Interest rates are rising, and it has become clear that they’re likely to continue to rise for the foreseeable future—ending a decade-long era where persistently low interest rates have dominated.
The end of this low-interest rate era signals a need for advisors to recognize that times are changing, and the trust planning advice that should be given to clients must change, as well. Clients who have been on the fence over including a trust such as a grantor retained annuity trust (GRAT) or charitable lead annuity trust (CLAT) in their estate planning should understand that now is likely the most advantageous time to act. Conversely, as rates continue to rise, advisors may wish to re-familiarize themselves with trusts that tend to provide the greatest value in a high rate environment, but have fallen into disuse in light of historically low rates
GRATs and CLATs
A GRAT essentially combines a trust that is established for a certain predetermined period of time with an annuity that pays the trust creator (the grantor) a set value each year of the trust’s existence. This annuity payout is the client’s retained interest. The remaining value passes to the client’s beneficiaries, and, thus, out of his or her estate.
The value of the taxable gift to the GRAT beneficiaries is equal to the fair market value of the property transferred into the GRAT minus the client’s retained interest. The client’s retained interest is the actuarially calculated value of the annuity stream he or she will retain over the GRAT’s life based on the Section 7520 rate in effect for the month in which the GRAT is created.
Because a lower Section 7520 rate will increase the present value of the grantor’s retained interest, and the current rate is locked in for the life of the GRAT, a low-interest rate will reduce the taxable value of the beneficiary’s gift (i.e., reducing gift tax liability). For the GRAT to succeed, tax-wise, the assets placed into the trust only need to outperform that locked-in Section 7520 rate. If a client’s assets are locked into the GRAT at today’s low interest rates, the probability of the assets appreciating at a more rapid rate as interest rates increase also increases.
CLATs are similar structures, except that the annuity payment is made to charity, and a primary goal is often maximizing the value of the deduction for charitable donations. At the end of the CLAT term, any remainder is distributed to the client’s beneficiaries. An interest rate is locked in at the time the assets are transferred to the CLAT, and excess investment performance is transferred to the noncharitable beneficiaries tax-free. The donor receives the charitable deduction for the assets that pass to the charity. If the trust is structured to “zero out” at the end of the term, no gift tax liability will arise and the donor will receive a larger deduction.
Trust Planning for a High Rate Environment
Qualified personal residence trusts (QPRTs) have seldom been used in the last decade because they benefit from high interest rates, and actually require transfer of the client’s residence. The client transfers his or her residence to the QPRT for a term of years, and retains the right to continue living there (instead of the annuity that applies with GRATs and CLATs).
The remainder is transferred to the client’s beneficiaries, making use of the gift tax exemption. However, if the value of the client’s right to live in the residence (his or her remainder interest) is high, less of the exemption will be used up. When rates are high, the value of the interest that passes to the client’s beneficiaries is lower. Clients interested in a long-term trust may be attracted to this option as interest rates rise.
Clients who wish to take advantage of a higher charitable deduction may find charitable remainder annuity trusts (CRATs) attractive in a high interest rate environment. This is because the client will take a charitable deduction for the value of the remainder interest that will ultimately pass to charity when the trust is funded. The annuity (income) stream that the donor receives from the trust is subtracted to determine the value of the gift, and when rates are higher, the amount going to charity will be valued higher—thus maximizing the value of the client’s deduction.
The trust strategy that will work best for a particular client is, of course, dependent upon the client’s specific goals and financial position. Details such as the client’s life expectancy must also be taken into account in determining whether a particular trust strategy will provide a tax benefit to the client.
- For previous coverage of planning for interest rate fluctuations in Advisor’s Journal.
- For in-depth analysis of qualified personal residence trusts, see Advisor’s Main Library.
- Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.