QPRT ends, then the value of the taxable gift of the remainder interest in the QPRT will be even lower. Thus, the grantor’s age (or life expectancy) to a large degree controls the value of the remainder interest in the QPRT, probably more so than the prevailing IRC 7520 rate of interest. With a low gift tax cost, the goal is to remove all future appreciation of the residence from the grantor’s taxable estate.
  • The downside to the use of a QPRT include: (i) the grantor’s mortality risk- a death before the retained exclusive use term ends, which means that the full value of the residence is included in the grantor’s taxable estate; (ii) the homestead exemption for real property taxes will be lost after the exclusive use term ends; (iii) no generation skipping transfer tax (GST) exemption can be applied to the transfer of the remainder interest in the residence transferred to the QPRT until the grantor’s exclusive use term ends, presumably when the home is worth more (meaning more of the grantor’s GST exemption will have to be used at that time); and (iv) if the grantor wishes to continue to reside in the residence after the retained exclusive use term ends, the grantor must pay rent to the trust or the remainder beneficiaries of the QPRT (i.e. the grantor is prohibited under the Tax Code from repurchasing the residence from the QPRT at the end of the exclusive use term.)
  • If a QPRT is considered, also look at selling or gifting the residence to a grantor trust as an alternative. In this situation, the grantor does not have to outlive the exclusive use term, but the grantor would have to lease back the residence from the grantor trust for its fair rental value to avoid estate inclusion under IRC 2036. Paying rent to the trust could actually move more wealth out of the grantor’s taxable estate over time (but the rent paid is not taxable as the rent is paid to a grantor trust.) If the transfer is a sale to the grantor trust, then the prevailing applicable federal rate of interest is use ( which will usually be much lower than the IRC 7520 rate of interest used to calculate the retained interest using a QPRT.)
  • GRIT: A grantor retained income trust (GRIT) is similar to a QPRT in how it functions. The grantor contributes income producing property to the GRIT and retains an income interest in the trust for a specified period of time, with the remainder interest in the trust ultimately passing to selected remainder beneficiaries. Again, the grantor’s retained income interest is valued using IRC 7520. The different between the fair market value of the grantor’s retained income interest and the value of the property contributed to the GRIT is a taxable gift to the trust remainder beneficiaries. In a high interest rate environment, the present value of the grantor’s retained income interest will be higher, thus a lower value is assigned to the gifted remainder interest.
  • The downside to the use of a GRIT include: (i) again, the grantor must survive the selected retained income period; (ii) the grantor cannot assign any GST exemption to the transferred remainder interest until the retained income period expires; and (iii) the IRC 2702 zero value rule applies if close family members are the remainder beneficiaries of the GRIT.
  • The Chapter 14 zero value rules were put in place in 1990 in the Tax Code to prevent perceived abuses with lifetime gifts among family members- example:  the parent would transfer assets to the trust based on an assumed income stream, but then invest the assets held in trust to provide less actual interest income to the parent, resulting in more assets passing to the children who were the remainder beneficiaries when the parent’s retained income period came to an end. To address this perceived abuse,  Chapter 14  provides that the value of the retained interest by the grantor will be valued at zero ($0.00) resulting in a full value of the gifted interest to the close family member who holds the remainder interest in the GRIT- an immediate taxable gift by the grantor of the full value of the entire transferred interest. This zero value retained interest rule applies when a member of the family holds the remainder interest. Member of the family is very broadly defined, but falling outside that definition are unrelated persons (e.g. live-in-companions)  and also nieces, nephews, and more distant relatives. IRC 2704(c)(2.) Thus, the utility of a GRIT is highly restricted to those situations where an individual might want to create a trust for a nephew or niece, or remote family member, or an unmarried companion.

CRAT: A charitable remainder annuity trust (CRAT) is where the grantor retains an annuity interest in the transferred assets for his or her life or for a set period of years, with any remaining assets passing to charities when the annuity period ends. A CRAT is the inverse of a CLAT from a mechanical how-it-works perspective. The grantor’s retained annuity stream is valued using the IRC 7520 rate. The grantor receives a current income tax charitable deduction for the value of the gifted remainder interest to the charity, which is the difference between the value of the transferred property to the CRAT and the present value of the retained annuity stream. The (delayed) gift to the charity must be equal to at least 10% of the value of the property initially contributed to the CRAT. As the IRC 7520 rate increases, the present value of the annuity interest will decrease and the amount of any remainder gift will therefore increase (along with the grantor’s present charitable income tax deduction.) If the annuity is paid to someone other than the grantor, excluding the grantor’s spouse, then other gift tax considerations apply, i.e. a gift tax will have to be paid, or the grantor’s exemption used to ‘pay’ the gift tax. Since the CRAT is classified as a tax exempt entity, it is frequently used to defer capital gains on the grantor’s planned liquidation of an appreciated asset (the annuity amount is based on the pre-tax value of the asset transferred to the CRAT, not the after capital gains tax net value, resulting in a larger lifetime annuity stream received by the grantor.) Thus, as interest rates increase, the grantor is likely to receive a larger charitable income tax deduction for the gift of the CRAT remainder interest to the charity.

  • In a low interest rate environment, it may be impossible to even create a CRAT where the grantor receives a charitable income tax deduction. That is because at certain levels the annuity payments to the grantor could be so large as to cause the remainder interest to fall below 10% when the CRAT was first funded. Or,  in the case of a CRAT where there is a lifetime annuity and the interest rates are low, it might be impossible to select a young annuitant for the trust (with a long life expectancy) which would either cause the trust to fail the minimum 10% value to be received by the charity when the trust is initially created, or it might also fail a separate 5% probability of exhaustion ‘test’ that the charity will not receive the anticipated amount when the annuity term ends (because the annuitant lived ‘too long’ and thus all trust assets were consumed paying the annuity stream.)

Example: The following examples using a CRAT show the impact of an increasing interest rate environment. Facts: Donor transfers $10.0 million to a CRAT. The expected annual growth rate in the CRAT’s assets is 6%. The annuity is paid to the grantor for 10 years, and then the trust terminates, all remaining assets then passing to  a charity.

  • Low Rate: Assume the IRC 7520 rate is 3.2% when the $10.0 million in assets are transferred to the CRAT. The immediate income tax charitable deduction is close to $1.0 million. After the 10 year annuity payment period, the amount that passes to the charity is $3.8 million.
  • High Rate: Assume the IRC 7520 rate is 6.0% when the $10.0 million in assets are transferred to the CRAT. The immediate income tax charitable deduction is close to $2.15 million. After the 10 year annuity payment period, the amount that passes to the charity is the same,  $3.8 million.

In a period under the new income tax rules with larger standard deductions where we search for a way to bunch charitable income tax deductions into a single income tax year in order to itemize the grantor’s income tax deductions including the charitable deduction (above the standard deduction amounts) funding a CRAT is one what to achieve that bunching objective.

Conclusion: There are other considerations in deciding what estate planning strategy to adopt. Individuals who are not charitable inclined will not be viable candidates for a CRAT. If assets held by the individual are not likely to meaningfully outperform the prevailing IRC 7520 hurdle rate, then none of these transfer strategies will make much sense to shift wealth to the next generation. But for some individuals, entering a period where interest rates are expected to climb,  these estate planning strategies should be considered, especially if the individual believes that the federal estate tax exemption will, in fact, return to the $5.0+ million level in 2026 (or sooner with a change in Congress.)