How Do Interest Rates Impact Your Estate Tax Liability?

Estate Planning Opportunities

Gone are the days of the 3% interest rate for a 30-year mortgage—ever since the Federal Reserve started a rate-rising cycle to combat inflation in 2022. Though the Fed may cut rates at its next meeting in mid-September, the magnitude of the cuts is still uncertain.¹ While investors wait to see whether the Fed will cut rates, we believe they should think about how to adjust their financial plans depending on the direction of interest rates. Interest rates play a key role in the attractiveness of many financial planning strategies. The increased cost of borrowing money creates financial hurdles for borrowers but could create opportunities for people thinking about their estates, as some estate planning strategies fare well in a higher interest rate environment. These considerations and strategies can prove to be cost-saving as you develop and deploy your estate planning strategy.  

Strategies to Consider in a Rising Rate Environment:

Qualified Personal Residence Trust

A qualified personal residence trust (QPRT) is an irrevocable trust that allows you to transfer a primary or secondary home into an entity out of your estate for the benefit of your family or another beneficiary. It is common for clients to move vacation homes to a QPRT to keep the property within their families. There are several questions to ask yourself before establishing one, including:

·      Is it likely that I will outlive the terms of the trust? If the grantor dies before the trust expires, the residence will be included in the grantor's estate.

·      Will you want to occupy the property after the trust expires? If so, ensure you include language to rent it back from the beneficiary (at a fair market value).

·      Do the residence's owners (usually parents) want the beneficiaries (usually children of parents) to call the shots?

·      A QPRT is an irrevocable trust. Once the trust is established and the property is transferred to it, you are unable to change your mind.

·      Additional tax considerations can come into play. If the property has a mortgage, any mortgage payments would be considered a gift. For tax purposes, the grantor would be responsible for any income and expenses generated by the QPRT.

Why would you want to consider a QPRT when interest rates are high? The method for calculating the gift of a residence is to establish the value of a future gift. At a high level, you would arrive at the future value of the gift by taking the difference between the property's fair market value at the time of transfer and the value of the grantor's retained interest.* The higher the interest rate used to determine the grantor’s retained interest, the lower the value of the future taxable gift. You would work with a tax professional to make these calculations.

‍Charitable Remainder Trust

If you are charitably inclined, another trust to consider in a rising interest rate environment is a charitable remainder trust (CRT). A charitable remainder trust is an irrevocable trust that distributes income to one or more non charitable beneficiaries for a specific period of time (specified lifetime or term of years). After the period expires, the balance of the trust is distributed to one or more charities. The grantor of the CRT receives an immediate income tax deduction when funding the trust equal to the present value of the remainder interest distributed to the charity. Similar to the QPRT, the §7520 rate is used to determine the value of the charitable gift. As interest rates rise, the present value of the gift increases, allowing the grantor to increase their charitable deduction. There are other factors to consider when determining the charitable deduction (type of asset used to fund the trust), and your advisor team can help you evaluate the various scenarios.

It is important to remember that a CRT is an irrevocable trust, and while this can be a great option for individuals, it is important to evaluate all the strategies for charitable giving before deciding on an option.

Strategies to Consider in a Declining Rate Environment:

Conversely, when interest rates are low, other estate planning strategies may be more advantageous. Lending strategies use the relevant applicable federal rate (AFR). If the AFR rate is low, then the amount of interest due on that loan is less than if interest rates were high.

‍Intrafamily Loan

The first is an intrafamily loan. This approach allows loved ones to borrow funds from a relative to purchase a business or real estate, pay down debt, etc. The borrower pays interest annually for the term of the loan and may make a balloon payment of principal when the loan expires. An installment sale to an intentionally defective grantor trust (IDGT) is similar to an intrafamily loan. It involves a lender (grantor), and a grantor trust is the borrower.

Charitable Lead Trust

The Charitable Lead Trust (CLT) is a strategy that should be considered for charitable gifting options in a low-interest-rate environment. A charitable lead trust is an irrevocable trust that makes annual payments to a charity or charities over a specified period of time. After the period expires, the trust balance is paid out to a beneficiary or beneficiaries. Any portfolio growth above the §7520 rate passes free of estate and gift tax to heirs.

Grantor Retained Annuity Trust

A GRAT is a trust one might consider when owning assets with a high likelihood of appreciation in the near future/over the term of the trust. The grantor contributes asset(s) to a GRAT and receives an annuity payment (represents the value of the asset plus interest) for a period of time.  Nearly all the appreciation of the assets within the trust will pass to the beneficiaries without gift tax implications. For this strategy to be successful, two things have to happen over the term of the trust: the growth in the asset(s) contributed to a GRAT must exceed the applicable IRS interest rate, and the grantor has to be living at termination. For example, someone who was taking a company public could put shares of the nonpublic company into a GRAT prior to the stock’s IPO.

In Closing

As with most things, estate planning strategies for changing economic environments have pros and cons. Taking advantage of strategies when the optimal environment presents itself can benefit your loved ones and ultimately reduce your tax liability. Please reach out to our relationship managers to explore estate planning strategies that might be of interest to you.

[1] Fed Chair Powellsays September interest rate cut could be ‘on the table’ as inflation cools (AP News)

*Calculated byusing the §7520 rate and the term (in years) outlined in the trust document.The §7520 rate, as defined by the IRS, is to be used to value certaincharitable interests in trusts. Pursuant to Internal Revenue Code 7520, theinterest rate for a particular month is the rate that is 120 percent of theapplicable federal midterm rate (compounded annually) for the month in whichthe valuation date falls. That rate is then rounded to the nearest two-tenthsof one percent. For example, the rate that is 120 percent of the applicablefederal rate (compounded annually) for January 2018 is 2.62 percent. That rateis then rounded to the nearest two-tenths of one percent or 2.6 percent forpurposes of IRC 7520.

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