TRUST & ESTATE PLANNING

Wealth Transfer Strategies for a Rising Interest Rate Environment

08.09.2017

It’s important to take interest rates into account when considering your wealth transfer options. That’s because interest rates influence how wealth transfers are valued for tax reporting purposes. With interest rates expected to continue to increase over the next several years, consider implementing strategies now to take advantage of today’s low rates.

1. Grantor Retained Annuity Trusts

A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust into which the grantor (creator of the trust) transfers assets and receives payment of a fixed dollar amount (the annuity) for a specified term of years (GRAT term). At the end of the GRAT term, the trust’s remaining assets, minus interest, pass to the designated beneficiaries, tax free.

How GRATs Work
The IRS assumes that a GRAT will grow at a rate (the “hurdle rate”) set at the time the trust is established. The IRS does not look at the actual growth of the assets, so any appreciation above the hurdle rate is passed on to trust beneficiaries free of gift and estate taxes. The lower the hurdle rate, the larger the potential tax-free gift. A GRAT can be an excellent wealth transfer option in a low interest rate environment because of the greater potential to outperform the hurdle rate than in a high interest rate environment.

Income Tax Advantages
Another advantage of a GRAT is that it is a “grantor trust.” This means that the grantor is considered the owner of the trust for income tax purposes and is taxed on all of the income. Payment of the income taxes by the grantor is, in effect, a further tax-free gift to the trust beneficiaries since the trust assets can grow without reduction for income tax payments.

2. Charitable Lead Annuity Trusts

A Charitable Lead Annuity Trust (CLAT) is similar to a GRAT, except the annuity payment is made to charity. The annuity must be paid out periodically, at least annually, usually for a specified number of years. At the end of the trust’s term, the remainder interest must be distributed to one or more non-charitable beneficiaries (usually family members).

Tax-Free Transfer to Family Members
The property contributed to a CLAT is assumed to grow at a rate equal to the IRS hurdle rate in effect at the time of the transfer. A CLAT works best in a low interest rate environment because any investment performance in excess of the hurdle rate passes tax free to the family members at the end of the trust’s term. The lower the rate, the larger the potential tax-free transfer.

Minimizing CLAT Gift Tax Costs
It is possible for a CLAT to trigger a taxable gift if it is not properly structured. The donor is allowed a charitable deduction on the value of the amounts passing to charity. Only the assets calculated to remain at the end of the CLAT’s term are subject to gift tax. A CLAT should be structured to zero out at the end of its term, resulting in little or no gift tax.

3. Intra-Family Lending

Another technique that works well in a low interest rate environment is intra-family lending, provided the loan is structured properly and fully documented. The IRS has established special interest rates for these loans that are usually considerably lower than the average 30-year mortgage rates.

No Gift Tax Liability
Intra-family mortgage lending can be a good way to assist family members without incurring gift tax. In addition to lower interest rates, other benefits include having the total interest expense over the life of the loan stay within the family instead of being paid to a bank, and allowing children with poor or no credit history to buy a home.

In addition, it allows families to avoid expenses for administrative costs such as closing costs and appraisal fees. The lender can also forgive part of the loan each year up to the annual gift tax exclusion amount, without a gift tax consequence. This will lower the principal balance ultimately paid at the expiration of the term, and reduce the size of the loan drawing interest.

Potential drawbacks exist, however. Parents or children (or both) might not be comfortable in this type of lending relationship, and gift taxes may arise if interest payments fall behind. In addition, unlike a bank loan, the borrower cannot establish a credit rating through this kind of lending relationship.

Loan to Trusts that Benefit Family Members
An intra-family loan does not necessarily have to be established for the purpose of acquiring a residence (although a benefit of doing so is the potential deductibility of the interest payments). In a low interest rate environment, a loan can be an attractive estate planning tool on its own.

To the extent the borrower is able to earn a rate of return on the borrowed funds that exceeds the applicable interest rate being paid, the borrower keeps the excess without a transfer tax cost. Ordinarily, the interest payments would be included as income on the lender’s income tax return. However, it is possible to structure the loan to a trust for the benefit of family members. If the trust is a grantor trust, the interest payments on the loan will not have an income tax consequence. Additionally, the income and gains of the trust would be taxable to the grantor, leaving the trust to grow for the benefit of family members without reduction for income tax liability.

4. Selling Property to a Grantor Trust

Selling property that is expected to appreciate to an irrevocable grantor trust is another potentially attractive planning strategy in a low interest rate environment. The grantor receives a promissory note with interest payable at today’s low interest rate. As with the loan technique, if the property sold to the trust earns a higher rate of return than the interest payable on the note, the excess represents a tax-free transfer to the trust. The property that is sold to the trust should generate enough cash flow to pay down the note.

After the grantor creates an irrevocable grantor trust, the trust is “seeded” by the grantor with sufficient funds to use as a cash down payment for the purchase. The seeding is advisable in order to establish that the sale is genuine. It is generally recommended that an amount equal to at least 10% of the property be contributed by the grantor for the down payment. That 10% transfer will constitute a taxable gift, but the grantor can use his or her lifetime exemption from the gift tax to reduce or eliminate gift tax cost. The seeding contribution is used by the trust to purchase the asset from the grantor, and the balance of the purchase price is payable with a promissory note, bearing interest at the minimum IRS rates.

Maximizing Leverage
It may be possible to structure the installment note as an interest-only note, with a balloon principal payment at the end of the term. If an interest-only note is utilized, the principal remains in trust and continues to appreciate in value for the maximum period of time.

Income Tax Advantages
The grantor is treated as the owner of the trust for income tax purposes. However, the trust property is not included in the grantor’s estate for estate tax purposes. There is no capital gain recognized when the property is sold to the trust, and the interest payments to the grantor are not considered taxable income. The grantor is responsible for the taxes on income and capital gains generated by the trust, so the trust property can grow income tax free.

Estate Tax Advantages
If the grantor outlives the term of the promissory note, the assets are completely removed from his or her estate. However, even if the grantor dies prior to full payment, only the outstanding balance of the note is includable in the estate for estate tax purposes (unlike the GRAT, which typically cannot be completed if the grantor dies during the term).

Minimizing the Risk of Gift Tax
The assets sold to the trust should be professionally appraised. If the IRS revalues the assets at a higher value than the sales price, the excess will be deemed a gift, triggering gift tax liability.

Next Steps

Many factors in addition to rates go into gifting decisions. We recommend speaking with your Fiduciary Trust Relationship Manager to determine the right strategies for your specific situation and goals.


This communication is intended solely to provide general information. The information and opinions stated are as of August 2017, and may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.

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