The current war in Ukraine has added fuel to the fire of inflation, which started in the aftermath of the Covid-19 pandemic and the fiscal stimulus implemented in response. It seems likely that the Federal Reserve will raise interest rates, perhaps as much as 2% over the next year to 18 months.

As interest rates rise, the changing rates affect estate planning. There are strategies that are more effective in high-interest rate environments and those more effective amid lower rates. But there is no “one-size-fits-all” strategy for both. From the beginning of 2010 through 2021, interest rates were at historic lows, reflecting the low rates of inflation. But now that inflation is rising, it’s most likely interest rates will follow, and when they do, it will be time to change strategies.

While the rates are still low, advisors should use strategies most effective in low-rate environments. But when the Fed raises the rates, the strategies should change to reflect them.

Which Rates Affect Estate Planning
Each month, the Internal Revenue Service publishes short-, mid- and long-term rates. The applicable federal rates, or AFRs, reflect the minimum interest rate that must be charged for loans between related parties. The Section 7520 rate is used to calculate annual payments for certain techniques and is 120% of the midterm applicable federal rate. All of these rates are calculated based on the yields of certain government debt obligations, and the target federal funds rate has a direct impact on these yields. Since the applicable federal rates and the Section 7520 rate are used when implementing a number of estate planning techniques, the effectiveness of the techniques changes with interest rates. Rising rates can motivate you to lock in interest rates while they remain low or prepare to capitalize on potentially higher rates in the future.

Usually, the rate that applies to a specific strategy is the rate in effect on the date the strategy is implemented. So you should consider the strategies that are most effective as the interest rate story changes and consider how they will affect your financial goals.

Strategies For The Current Low-Interest-Rate Environment
Planning in the current environment will involve lending strategies that take advantage of lower rates so that clients can transfer wealth with little or no gift tax. These strategies usually involve senior family members lending younger family members money at the relevant interest rate. The loan proceeds are then invested by the younger family members. The interest rate reflects the hurdle that the investments’ growth must overcome before the strategy will work to transfer value to the younger family members.

For example, the Section 7520 rate for March 2022 was 2.0%. If you had made a loan of $1 million to a child that month, the interest rate would be 2%. If, as the market appreciated, the child actually made 8% on the funds, he or she would get the difference between the interest rate paid ($20,000) and the amount received from the invested loan proceeds ($80,000). The net benefit is $60,000, free of gift tax.

This technique enables wealthier family members to “freeze” the value of the assets they lend, assets that will eventually be subject to estate taxes, and pass the assets’ appreciation to less wealthy family members or to trusts for their benefit.

An intra-family-loan strategy is the simplest way to take advantage of low interest rates. A cash loan can be structured as an interest-only loan with a balloon payment on maturity; if the assets purchased by the borrower with the loan proceeds appreciate more than the interest rate paid on the loan, the excess passes to the borrower free of gift tax.

Another low-interest strategy is an installment sale to an intentionally defective grantor trust. This is similar to an intra-family loan, except the borrower is a trust created by the lender—a “grantor trust” for income tax purposes (which means that the lender/grantor is responsible for any income tax, including capital gains tax, incurred by the trust. The asset sold to the trust or the property into which the cash from the loan is invested is often a non-cash asset, such as closely held company stock. Because the lender and the borrower are the same taxpayer, no gain is realized on the sale of the asset to the trust. Because the lender is required to pay the trust’s income tax liability, the loaned assets are able to grow inside the trust without being depleted by income tax payments. In addition, the asset appreciation over the interest rate accrues to the trust beneficiaries free of gift tax. This structure also uses the relevant applicable federal rate.

A third strategy to pursue when interest rates are low is the grantor retained annuity trust (GRAT). The strategy is similar to the installment sale to an intentionally defective grantor trust, except the annual payments to the grantor must be fully amortized over the term of the trust, and the Section 7520 rate (which is higher than the short-term and midterm applicable federal rate) must be used. The assets’ appreciation over the Section 7520 rate accrues to the trust beneficiaries.

The economic benefits of this strategy are often not as great as that of the installment sale strategy, since the annuity includes portions of both interest and principal. It is, however, possible to create a series of short-term, rolling GRATs (where the donor funds a new GRAT each year with the annuity from the previous one). This strategy is sometimes preferred to a single, longer-term GRAT for clients who want to increase the wealth transfer benefits and capitalize on market volatility.

Finally, there is the charitable lead annuity trust. Like a GRAT, asset appreciation over the 7520 rate passes to the trust beneficiaries free of gift tax. Unlike a GRAT, however, 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 trust. Depending on how the charitable lead trust is structured, the grantor may receive either a charitable gift-tax deduction or a charitable income tax deduction in the year the trust is funded.

Strategies For A High-Interest-Rate Environment
The strategies for higher interest rates are meant to reduce the actuarial value of taxable gifts.

First, there is a qualified personal residence trust, which is used to transfer a personal residence to trust beneficiaries. It lasts for a term of years, during which the grantor may continue to use the residence as his or her own. After the initial trust term, the residence passes to remainder beneficiaries. If the grantor wants to continue to live in the home, the trust or its beneficiaries can rent it to him or her at a fair-market-value rent.

The initial transfer to the qualified personal residence trust is a taxable gift of the value of the remainder interest (a future right to the property held by somebody other than the grantor that only comes into the other person’s hands after the original owner’s interest is terminated upon his or her death or the end of the estate). Remainder interest, which must be established at the same time as the present interest, is calculated using the Section 7520 rate. The higher the 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. So as the Section 7520 rate increases, the taxable gift decreases, making the qualified personal residence trust a more attractive strategy with higher interest rates.

Next is the charitable remainder annuity trust: With this, the grantor receives an annuity from the trust for a term of years, and the charity receives whatever remains at the end of the term. Here, the value of the remainder, again calculated using the Section 7520 rate at the time the grantor creates the trust, gives the grantor an income tax charitable deduction. However, in order to pass IRS review, the value of the remainder must reach a minimum threshold; the higher the Section 7520 rate, the higher the value of the charitable interest and the more likely that the charitable remainder trust will pass IRS review. These trusts must also make a minimum annual payment to the grantor; younger grantors who want to create these trusts can have a harder time meeting the minimum payment if rates are too low.

Again, in the current low-interest-rate environment, you should consider implementing: 1) intrafamily loans, 2) loans to an intentionally defective grantor trust, 3) gifts through a grantor retained annuity trust, and 4) a charitable lead annuity trust. As interest rates rise, you should consider a qualified personal residence trust and a charitable remainder annuity trust. In both cases, it pays to plan ahead in these volatile times.           

Matthew Erskine is a managing partner at Erskine & Erskine.