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Score a Huge Win with Estate Planning Moves in a High Interest Rate Environment

Score a Huge Win with Estate Planning Moves in a High Interest Rate Environment

August 25, 2023

Interest rates remain on the rise, and the Federal Reserve has signaled that more hikes could be on the way.  This means it will be at least two years before rates might decline.  What does this mean for estate planning?  The experts at Cedar Point Financial Services LLC are working with clients and their advisors on estate planning strategies that are more advantageous in a high interest rate environment. 

In 2020, interest rates reached their lowest point in 10 years and have been rising since, with the midterm Applicable Federal Rate (AFR) rate moving from 1.67% in January 2020 to 3.50% in June of this year.  For those borrowing money, the Secured Overnight Financing Rate (SOFR) increased from 1.55% to 5.02% during the same period.  While there are negative consequences from rising interest rates, namely higher borrowing costs, these increases create opportunities to implement wealth transfer strategies that do well in high interest rate environments.   

With rates at these levels, now is a good time to contact Cedar Point Financial Services LLC to review your planning and to consider locking in wealth transfer strategies that take advantage of higher interest rates.  

Understanding the Interest Rates Impacting Estate Planning 

Two federally established interest rates, the APR and the Internal Revenue Code §7520 rate are set on a monthly basis and are based on yields of specific government debt obligations.  As interest rates increase in general, so do the APR and §7520 rates.   The §7520 rate is calculated at 120% of the AFR mid-term rate in effect for the month when the valuation date falls, and is then rounded to the nearest 2/10 of a percent.  Both rates affect certain estate planning strategies that are interest-rate sensitive, including some types of trusts. 

Generally, the interest rate that applies to a specific planning strategy is the rate in effect at the time the strategy is initiated.  As rates rise, the effectiveness of specific planning approaches changes.  Some planning strategies are more favorable in a low-interest rate climate, while others are more beneficial in a rising rate or higher rate environment. 

For example, the APR determines the minimum interest rate that is necessary to be charged to avoid gift tax on loans between related individuals.  As APR rates rise, the allowable minimum interest rate on an intra-family loan increases, which can affect uses of intra-family loans as part of an estate plan.  Similarly, the §7520 rate is used to calculate taxable values for specific estate planning approaches, including certain types of trusts.  A change in the §7520 rate can either increase or decrease the taxable value, depending on the specific strategy or type of trust. 

Intra-family loans, Installment Sales to Intentionally Defective Grantor Trusts (IDGTs), Grantor Retained Annuity Trusts (GRATs), and Charitable Lead Annuity Trusts CLTs), are more favorable estate planning approaches during a low-interest rate environment. Those strategies had been popular during the recent period of historically low interest rates. 

As interest rates increase, Charitable Remainder Trusts (CRTs), Qualified Personal Residence Trusts (QPRTs) and the swapping or purchase of low-basis assets from an irrevocable trust may provide more benefit in an estate plan than the low-interest rate approaches.  These strategies become more favorable in a rising rate environment because higher rates can reduce the actuarial value of the taxable gift.  Many of the benefits of these strategies are amplified by incorporating life insurance into the solution and this is where Cedar Point Financial Services LLC can help.   

Strategies for a High Interest Rate Environment 

Charitable Remainder Trust (CRT) 

A CRT is an irrevocable tax-exempt trust that either pays a stream of cash income to the donor, other assets to the trust or another donor designee, and then pays whatever is left at the end of the trust term (the ‘remainder’) to a designated charity.  The income stream payable from the trust can last for life or a specific number of years (not to exceed 20 years). 

The income stream payable is determined in one of two ways.  The first way is when a Charitable Remainder Unitrust (CRUT) pays a fixed percentage based on the annual value of the trust.  The second way an income stream payable occurs is when a Charitable Remainder Annuity Trust (CRAT) pays a fixed dollar amount each year based on the value of the trust assets when the trust was first created.  Higher interest rates can often lead to a higher income stream here. 

One of the primary advantages for a donor in creating a CRT is the ability to claim an income tax deduction up front, which is generally equal to the value that is expected to pass to the charity – the remainder value at the end of the trust term.  CRTs are often used to diversify a donated concentrated stock position, while permitting the donor to use trust income to purchase life insurance for the benefit of children and/or grandchildren, thus replacing the value of assets ultimately passing to charity. 

