It still comes as a surprise to so many people that the outcome of key estate planning strategies often hinges on fluctuations in interest rates. So, changes in rates should sway the choice, or timing, of these strategies. Some estate planning strategies generate more benefits when interest rates are low, while others provide more benefits to you and your loved ones when rates are higher. With interest rates rising and set to rise more, you should consider interest rate trends when deciding whether to accelerate or delay the implementation of your estate plan.
Let’s look at the six major strategies that are affected by rate changes.
- Family Loans
These are very flexible and simple ways family members can make loans between each other. They’re very popular because these loans typically carry no interest rate or very low-interest rates, which is why they’re often called interest-free or low-interest loans. This strategy is better when interest rates are low. Keep in mind that the loan must be a real loan (expect the principal to be repaid at a certain time). There should be a written agreement that lists the interest rate charged and a payment schedule. Otherwise, the IRS might treat the transfer as a gift or other transaction.
There are two main reasons to consider the family loan:
- A family member wants to arbitrage the investment. That is borrowed at a lower rate than the income and/or capital gains generated from the principal and keep those benefits.
- A family member wants to pay a lower interest rate than a commercial lender would charge, while the lender might earn a higher yield than is available through a safe investment, such as a money market fund. Picture a parent or grandparent sitting on significant cash earning 1% at the bank. They could carry the mortgage of their grandkid or refinance their 7-9% student loan and get a better return.
One way to make a family loan is to charge at least the minimum interest rate required by the tax code. When you do that, there are no special income or gift tax consequences. As loan repayments are made, the interest portion is income to the lender, and the rest of the payment is tax-free. The Internal Revenue Service (IRS) publishes a monthly update to the applicable federal rates (AFRs) and 7520 rates. The AFR is calculated by the IRS under Section 1274(d) of the Internal Revenue Code (Code) and is used for many purposes. One of its most common applications is to establish the minimum interest rate that can be charged on an intra-family loan without income or gift tax consequences. Planning professionals and their clients should take note of fluctuations in these rates and be mindful of planning opportunities that come with rate changes. The AFR rate for March 2018 and the preceding six months, for a 10 year and longer loan (compounded annually) is 2.88%. This is huge savings. For example:
- If Jim was looking to purchase a home in Southern California and needed $500,000 in lending, he could pay 4.5% for the current cost of a 30-year fixed mortgage or he could reach out to his grandfather, Paul, who has more money than he needs due to a pension and rental income. Paul could charge him 2.88% and save Jim ~$450/month and over $150,000 in total interest!
Another way to make the loan is to charge no interest or less than the IRS minimum rate. In that case, the interest not charged is a gift from the lender to the borrower. If the interest plus other gifts to the borrower for the year are less than $15,000, there are no real consequences, because that’s the amount of the annual gift tax exclusion. Any excess over the $15,000 exclusion will reduce the lender’s lifetime estate and gift tax exemption, or will be a taxable gift. Details of those exceptions are in IRS Publication 550, beginning on page six under the heading “Below-Market Loans.”
- Grantor Retained Annuity Trusts (GRATs)
A grantor retained annuity trust (GRAT) is a good way to transfer the gains from appreciating assets to loved ones. It generates more benefits when interest rates are low. In a grantor retained annuity trust, you set up an irrevocable trust (removed from your estate) funded with assets you expect will have a fairly high appreciation rate. This can be technology stocks or a closely held business.
The trust pays you annual income over a period of years. The total income payments equal the original trust principal plus the IRS minimum interest rate. The AFR rate for March 2018 and the preceding six months, for no longer than 3 year (compounded annually) is 1.96%. At the end of the trust term, whatever remains in the trust is transferred to the other beneficiaries after the trust expires, usually your children or grandchildren. A grantor retained annuity trust usually should be short-term. Most tax advisors say a two to three years trust term is best.
Your loved ones receive the investment return of the trust that exceeds the minimum interest rate, and there are no estate or gift taxes due. For example:
- Grandma Sue, 65, puts her $5 million of Apple stock in a GRAT with a three-trust term. During that three year period, the Apple stock had an annualized return of 22%. The investment gains from Apple above the annual annuity of principal and IRS minimum interest rate of 1.96% is transferred from the trust to her grandkids.
To make incurring the costs of creating the trusts worthwhile, they should be funded with at least $250,000 of assets that are expected to generate a total return well above the IRS minimum interest rate. If the trust assets don’t earn more than the minimum rate, your heirs won’t receive anything. The result will be the same as if you hadn’t created the trust, minus the fees related to it.
- Charitable Remainder Trusts
These trusts come in two forms: charitable remainder unitrust (CRUT) and charitable remainder annuity trust (CRAT). Both of them provide more tax benefits when interest rates are higher because a higher APR will result in a higher income tax deduction for the remainder interest in a charitable remainder trust. For either trust, you create an irrevocable trust and fund it with money or property, preferably appreciated long-term capital gains property. The trust pays you income for life or a period of years. The charitable remainder unitrust pays you a percentage of the trust’s value each year as income. The charitable remainder annuity trust pays you a fixed amount each year, regardless of the trust’s value. After the income period, the remaining property in the trust is transferred to charity. Hence the name Charitable Remainder Trust.
