How Interest Rates Affect Your Estate Planning

Interest rates were expected to rise the last couple of years. Instead, rates declined. They declined again to open 2016. Interest rate changes matter to your Estate Planning. Some strategies are better when rates are low and others when rates are higher. Especially when your estate might be taxable or you don’t want to shelter your lifetime exemptions, pay attention to interest rates when considering strategies to use.

The rates that matter usually are those issued by the IRS each month. The IRS sets the rates for tax strategies using current market interest rates. To find the latest rates, go to the IRS web site at www.irs.gov and type in the search box “adjusted applicable federal rates 2016.” The rates for the latest month should be among the top links in the results. Fresh rates usually are issued during the second week of each month. Different rates are used for different strategies, and your estate planning advisor can identify the rates that apply to the strategies you’re considering.

Here are some estate planning strategies to use while those rates are low and some to consider deferring until rates are higher.

1 Low-interest or no-interest loans.

These perennial favorites are especially valuable when rates are low. You lend money or property to a family member, expecting it will appreciate or earn income while the member holds it. You take back a note that promises the loan will be repaid with interest at a certain time. At the end of the loan term, you are repaid and the family member keeps the income or appreciation that exceeds the interest charged on the loan.

There is no gift the IRS cares about from the strategy as long as you charge at least the minimum interest rate on the loan. You’ll have to include the interest in income, but you transferred out of your estate the income or gains that are retained by the family member. You don’t even use part of your $14,000 annual gift tax exclusion, because as far as the IRS is concerned you didn’t make a gift.

The key is that the interest rate on the loan must be at least the IRS minimum. The latest minimum rates are 0.81% for short-term loans, 1.82% for mid-term loans, and 2.62% for long-term loans. (I expect those rates to decline a bit in the next month.) So, if your family member is able to earn a return that exceeds those rates, he or she keeps the excess and your principal is returned to you with a little interest. If the investment doesn’t work out, you can write off whatever can’t be repaid and treat it as a gift to the family member.

You might be able to make loans that don’t charge any interest without tax consequences if the loans are less than $10,000. Also, the income and gift taxes could be modest when total loans are less than $100,000. Details of those exceptions are in IRS Publication 550, beginning on page six.

2 Grantor retained annuity trusts (GRATS).

These are favorites for investors in growing businesses, especially those that might go public, but can be used with any investment opportunity with strong appreciation potential over two to five years. If you’re interested in the strategy, consider using it soon not only because rates are low but also because the IRS and others in Washington want to end it.

In this strategy, you create an irrevocable trust that will pay you an annuity for two to five years, whichever period you choose. You transfer to the trust assets you believe have high growth potential over that time. The annuity payout usually is set at a rate that will distribute the original value of the assets plus the applicable adjusted federal rate within the term. Any return on the property exceeding that amount belongs to your heirs, either directly or through the trust. You’ll have transferred the money to them without estate or gift taxes or using the annual gift tax exclusion. That’s why it is a good vehicle for assets you expect to appreciate fairly rapidly in the next few years.

If the trust earns less than the minimum rate or even loses money, then there’s nothing for your heirs. The result will be the same as if you hadn’t created the trust. You’ll be no worse off, except for legal fees.

3 Qualified personal residence trusts.

This is a strategy you might want to delay until rates are higher. With the QPRT, you transfer a house to an irrevocable trust. For a period of years you retain the right to use the home as though you still were the owner. After that, the trust owns the property or passes ownership to the beneficiaries of the trust (who usually are your children). If you continue to use the property after that, you have to pay fair market rent. That’s why the QPRT is best used for a second home or vacation home instead of a primary residence.

When the residence is transferred to the trust, you’ve made a gift that is calculated using IRS tables. Under the tables, the lower the interest rate when the house is transferred to the trust, the higher is the value of the gift. So, it is better to use the strategy when rates are higher. Also, if you pass away before the term of years ends, the property is included in your estate as though no transactions were made. That’s why it is important to use a term of years that is less than your life expectancy.

4 Charitable remainder annuity trusts.

In a CRAT, you transfer appreciated property to an irrevocable trust. The trust pays you a fixed amount of income each year for either life or a period of years. After the income period expires, the property remaining in the trust goes to a charity or charities you designated.

There is no capital gains tax on the appreciation that occurred while you owned the property. Also, you receive an income tax deduction when property is put in the trust. The deduction is the present value of the remainder interest that eventually will go to charity. The remainder interest is more valuable when interest rates are higher. So, this is another strategy that delivers the most benefits when rates are higher rather than lower.

Interest rates shouldn’t be the sole factor to consider in your estate planning. But consider their effects when there’s flexibility over when to execute a strategy.