How Interest Rates Affect Your Estate Plan

Along with inflation, interest rates have been rising this year. This trend has already impacted business and personal finances in North Carolina, but it can also have an effect on your estate plan – especially if yours is tuned to minimize taxes and preserve your wealth. These goals are affected by interest rates, and certain strategies may be more or less favorable depending on whether rates are high or low.

Interest Rates & Estate Planning

In many cases, the interest rate applicable to any given estate planning strategy is the one that was in effect when the planning began. This means that how much your plan works in your favor can flex depending on these rates.

The Applicable Federal Rate (AFR) and Section 7520 rate apply to most estate planning strategies and change on a monthly basis. The former of these reflects the minimum interest rate for loans between related parties on a short-, mid-, and long-term basis, while the latter is 120% of the mid-term AFR and is used to calculate taxable values for trusts and other estate planning methods.

Estate Planning When Interests Rates Are High

When interest rates are up, as they are in 2022, estate-planning strategies should align to maximize deductions and minimize taxation.

Charitable Remainder Trust

A Charitable Remainder Trust (CRT) is a trust that pays an annuity to its grantor for a specified term. At the end of this term, assets remaining in the trust are distributed to a predetermined charity.

There are two versions of a CRT in common use: the Charitable Remainder Annuity Trust (CRAT) and the Charitable Remainder Unitrust (CRUT). When a grantor creates a CRAT, they receive a fixed income stream. This is a percentage of the initial fair market value of assets funded into the CRT, and the annual payment doesn’t deviate during the trust’s term.

A CRUT’s income stream, however, is based on a fixed percentage of the balance of the trust’s assets. This property is revalued every year, which means the payment the grantor receives will also change every year until the trust terminates.

Regardless of the type of CRAT a grantor uses, they can claim an income tax deduction for the charitable portion of the transfer – but the charity must benefit from at least 10% of the initial contribution when the trust expires. When interest rates are high, a CRT may be advantageous to claim a greater charitable deduction on quickly growing assets.

Qualified Personal Residence Trust

A Qualified Personal Residence Trust (QPRT) is an irrevocable trust that allows a grantor to remove their personal residence from their estate to reduce the gift tax incurred upon the property’s transfer to the trust’s beneficiaries.

A grantor can live in and use the home during the QPRT’s term with retained interest. Upon the trust’s expiration, however, the grantor must pay the trust’s beneficiaries rent at a fair market value. The remainder interest is also transferred.

Typically, the retained interest is calculated based on AFR. Because of the owner’s retained interest, the property’s fair market value as a gift is lowered, which reduces gift tax consequences. When interest rates are high, the grantor has a greater retained interest, which can significantly decrease gift taxation.

Estate Planning When Interest Rates Are Low

When interest rates are low, it may be beneficial to use one or more lending strategies to transfer wealth without triggering gift tax consequences.

Intrafamily Loan

An intrafamily loan is a cash loan from the estate planner to the loved ones whom they wish to benefit. It is not a gift because the loan must be repaid, and it must be repaid using the appropriate AFR rate for the loan’s duration.

Intrafamily loans, however, can be structured as interest-only loans and made payable in full on the loan’s maturity. A structure such as this allows the borrower to use the loan to purchase appreciable assets such as a home or business, which can effectively transfer wealth and avoid the gift tax. Any default on the loan, however, can trigger gift tax consequences for the estate planner.

Installment Sale to an Intentionally Defective Grantor Trust

An Intentionally Defective Grantor Trust (IDGT) is a special type of irrevocable trust. The grantor pays income and capital gains tax on property in the trust, but the property avoids estate taxation because it’s not considered part of the grantor’s estate.

An installment sale to an IDGT is similar to an intrafamily loan, but the borrower in this case is the trust itself. The grantor sells a non-cash asset to the trust for an installment note but remains responsible for income tax and capital gains tax incurred by the trust. No gain is realized on this sale because the lender and borrower are the same taxpayer. Assets sold to the trust, such as a home or business, can appreciate over the interest rate and transfer to beneficiaries without incurring the gift tax.

As with an intrafamily loan, the AFR rate is used for determining this method’s interest rate.

Grantor Retained Annuity Trust

A Grantor Retained Annuity Trust (GRAT) is another type of irrevocable trust. The grantor places income-earning assets in a GRAT, which pays out an annual annuity to the grantor. Upon the trust’s expiration and final annuity payment, the beneficiaries of the GRAT receive its assets and avoid most gift tax consequences.

The Section 7520 rate must be used with a GRAT, but appreciation over this rate accrues to the trust beneficiaries. In most cases, people tend to choose a series of short-term GRATs to increase wealth transfer potential and take advantage of market volatility. A GRAT with a longer term may not otherwise provide particularly advantageous economic benefits.

Create or Revise Your Estate Plan with Legal Guidance

Higher interest rates mean that you should review your estate plan to make sure it is working to protect your wealth. At Jetton & Meredith, PLLC, our experienced estate planning attorneys can help you review your current estate plan today to ensure it is ready for the future.

Learn more about our estate planning services in an initial consultation. Contact us now to get started by calling (704) 931-5535.