Estate planning for rising interest rates
Different planning techniques work better when interest rates are at different levels (high vs. low) or on different trajectories (rising vs. falling). Knowing what techniques are appropriate for which environments can make your planning more efficient.
In a rising interest rate environment, you may want to lock in lower interest rates now while preparing to capitalize on higher interest rates in the future.
As interest rates rise, you may be wondering how these changing rates affect estate planning. There are a number of strategies that are most effective in either high- or low-interest-rate environments—but not both. From 2010 through 2021, rates have remained at historic lows; however, if rates begin to rise, it is important to consider (and implement) the estate planning opportunities that are most effective in a low-interest-rate environment and prepare for the strategies that work best when interest rates are higher.
Interest rates that affect estate planning
Each month, the Internal Revenue Service publishes short-, mid- and long-term rates (the Applicable Federal Rates, or AFRs) and the §7520 rate. The AFRs reflect the minimum interest rate that must be charged for loans between related parties;1 the §7520 rate (used to calculate annual payments for certain techniques ) is 120% of the mid-term AFR.
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 AFR and the §7520 rate are used when implementing a number of estate planning techniques, the effectiveness of these techniques changes when these rates change. Rising interest rates can motivate you to lock in interest rates while they remain low or prepare to capitalize on potentially higher rates in the future.
Below is a chart showing the historical AFRs and §7520 rate. While the rates over the past few years have remained relatively low,2 they have been slowly increasing since their historic lows in 2020
Historical deferal interest rates (AFR, §7520 rate)
Usually the rate that will apply to a specific strategy is the rate in effect on the date the strategy is entered into. You should think about your goals for your wealth as you consider the strategies that are most effective in the evolving interest rate environment. You may want to lock in the rates that are most advantageous for you (whether high or low) as you consider your planning.
Strategies for a low-interest-rate environment
Planning in a low interest rate environment often involves implementing one or more lending strategies that leverage the low interest rates in order to transfer wealth with little or no gift tax. At their core, these strategies involve senior family members lending younger family members money at the relevant interest rate; the loan proceeds are 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.
These techniques enable senior family members to (i) “freeze” the value of the assets that they lend, which would generally be included in their estates for estate tax purposes and (ii) pass the asset’s appreciation to junior family members or trusts for their benefit.
Intrafamily-loan: The simplest way to plan in a low-interest-rate environment is to make a cash loan to the person whom you wish to benefit. The 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. This structure uses the relevant AFR depending on the maturity of the loan.
Installment Sale to an Intentionally Defective Grantor Trust (IDGT): This is similar to an intra-family loan, but (i) the borrower is a trust created by the lender; (ii) the borrower trust is a “grantor trust” with respect to the lender for income tax purposes (which means that the lender/grantor is responsible for any income tax, including capital gains tax, incurred by the trust), and (iii) the asset sold to the trust or into which the loan proceeds are invested is often a noncash asset. Because the lender and the borrower are the same taxpayer, no gain is realized on the sale of the asset to the trust. And 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 AFR.
Grantor Retained Annuity Trust (GRAT): A GRAT functions like an installment sale to an IDGT, except (i) the annual payments to the grantor must be fully amortized over the term of the GRAT and (ii) the §7520 rate (which is higher than the short- and mid-term AFRs) must be used. Appreciation over the §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; as a result, individuals often create a series of short-term, rolling GRATs (the donor funds a new GRAT each year with the annuity from the previous GRAT) rather than a single, longer-term GRAT, to increase the wealth transfer benefits and capitalize on market volatility.
Charitable Lead Annuity Trust (CLT): Like a GRAT, the §7520 rate must be used for this structure and asset appreciation over the §7520 rate passes to the trust beneficiaries gift tax free. 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 CLT. Depending on how the CLT is structured, the grantor may receive a charitable income tax deduction upon funding.
Strategies for a high-interest-rate environment
You may be able to capitalize on strategies whose benefits hinge on using higher interest rates to reduce the actuarial value of a taxable gift. The higher the rate, the more beneficial these strategies will be.
Qualified Personal Residence Trust (QPRT): A QPRT is a trust used to transfer a personal residence to trust beneficiaries. The QPRT lasts for a term of years, during which the grantor may continue to use the residence as his or her own. After the initial QPRT 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 the grantor at a fair-market-value rent. The initial transfer to the QPRT is a taxable gift of the value of the remainder interest, calculated using the §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 §7520 rate increases, the taxable gift decreases, making the QPRT a more attractive strategy with higher interest rates.
Charitable Remainder Annuity Trust (CRT): This is the reverse of a CLT; the grantor receives an annuity from the CRT for a term of years, and charity receives whatever remains at the end of the term. Here, the value of the remainder, calculated using the §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 §7520 rate, the higher the value of the charitable interest and the more likely that the CRT will pass IRS review. CRTs must also make a minimum annual payment to the grantor; younger grantors who want to create certain CRTs sometimes can have a hard time meeting this minimum payment if rates are too low.
Please contact your J.P. Morgan Advisor, as well as your legal and tax advisors, to discuss any of these strategies and additional considerations when implementing them.