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.