With the recent rise in interest rates, there has been a lot of discussion about how it impacts people buying homes and vehicles. However, a change in interest rates can also affect the type of trust(s) used in an estate plan.
What Interest Rates Affect an Estate Plan
There are multiple interest rates published by the Internal Revenue Service on a monthly basis including the Applicable Federal Rates (AFRs) and the §7520 rate. Both the AFRs and the §7520 rate are used in determining estate planning strategies. When the rates are lower, you may want to utilize one type of strategy whereas when the rates are higher, you may want to utilize another type of strategy. Some trust types are better suited for lower interest rates while other trust types are better suited for higher interest rates.
Trusts for Low Interest Rates
When the interest rates are low, there is usually a focus on transferring wealth with little or no gift tax. Trust types we see during a period of low interest rates can include an Intentionally Defective Grantor Trust, a Grantor Retained Annuity Trust, and a Charitable Lead Annuity Trust.
For an Intentionally Defective Grantor Trust (“IDGT”), the name of these trusts refers to the somewhat contradictory tax treatment that they receive. The trust terms are drafted such that the assets held by the trust will not be counted as part of your taxable estate for estate tax purposes. But at the same time, the trust agreement includes an intentional ‘flaw’ that allows you to continue paying the income taxes on the assets (and by making such payments yourself instead of by your children, this continues to further reduce your taxable estate). This can be a particularly appealing tax planning option if interest rates are low and/or values of the assets have depreciated such as during a real estate or stock market downturn.
A Grantor Retained Annuity Trust (“GRAT”) is a trust that provides certain tax benefits. Generally, the Trustmaker transfers an asset that is expected to significantly grow in value to the trust for less than its full market value. GRATs may be used to remove the full value of the asset and its future appreciation from the Trustmaker’s taxable estate to reduce future estate taxes upon death.
For a Charitable Lead Annuity Trust (“CLAT”), a designated charity receives income from the assets held by the trust and the assets then later pass to beneficiaries named by the Trustmaker. Charitable lead trusts may be used for tax planning purposes to take advantage of charitable deductions associated with the gifts being made. Unlike a GRAT, the annuity payments during the trust term are made to charity and not the grantor, who is therefore not able to continue to benefit from the assets contributed to the CLAT.
Trusts for High Interest Rates
When interest rates are high, there is a focus on using strategies to reduce the actuarial value of a taxable gift. Trust types we see during a period of high interest rates can include a Qualified Personal Residence Trust and a Charitable Remainder Annuity Trust.
For a Qualified Personal Residence Trust (“QPRT”), this trust is an irrevocable trust that holds the Trustmaker’s primary residence or vacation home as its only asset. The Trustmaker retains the right to live in the residence or use the vacation home for a fixed number of years. While the transfer of the property to the QPRT is a taxable gift, if the Trustmaker/taxpayer lives until the end of the trust term, the value of the residence or vacation property plus any later appreciation will pass to the trust beneficiaries without being included in the Trustmaker’s taxable estate. The higher the interest rate, the higher the value of the grantor’s right to use the residence as his or her own during the term of years, and the lower the value of the gift of the future remainder interest.
A Charitable Remainder Annuity Trust (“CRAT”) is essentially the converse of a charitable lead trust. With a charitable remainder trust, the Trustmaker or a beneficiary designated by the Trustmaker receives income from the trust for a specified period of time, such as the Trustmaker’s lifetime or a designated period of years. When the income beneficiary’s interest ends, the trust assets then passed to a designated charity. Again, charitable remainder trusts may be used for tax planning purposes to take advantage of charitable deductions associated with the charitable bequests being made.
However, in order to pass IRS review, the value of the remainder must reach a minimum threshold; the higher the §7520 rate, the higher the value of the charitable interest and the more likely that the CRAT will pass IRS review. CRATs must also make a minimum annual payment to the grantor; younger grantors who want to create certain CRATs can have a harder time meeting this minimum payment if rates are too low.
Deciding on a Trust Type
Establishing the trust that’s best for your situation can be a confusing and tedious process. If you’re ready to set yours up or interested in changing the type of trust you currently have, give our office a call at 919-443-3035 to set up a consultation with one of our estate planning professionals.