For many investors, the focus for the last 18 months has been understanding how rising interest rates will impact the macroeconomic landscape, the capital markets, and cash flow planning. And for many families, it’s just as important to understand the impact of rising interest rates on generational wealth transfers and estate planning.
All estate planning strategies have “seasons,” and depending on the macro-economic environment, the strategies which are most attractive at any given moment in time will change. In this article, we discuss three popular estate transfer strategies which have moved out of favor given the current environment, and two strategies which are now worth a closer look. Should you have any questions about the ideas covered or about your unique opportunity set, we invite you to connect with our team.
Three Strategies to Reconsider Right Now
Three of the strategies that are less effective in high-interest-rate environments are intra-family loans, grantor retained annuity trusts (GRATs), and charitable lead trusts.
An intra-family loan can be a valuable tool for transferring the growth of your assets to your loved ones without paying taxes on an outright gift. However, originating new intra-family loans is less attractive in higher-interest rate environments.
When you loan money to a family member via an intra-family loan, the IRS requires you to charge certain minimum interest rates, called applicable federal rates (AFRs). There are different federal rate requirements for short-term, mid-term, and long-term intra-family loans. The recipient of the loan must pay back the money with interest to you, the lender, according to a predefined payment schedule.
In order to successfully transfer wealth to your loved ones using an intra-family loan, the loan recipient must be able to use the loan to earn more money than they’ll be required to pay you back in interest. For example, if the current federal rate for your intra-family loan is 2% per year, the loan recipient’s goal should be to use the loan to earn more than 2% per year by investing the money in the stock market, real estate, or other assets that may appreciate in value. This means that any pre-existing intra-family loans locked in at lower rates are valuable, but for new intra-family loans, at a higher minimum interest rate, it’s more difficult to out-earn the interest rate.
To put this in perspective, the current short-term AFR for an annually compounding loan is 4.80%. A year ago, that figure stood at 2.37%. While the respective increase for longer-term loans is less dramatic, the return required to make intra-family loans advantageous has increased across the board.
Grantor Retained Annuity Trusts (GRATs)
A grantor retained annuity trust, or GRAT, is a trust often used by individuals to transfer appreciation on their assets to their beneficiaries tax-free.
When you open a GRAT, you contribute assets such as cash and securities. The trust then pays you annuity payments with interest, calculated with the Section 7520 interest rates set by the IRS. When the trust expires, the remainder (any money that is left over after all scheduled annuity payments have been made to the grantor) is given to your beneficiaries.
The IRS required rates have risen from around half a percent in early 2021 to about 4.5% in the first quarter of 2023. Since interest rates are higher right now, GRATs have to pay more money in annuity payments to their grantors. While GRATs can still be a good option for assets with significant appreciation potential, higher interest rates mean that more of the appreciation on GRAT-held assets will go back to the grantor instead of to the trust’s beneficiaries.
Charitable Lead Trusts
When you open a charitable lead trust, you fund it with your assets and take a tax deduction for the contribution. Then, the trust makes annuity payments to a charitable beneficiary every year. When the trust expires, the remainder goes to your heirs. Charitable lead trusts work similarly to GRATs, except the annuity payments go to a charity instead of back to the grantor.
Charitable lead trusts are valued using the same IRS required rates as GRATs. When these rates are lower, the value of the trust is higher. With today’s higher interest rates, the value of your charitable lead trust will be lower than it would have been in the past. However, the trust must still make its predetermined annuity payments to the charitable beneficiary, so the amount to be left to the trust’s beneficiaries will be reduced.
Two Strategies Now Worth Exploring
There are several estate planning strategies which become more attractive as rates rise as they have recently. These are charitable remainder trusts (CRTs) and qualified personal residence trusts (QPRTs).
Charitable Remainder Trusts
A charitable remainder trust (CRT) is a trust designed to structure a predictable income stream for you (or your family) while ensuring a substantial philanthropic gift in the future. When you open a CRT, you fund it with assets and determine the payment terms. You can then take an immediate tax deduction based on the anticipated remainder that will be available for charity once all payments to beneficiaries have been made.
This remainder is valued based on Section 7520 interest rates. When these rates are high, as they are now, the anticipated charitable remainder is lower. This means you will take a smaller tax deduction. However, since the total amount of the trust is split between beneficiaries and the remainder, this also means that a larger portion of the trust can be paid out to you or your family.
In addition, a CRT does not have to pay immediate capital gains taxes on sales. Instead, these taxes are spread out over time as distributions are made to beneficiaries. Overall, a CRT can be an effective tool for charitable giving and tax deferment which becomes more useful as rates rise. While charitable remainder trusts and charitable lead trusts are often seen as sister strategies, their inverse structures mean that interest rate changes have opposite impacts on their usefulness.
Qualified Personal Residence Trusts (QPRTs)
A qualified personal residence trust (QPRT) allows you to move your home out of your estate while still living in the home. When you set up the QPRT, you will transfer your home into the trust. As such, when the home is eventually passed to your family, it will not be subject to estate tax. However, the initial transfer will cause the trust’s beneficiaries (likely your family) to be subject to a gift tax.
The gift tax amount, however, is not the full value of the home. The reason why is that you still get to live in your home during the term of the trust, meaning you still retain interest in the property. The total gift tax amount, therefore, is the value of the home minus this retained interest. When interest rates are higher, the retained interest is higher, meaning the gift tax your family is subject to will be lower.
For this reason, a QPRT becomes more attractive as rates rise. The main draw of the QPRT, however, remains the ability to exclude your home from your estate. As long as you survive the length of the trust’s terms, the home will not be subject to estate taxes. Therefore, assuming that the value of your home will increase during the length of the trust, the appreciation will be tax-free.
Critically, if you pass away before the expiration of the trust, the property will be moved back into your estate and will be subject to estate taxes when being granted to your heirs. This is why it’s crucial to choose an appropriate length of time for a QPRT.
If you’re still alive when the trust expires and your remainder interest is transferred to the beneficiaries (which is the goal), you will no longer own the property. Many people who use QPRTs will then lease the property from their beneficiaries for the remainder of their lives. These “rent” payments further reduce the size of your estate and pass additional wealth to beneficiaries.
The amount of gift tax you pay when your home is ultimately transferred to the beneficiaries of the QPRT depends largely on the term of the trust and the interest rate. A higher interest rate combined with a longer term means that you won’t reduce your lifetime gift tax exemption by as much. In fact, in the current interest rate environment, some individuals are only required to pay gift taxes on about half of the fair market value of their property when transferring it into a QPRT.
All investment and estate planning strategies have their seasons, and it’s important to deploy estate strategies that are optimized for the current environment.
At RVP, we are committed to understanding the macroeconomic environment, your opportunity set, and your unique goals. If you have any questions or would like to discuss how to adapt your generational wealth strategy to today’s interest rate environment, we invite you to connect with our team.