How to Take Advantage of Higher Interest Rates in Your Estate Plan
For more than a decade, high net worth individuals often relied on a handful of estate planning techniques that exploit low interest rates to pass wealth to family members at little or no estate and gift tax cost. Those techniques, which include grantor retained annuity trusts (GRATs), charitable lead trusts (CLTs) and sales to intentionally defective grantor trusts (IDGTs), were explained in the blog “How to Use Today’s Low Interest Rates to Save Estate and Gift Taxes” and again in “Low Interest Rates, Depressed Markets Present Estate Planning Opportunities.” However, for the last couple years, rates have crept higher, rendering these techniques less attractive. Thankfully, there are a couple of estate planning vehicles – namely Qualified Personal Residence Trust and Charitable Remainder Trusts – that achieve optimal results when interest rates are high. Now may be an ideal time to dust off these vehicles and take them for a spin.
Qualified Personal Residence Trusts
A Qualified Personal Residence Trust (QPRT) involves the donor transferring his or her primary or vacation residence to an irrevocable trust. A QPRT can be broken down into two distinct interests: the “QPRT term,” in which the donor retains a right to use the residence rent-free for a specified term of years, and the “remainder interest,” which applies after the QPRT term expires and typically provides that the residence passes in further trust for the donor’s spouse or children.
The primary benefit of a QPRT is that, for gift tax purposes, the transfer of the residence is treated as a gift only to the extent of the present value of the remainder interest. The gift portion is the only part of the transfer that uses up some of the donor’s estate and gift tax exemption – the maximum amount of wealth that an individual can transfer to heirs tax-free. For 2023, the exemption is $12,920,000. It is likely to increase in January of 2024 and 2025, to keep pace with inflation, and then plummet in January 2026 pursuant to a “sunset” provision contained in the current law. The calculation of the present value of the remainder interest incorporates the appraised value of the residence, the donor’s age, the length of QPRT term and the “7520 Rate” published by the IRS for the month of the transfer. A higher 7520 Rate reduces the value of the remainder interest, which results in the donor using less of his or her estate and gift tax exemption.
For example, assume a 65-year-old homeowner transferred his residence, valued at $3 million, to a QPRT with a 10-year term when the 7520 Rate was 0.6% (the rate for January 2021). Under the IRS actuarial tables, the gift portion would have been $2,320,950. On the other hand, if the homeowner creates the same QPRT in September 2023, utilizing a 7520 Rate of 5.0%, the gift portion would be only $1,512,690. The change in the 7520 Rate, by itself, reduces the gift by over $800,000. At a 40% estate and gift tax rate, that translates to tax savings of over $320,000!
Like a higher 7520 Rate, the longer the QPRT term, the lower the gift amount. However, the donor should be careful to choose a term that he or she is likely to outlive. If the donor dies during the term, the value of the entire property at the time of the donor’s death will be included in his or her estate for estate tax purposes, nullifying the tax savings that the QPRT is intended to accomplish. On the other hand, if the donor survives the QPRT term, the value of the residence, including any appreciation after it is transferred to the QPRT, escapes estate tax.
However, a QPRT is not without disadvantages.
- A QPRT is irrevocable. Once it is created, it cannot be changed or unwound without causing adverse tax consequences.
- If the residence is sold during the QPRT term, the donor does not receive the proceeds. Instead, the proceeds can be reinvested in another personal residence. To the extent not reinvested, the proceeds are held in a GRAT, requiring annual annuity payments to the donor for the balance of the term.
- Assuming the donor survives the QPRT term, the remainder beneficiaries (often children or trusts for their benefit) would take a “carryover” income tax basis in the residence equal to the donor’s basis. On the other hand, if the donor retains the residence until his or her death, the beneficiaries would take a “stepped-up” basis equal to the residence’s date-of-death value, thereby eliminating any potential capital gains tax on the pre-death appreciation of the residence.
- At the end of the term, the donor’s right to the rent-free use of the residence ceases. If the donor is then married and a trust for the donor’s spouse has been designated as the initial remainder beneficiary, the donor will have the right to use the residence indirectly through the donor’s spouse. If, however, there is no spouse or if the spouse is not designated as the beneficiary, the residence will pass to the remainder beneficiaries (again, often the donor’s children or trusts for their benefit). In that case, if the donor wants to continue to use the residence, he or she will be required to pay fair market rent to the beneficiaries. From a tax perspective, this is an appealing side effect, allowing the grantor to transfer additional wealth to the beneficiaries, free of estate and gift taxes.