Two main reasons to set this up:
- You don’t owe capital gains taxes on appreciated property transferred to the trust, because it is a charitable trust.
- You receive a charitable contribution deduction when the trust is funded. The deduction is the present value of the property the charity is expected to receive at the end of the trust.
The amount of the deduction depends on how long the trust is expected to last and on the current IRS interest rate. There are assumptions that will need to be made and is best to run different scenarios factoring cost basis, marginal tax bracket, and expected return
- Charitable Lead Annuity Trust (CLAT)
The CLAT is sort of the opposite of the charitable remainder trusts. In the CLAT, you create an irrevocable trust and fund it. The trust pays fixed annual income to a charity for years. After the period ends, the assets that remain in the trust are transferred to a beneficiary you named. It could be you, your spouse, a child, or a grandchild.
You might receive a charitable contribution deduction for the charity’s stream of income from the trust, depending on the details of how the trust is structured. If the remainder beneficiary is someone other than you and your spouse, the present value of the remainder interest is a gift from you. If the trust earns more than the IRS minimum interest rate, the excess will pass to the beneficiary free of estate or gift taxes.
So, a lower IRS interest rate means better results for you and your beneficiary. Also, the lower the applicable interest rate (APR), the higher the charitable contribution deduction because the lower APR will provide a higher present value and thus greater tax deduction
- Qualified Personal Resident Trust (QPRT)
This trust is used to minimize estate and gift taxes when transferring a residence or vacation home to the next generation. The tax results are better when interest rates are higher. You transfer the title of the real estate to an irrevocable trust. You reserve the right to use the home as your own for certain years. After that period expires, the property belongs to the beneficiaries of the trust, who usually are your children or grandchildren. If you want to continue using the property, you’ll have to pay a fair market rent. That’s why it’s best to use the QPRT for a second home, not your principal residence.
The property will be out of your estate after the term of years ends. When the property is transferred to the trust, you’ll be treated as making a gift of the property’s present value when the trust terminates to the beneficiaries. The higher current interest rates are, the lower that value will be. So, you’ll either use less of your lifetime estate and gift tax exclusion or pay less in gift taxes as rates rise.
If you pass away before the trust term ends, the property will be included in your estate and treated as though the trust wasn’t created.
- Charitable Gift Annuities
In a charitable gift annuity, you transfer money or property to a charity in return for a promise that you will be paid a fixed annual income for the rest of your life. The annuity payments will be less than from a commercial annuity, and the difference is your gift to the charity. There’s a tradeoff with charitable annuities, but they probably have more benefits when rates are higher.
There are two tax benefits of the charitable annuity that fluctuate with interest rates.
- You receive a charitable contribution deduction when you transfer money or property to the charity. The deduction is the present value of the charity’s eventual gift.
- The second benefit is that, when the charity makes payments to you, part of each payment is tax-free as a return of your principal. The rest of each payment is taxable income.
The main benefit is the charitable contribution deduction, and it is greater when interest rates are higher. Lower interest rates at the time the annuity is created, however, increase the tax-free portion of each annuity payment.
- Long-term Property Sales
There are several estate planning strategies used to transfer property to the next generation while minimizing estate and gift taxes. They are installment sales, private annuities, and self-canceling installment notes. They usually are used to transfer interests in businesses or real estate from parents to their children or later generations. What they have in common is the estate tax planning benefits are greater if they are implemented when interest rates are low.
Generally, under these strategies, the parents sell the property to the younger generation by transferring the property in return for promises from the younger generation to make payments to the parents over time. Each of the strategies has detailed rules that must be followed, and there are different situations in which each is more appropriate. If you have a business or valuable real estate, talk to an estate planner about the options.
- Real Estate
Rising interest rates often signal a healthy economy (assuming that inflation is stable), which usually bodes well for the real estate industry. This is important those who are executors or trustees that are monitoring commercial property and those that cannot sell their real estate due to significant tax consequence (depreciation recapture).
If interest rates continue to rise and lenders sense the need to protect themselves against a potential decrease in property value, they could eventually tighten lending standards further and require more equity from borrowers as they seek to increase their loan-to-value ratios. Lenders can tighten lending standards in a variety of ways, such as requiring more equity or collateral from the borrower, limiting lending for borrowers deemed less creditworthy and reducing exposure to riskier properties, markets or types of financing (such as construction lending vs. refinancing). This is critical when attempting to refinance before a payment balloon.
Cost of capital is a major consideration, as higher rates mean that the “rental price of money” has gone up. This could lead to borrowers paying more interest to lenders (a good thing for financial institutions). However, it could also lead borrowers to get smaller loans in the first place if they calculate that they would not be able to keep up with interest payments on a larger loan, forcing them to either put up more equity or target lower-priced properties. Further, riskier loans (like construction loans) and riskier assets may be even harder to finance efficiently, given the added risk premiums.
Higher capital costs could also increase default risks. These may be bad for lenders, too… that is unless they are non-traditional “vulture” players employing a loan-to-own strategy and secretly hoping for defaults to seize properties. In an extreme situation, if these defaults start to spread, they can ultimately be bad for the economy as a whole.