When interest rates are higher, there’s a higher charitable deduction upon creation of the CRT. In this case, it’s assumed the assets in the CRT will grow quickly, meaning there will be a larger amount left for the charity when the annuity payment ends. 

Qualified Personal Residence Trust (QPRT) 

A QPRT is an irrevocable trust that reduces a taxable estate by transferring a residence into a trust for a period of time, known as a term interest.  Upon expiration of the term interest, the residence is transferred to remaining beneficiaries — oftentimes, children or trusts for the benefit of children. 

A QPRT can be an effective estate tax minimization tool because it allows donors to continue enjoying the benefit of using the home, while removing it from their estate.  It is important to note that a limit of two residences may be transferred to a QPRT (a primary residence and a secondary residence). 

Upon the expiration of the term interest, a donor can continue to live in the residence by paying rent at fair market value to the remaining beneficiaries.  This provides an additional way to transfer wealth since the rent is not considered a gift.  Additionally, the QPRT is generally structured so that the tax liabilities flow back to the donor who is the grantor of the trust.  In the IRS’s eyes, the donor is essentially paying rent to himself or herself, and the rental payments are therefore income tax-free. 

The initial transfer to the QPRT is a taxable gift of the value of the remainder interest that’s calculated using the §7520 rate.  The higher that rate is, the higher the value of a donor’s right to use the residence as their own during the term interest, and the lower the value of the gift of the future remainder interest.  Therefore, as interest rates increase, the taxable gift decreases, which makes a QPRT a more effective wealth transfer strategy with higher interest rates. 

The worst case in a QPRT scenario is if the donor dies before the end of the term.  If this happens, the property will revert back to the donor’s gross estate, which simply brings everything back full circle – no penalties are imposed, or other repercussions are involved, especially where a QPRT is part of a comprehensive estate plan. Nothing would be accomplished, yet nothing would be lost.  The proceeds from a life insurance policy on the life of the donor purchased by the QPRT or a separate irrevocable life insurance trust can be used to meet potential estate tax obligations, stemming from the residence’s inclusion in the donor’s gross estate. 

Trust Asset Swapping 

When interest rates rise, it is common to experience increased periods of decline in equity markets.  When this happens, it may be prudent to evaluate already funded irrevocable trusts for opportunities to substitute assets.  Swapping low-basis assets with those assets already contained in a taxable estate could result in an increased death benefit. 

Under certain circumstances, it could also be beneficial to structure those swaps as a sale, whereby the trust sells low basis assets to the grantor, thus trading cash for an asset eligible for a step-up in basis.  Alternatively, swapping assets with high-growth potential from an estate to a trust in order to exclude future appreciation from an estate may also be prudent. 


Sale to an Intentionally Defective Grantor Trust (IDGT): 

A cornerstone of a sale to an IDGT is a promissory note bearing interest at the AFR.  A low interest rate sale of an asset with appreciation potential makes this an efficient strategy when rates are low.  Conversely, a higher AFR makes this technique look less appealing.  However, there are still aspects of a sale to an IDGT that are appealing in a high interest rate environment:  currently depressed asset values, fractional interest discounts, and the potential to refinance promissory notes in the future when rates drop mean that this strategy should not be written off. 

The decision to incorporate any of these strategies requires the coordination of members of a planning team consisting of legal, accounting, and life insurance professionals, including the planning specialists at Cedar Point Financial Services LLC. 

The Clock is Ticking 

Fluctuating interest rates are a reminder to review an estate plan and implement the most favorable estate planning strategies for the current financial environment.  If you or one of your clients has a taxable estate, it’s critical that you review the estate plan now and put appropriate strategies in place.   

In addition to the rate environment, timing matters since the current estate tax exemption sunsets at the end of 2025.  This is when the lifetime federal estate and gift tax exemption (currently $12.92 million for an individual and $25.84 million in 2023) falls to between $6 million and $7 million for an individual with the precise number to be announced in 2025.  As interest rates continue to rise, the team at Cedar Point Financial Services LLC is here to assist clients in protecting their legacies.