As a final consideration, if the QPRT will be funded with the donor Florida homestead, care must be taken to ensure that the donor doesn’t lose the benefits of Florida’s homestead exemption, including the 3% annual limit on increases in the assessed value for property tax purposes (the so-called “Save Our Homes” cap). A detailed discussion of this topic is beyond the scope of this article but, rest assured, there are relatively simple methods to ensure that the QPRT will not cause the homestead exemption to be forfeited.
Charitable Remainder Trusts
With a Charitable Remainder Trust (CRT), the donor transfers property to an irrevocable trust, which makes an annual payment to one or more individuals – typically the donor, the donor’s spouse or the donor’s children – for their lives or for a term not to exceed 20 years. After the deaths of the individual beneficiaries or the expiration of the term, the balance of the trust property passes to one or more public charities or private foundations.
Generally, a CRT is a tax-exempt entity. Therefore, if you contribute appreciated property to a CRT, the trust does not incur tax if and when it sells the property or earns income on the reinvested proceeds. Instead, taxes are deferred and recognized by the individual beneficiaries only as they receive distributions from the CRT. Moreover, in the year the donor funds the CRT, the donor receives an income tax deduction equal to the present value of the charity’s remainder interest (subject to certain limitations, based on a percentage of the donor’s Adjusted Gross Income).
IRS rules require that the present value of the remainder interest equals at least 10% of the value of the contributed property (the so-called “10% Test”). The calculation incorporates the value of the property contributed to the CRT, the age of individual beneficiary or beneficiaries (or, if a term of years is used, the length of the term), the payout rate, the frequency of payments and the 7520 Rate. The donor may use the 7520 Rate for the month of the transfer or either of the two prior months, whichever is most favorable (i.e., the highest). For a CRT, a higher 7520 Rate increases the value of the remainder interest, which results in a larger charitable deduction for the donor. Alternatively, a higher 7520 Rate makes it easier to increase the annual payout to the beneficiary or to lengthen the term of the trust, perhaps even for the duration of the beneficiary’s life, while still satisfying the 10% Test. When interest rates were lower, it was much more difficult to structure a CRT is a way would meet with donor’s goals while not running afoul of the IRS rules.
For example, consider a donor who contributes $3 million of property to a Charitable Remainder Annuity Trust (a particular type of CRT discussed below) with a term of 15 years and a $150,000 annual payout (5%). If the trust was created when the 7520 rate was 0.6% (the best rate available in January 2021), the donor’s income tax deduction would have been $854,430. If the donor instead created the same trust in September 2023, utilizing a 7520 Rate of 5.0%, the deduction would be $1,443,045. Alternatively, assume the Charitable Remainder Annuity Trust is structured to pay the donor, who is 64 years old, $150,000 annually for the remainder of the donor’s life. At a 5.0% 7520 Rate, the donor’s deduction would be $1,255,500, which is 41.85% of the amount contributed to the trust.
On the other hand, if the trust was created in January 2021, when the 7520 rate was only 0.6%, the value of the charity’s remainder interest would be $229,335, only 7.65% of the amount contributed to the trust, and the trust would fail the 10% Test.
The annual payment from the CRT can take the form of a fixed annuity amount (called a Charitable Remainder Annuity Trust or CRAT) or a unitrust amount equal to a percentage of the fair market value of the trust’s assets, valued annually (called a Charitable Remainder Unitrust or CRUT). CRUTs tend to be more popular than CRATs for a couple of reasons. First, they result in a larger payout as the trust assets appreciate in value. Second, CRUTs come in a couple of special varieties that can offer more flexibility when the asset being contributed will not generate a consistent stream of income.
With a standard CRUT, the individual beneficiary receives a fixed percentage of the value of the trust assets, regardless of the income earned by the trust; if income is less than the required distribution amount, principal is distributed to make up the shortfall. On the other hand, with a “NIMCRUT” (Net Income with Makeup CRUT), the beneficiary receives annually the lesser of the fixed percentage and the net income earned by the CRUT; then, in future years, if and when income exceeds the fixed percentage, the beneficiary receives an additional “makeup” amount. Additional flexibility can be afforded with a “Flip” CRUT, which starts out as NIMCRUT, but on the occurrence of a certain event – such as the sale of the contributed property – “flips” to a standard CRUT, thereafter paying the fixed percentage each year. Flip CRUTs are often used when the donor contributes non-income-producing property, such as real estate, artwork or closely-held stock, intending that the payments to the beneficiary commence after the CRUT sells the property.
Take Advantage of High Interest Rates
With the rise in interest rates, we’ve returned to an environment in which QPRTs and CRTs are perhaps more attractive than they have been in over a decade. You may want to consider whether incorporating these techniques into your estate plan would be beneficial for you and your family.
Contact me or another member of Kaufman Rossin’s estate and trust team to discuss how these techniques and others might help advance your estate planning goals.