Using Low Interest Rates to Cut Your Taxes

Low interest rates put a crimp in your investment income, but they can help reduce your income, estate, and gift taxes. Treasury rates and mortgage rates recently hit record lows, and that means the rates the IRS uses to calculate taxes on different strategies also were at all-time lows.

Around the middle of each month the IRS issues the interest rates to be used on certain transactions that take place the next month. To find the rates, go to the IRS web site at www.irs.gov. In the search box, type “adjusted federal rates” and the month and year before the month you are seeking. If you’re searching for the interest rates for October 2011, type “adjusted federal rates September 2011.” In the search results, look for the Internal Revenue Bulletin (or IRB) entry for around the middle of that month.

For October, IRS Revenue Ruling 2011-22 says the short-term rate (for transactions of less than three years) is 0.16%; the mid-term rate (for three to nine years) is 1.19%, and the long-term rate is 2.95%. There’s a blended rate used for some estate planning transactions that’s 1.4%.

Here’s how to use those low rates to transfer wealth at little or no tax cost.

One tool we discussed in past visits is the intrafamily low-interest or no-interest loan. When an interest rate below the federal adjusted rate is charged on a related party loan, the tax law imputes the minimum interest rate except for a few exceptions I won’t discuss in this visit.

Suppose two parents lend $200,000 to an adult child for 10 years. The tax law requires at least a 2.95% rate. The parents could set that as the loan term, requiring the child to pay $5,900 in interest each year. The interest would be deductible by the child when the loan is secured by the home and meets the other requirements for deducting home mortgage interest.

When the parents need the money back and intend this as a way to help the child obtain a low-cost loan not available elsewhere, the child makes regular payments each year. Or the parents could use the loan to transfer wealth to the child tax free. Each year, the parents can jointly forgive up to $26,000 of principal and interest each year. When they need the cash or are concerned how the child is handling money, they can forego debt forgiveness and require the year’s payment.

The parents also can charge no interest on the loan. In that case, the tax law treats the parents as if they made a gift to the child of the minimum required 2.95% rate and the child in turn paid this interest to the parents. That gives the parents phantom interest income of $2,950 on interest they didn’t receive. Alternatively the parents could charge the minimum interest rate and forgive the interest each year as a gift (that’s tax-free to the child).

Some families use low or no-interest loans to help the children increase their wealth. The children invest the loan proceeds for a period of years. They keep all the investment earnings and return the loan principal at the end of the term. The parents have lost only the income they could have earned on the money and have effectively transferred that to the children at no tax-cost.

This strategy works really well when you can lend a large sum to a child. Suppose you lend $1 million for just over one year at the short-term 0.16% rate. The child invests the money and at the end of one year has a capital gain of 5%. The child can sell the investment after holding it for one year and one day and pay the 15% long-term capital gain rate on the sale. So, he’s made a $50,000 profit with $42,500 after taxes. He repays you $1 million plus $1,600 interest and nets $40,900. That’s money you transferred free of income, gift, and estate taxes.

A low-interest loan can be used to help children buy a home or other asset, cover needed expenses, or invest profitably.

Businesses also can use low-interest loans as a form of compensation. A loan also helps retain quality employees, because an employee would have to pay the loan in full upon leaving the employer.

If you already are using low-interest loans, review them. You could be able to “refinance” or restructure them to capture today’s record low yields and provide greater benefits.

In the past we discussed grantor retained annuity trusts (GRATS), and these are more effective than ever with low interest rates.

In a GRAT, you put assets in a trust that pays you a guaranteed income for a period of years. After the period ends, whatever’s left in the trust goes to the named beneficiaries, which can be your children or other loved ones. You can make this transfer free of estate and gift taxes by having the annuity payout based on the IRS’s minimum-required interest rate, which recently was 1.4%. This means if the trust earns 1.4% or less annually, you’ll receive all the trust property back and there won’t be anything extra for your heirs. When the trust earns more than 1.4%, your heirs receive all the excess.

Most estate planners recommend that a GRAT be for a term of two to 10 years. For example, a wealthy person could set up a two-year GRAT each year. It beats a low-interest loan, because you don’t have to worry about collecting on a loan. The attorney’s fees to set up a GRAT are likely to be higher than for a no-interest loan.

There have been proposals the last few years to require a minimum 10-year period for GRATS, so you should talk to an estate planner soon if this might work for you.

You also can give remainder interests in property to charity and generate current tax benefits. Suppose you have investment real estate or a second home. You can change the deed so that a charity receives the property after you pass away. That is called giving a remainder interest to the charity. You own the property for the rest of your life and can use it. You receive a charitable deduction today for the present value of the charity’s share of the property. The percentage of the property’s current value you can deduct depends on your age and current interest rates.

With interest rates so low, you’ll receive close to twice the deduction you would have received four or five years ago. Your deduction will decline if you wait and give the remainder interest when interest rates are higher.

Of course, you can create a trust that benefits charity. We discussed the alternatives in last month’s visit. The trust that benefits from low interest rates the most is the charitable lead trust. Review last month’s visit, available on the web site, for details.

Sellers of businesses or business assets might want to consider financing the sale through an installment sale. When you receive payments, each payment will be divided into return of principal, long-term capital gains, and interest on the loan. Today’s low interest rates ensure the minimum amount will be allocated to interest taxable at your top tax rate and the maximum amount will be long-term capital gains.

RW November 2011