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Estate planning when interest rates rise

Key takeaways

  • Some popular estate planning strategies rely on interest rates to calculate the value of assets that are gifted or loaned to a family member or a trust.
  • When rates are relatively low, intrafamily loans and GRATs are often more effective.
  • As rates continue to rise, families may want to consider techniques like qualified personal residence trusts and charitable remainder trusts that are more effective in higher-interest rate environments.

For individuals and families interested in passing assets to the next generation, higher interest rates could affect the tax efficiency of certain popular wealth transfer strategies, explains Michael Christy, vice president, advanced planning at Fidelity—in some cases for the better and in some for the worse.

When rates are high, it's worthwhile to consider how different estate planning strategies may be affected. Since these techniques are complex, you'll want to discuss with your tax attorney and financial professional which may be best suited for your family's situation.

Intrafamily loan

How it works: An intrafamily loan is a private loan between family members. The loans can be used to help children purchase a new home, for example, at potentially more favorable interest rates than are commercially available. This strategy can also be leveraged as a wealth transfer technique. That's because any appreciation on the loaned funds that exceeds the interest rate charged isn't included in the lender's estate. "For estate tax purposes, the value of the asset being loaned is frozen and the appreciation passes to the beneficiary free of estate and gift tax," explains Christy.

Why interest rates matter: To avoid an intrafamily loan being treated as a gift, the IRS requires, among other formalities, that a minimum amount of interest be charged. Accordingly, the IRS sets the minimum interest rates for intrafamily loans, generally at a rate well below what borrowers would find at a commercial lender. Known as the Applicable Federal Rate (AFR), it is based on the prior 30-day average market yields of corresponding US treasury obligations, such as T-bills. You can find current rates on the IRS website. In April 2023, the minimum interest rate that must be charged for loans that will last between 3 and 9 years was 4.15%. During the term of the loan, any income and growth the borrower receives on the loan assets above the AFR rate isn't considered as part of the lender's estate.

"As interest rates increase, AFRs will increase as well, which means that this technique could become less effective if rates continue to rise," notes Christy.

Grantor retained annuity trust (GRAT)

How it works: A grantor places certain assets—generally those with the potential to highly appreciate, such as shares of a business—in a trust. In return, the grantor receives a stream of payments (in the form of an annual distribution) for the trust's duration (the "retained annuity"). If structured properly, assets that remain in the trust at the end of the trust term can pass on to heirs, potentially free of any gift tax.

Why interest rates matter: The amount of interest required to be returned to the grantor is calculated using what's known as the §7520 rate or hurdle rate, which is 120% of the midterm AFR (5% in April 2023). Any appreciation of the assets in the GRAT in excess of the hurdle rate passes to the beneficiaries outside the grantor's taxable estate. "The §7520 is fixed for the duration of the GRAT," explains Christy. "So this strategy is more likely to be successful when rates are relatively low."

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Intentionally defective grantor trust (IDGT)

How it works: This somewhat oddly named strategy is similar to a GRAT, except that the grantor generally makes an initial lump sum gift to the trust, and then can subsequently sell or loan additional assets to the trust. The transfer of assets to an IDGT is irrevocable and for estate tax purposes are treated as no longer part of the grantor's estate. However, the trust is structured so that the grantor is still taxed on the trust's income. The result is a trust that is intentionally "defective" for income tax purposes, (hence the "defective" part of the name) to enable trust assets to appreciate without the liability of income taxes.

Why interest rates matter: When assets are lent to an IDGT, it works similarly to an intrafamily loan, except instead of loaning assets to an individual, the grantor makes the loan to the trust. In return, the grantor receives an interest-bearing promissory note, payable by the trust.

If assets are sold to the IDGT by the grantor, it is structured as an installment sale with the grantor taking back an interest-bearing promissory note, also payable by the trust. In both cases, the rate on the note is determined by the AFR. "The lower the AFR, the more likely it is that the assets placed in the IDGT will appreciate in value at a faster pace than the AFR rate," Christy explains. With the April AFR at 5% for loans between 3 and 9 years, assets would need to appreciate in excess of that rate for the technique to be successful, so it is critical that anyone considering a loan to an IDGT, or any of these strategies, determine the most appropriate asset or combination of assets that have the maximum potential to adequately appreciate.

Charitable lead annuity trust

How it works: For families who might want to provide financial support to a charity, a charitable lead annuity trust (CLAT), allows a grantor to direct a stream of payments generated from trust assets to one or more charities. When the grantor dies or a certain fixed term of years is reached, the assets in the trust are distributed to non-charitable beneficiaries—such as family members. A CLAT is often set up for a certain number of years, and, depending on the type of CLAT, the grantor may be eligible to take an immediate tax deduction when the trust is funded.

Why interest rates matter: At the time the assets are transferred to the CLAT, the present value of the remainder to the family is a taxable gift, thereby using a portion of the grantors' lifetime estate and gift tax exemption. Like with a GRAT, the IRS §7520 rate is used to determine the value of the gift—so the lower §7520 rate, the lower the value of the gift, and the less lifetime estate and gift tax exemption is consumed.

If rates continue to rise

There are certain strategies that tend to be more effective in a higher interest rate environment. Christy points to 2 in particular:

Qualified personal residence trust (QPRT): This strategy allows a homeowner to remove the home from their estate by transferring ownership to a trust, while retaining the right to live in the property. When the term of the trust ends, the home is passed to the beneficiary. The transfer of the home to the QPRT is treated as a gift, but the value of the gift is reduced by the value of the grantor's retained rights at the time the gift transfer was made. The higher the interest rate, the lower the value of that gift and the less estate and gift tax is consumed when funding the QPRT. "This is also considered a freeze technique because the QPRT freezes the value of the home for estate tax purposes," says Christy.

Charitable remainder annuity trust (CRAT): Essentially the inverse of a CLAT, a CRAT allows the grantor to provide a regular income stream to non-charitable beneficiaries for the term of the trust, with the remaining trust assets left to charitable beneficiaries. When the assets are gifted to the CRAT, the grantor will receive a potential income tax deduction based on the remainder value that is being left to charity. The §7520 rate is used to calculate the value of the remainder to charity, so the higher the §7520 rate, the higher the potential income tax deduction. As a result, a CRAT becomes a potentially more attractive philanthropic vehicle as interest rates rise.

Estate and tax planning can be complicated, and careful consideration needs to be given to the implications of any arrangement. If you think any of these strategies might be appropriate for you, contact your attorney and tax professional to discuss how they may fit within your overall wealth plan.

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Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

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