Interest rates

How Rising Interest Rates Are Harming Estate Planning Strategies Used by the Ultra-Wealthy

Rising interest rates have triggered a series of increased costs on everything from mortgages and credit card balances to auto loans and revolving lines of credit. They also overhauled the tax strategies favored by wealthy investors to pass assets to their heirs.

After three federal rate hikes so far this year, some techniques are gaining, while others are losing. Wealth advisers warn that as the country’s central bank signals more hikes are to come, many previously established estate plans may yield unwanted surprises. At the same time, some plans drawn up over the past 15 years when interest rates were mostly close to zeromay need to be reorganized or dropped in favor of new plans.

“It gets people thinking about strategies that they haven’t used in the past, and it makes us think a little bit more about things that have been sort of obvious in the past,” said Bryan Kirk, director finance and estate planning at Fiduciary Trust International in San Mateo, California.

Advisors are finding clever ways to use the tax code to pass so much of a client’s money to their heirs tax-free. A single person can protect an estate of just over $12 million (slightly more than twice that of married couples) from 40% estate and gift tax.

But the strategies are also very sensitive to changes in a big number that affects everyone: the benchmark interest rate, or the amount that commercial banks charge to borrow and lend money from day to day. the following day. This base rate, the main driver of the government’s efforts to steer the pandemic economy, affects the prime rate, which governs the cost of lending to individuals and businesses. But it also directly determines the economics of many estate planning techniques involving trusts and loans.

This is because the Internal Revenue Service sets its own interest rates for cash and other assets that trusts and family members lend to other family members or give away.

‘Bank of me’ loses
In a typical intra-family loan, a parent lends money to a child, who then invests it in asset appreciation. Tax rules require that the money be repaid with interest so that it is not considered a taxable gift by the parent. Meanwhile, the appreciation of the invested money flows out of the parent’s taxable estate and goes to the child who “borrowed” the money.

Mallon FitzPatrick, managing director and head of wealth planning at Robertson Stephens in New York, called it a “tax-free gift”. Although the money repaid and the interest remain in the lender’s taxable estate, future appreciation of the loaned money does not reduce the parent’s lifetime tax exemption.

For these loans, the IRS sets various rates that are tied to the benchmark interest rate. These “applicable federal rates”, which change monthly, exist so that the loan is not considered a taxable gift, and vary depending on whether the loans are short, medium or long term. For October 2022the rate for a long-term loan of more than nine years to a family member is 2.6%, compounded annually.

The rate of a loan already made is generally locked at the time of the transaction. Today, such a loan would have to be repaid with higher interest than before the Fed’s interest rate hikes, making it less attractive to both lender and recipient. Future IRS rates will rise after the Federal Reserve raised the federal funds rate by three-quarters of a percentage point to 3.25% on September 19, the third increase so far this year.

“The good news is that intra-family loans can be refinanced, but there may be gift and income tax implications,” FitzPatrick said.

The same consequence follows when the equivalent of an intra-family loan is made through a type of popular trust. When the owner of an intentionally defective grantor trust lends it money to buy an appreciating asset, such as securities or property, the goal is for the growth of the asset to exceed the interest rate of the transaction. But because the owner, or grantor, must pay federal income tax on the interest earned, higher interest rates mean a higher income tax bill. Nevertheless, interest payments on the loan by these trusts may be deductible.

Indirect hits
Actions taken by the Fed to redress the economy also have an indirect impact on estate plans.

Take trusts that give assets such as a business interest or property to heirs while establishing a stream of payments to the settlor of the trust. The latter must establish a value for the IRS of what she gave and what she withheld. It is calculated by taking 110% of the rate used for intra-family loans. Any appreciation of an asset above this rate, called 7520 for a section of the tax code, goes to the beneficiaries of the trust without triggering gift taxes.

The strategy allows a trust donor to transfer “the full value” of the appreciation of transferred assets to beneficiaries without triggering gift taxes, accordingMorgan Stanley. Higher IRS rates, thanks to Fed rate hikes, “will likely reduce the amount of appreciation and the amount passed on to the recipient’s tax-free gift,” Robertson said.

One of the most popular types of these trusts in recent years has been a settlor-retained annuity trust, known as a GRAT. The settlor places the assets that are expected to increase in value into an irrevocable trust, which then pays an “annuity” to the settlor consisting of principal and interest. Growth in excess of annuity payments can flow to beneficiaries tax-free.

High net worth investors like to use GRATs “to zero”, sometimes setting up trusts every two years, so that the annuities equal the value of what was originally placed in the trust. The strategy, a staple with the top 1% of Americans, allows trust assets to appreciate over time and pass from estate to heirs.

“In the case of zero GRATS, it is more difficult to reduce the cost of gift tax as interest rates rise,” Robertson said.

That’s some of the bad news for estate planning strategies. But there is also good news.

Two trusts for victory
Want to make sure your much-appreciated home will pass to your heirs without triggering gift and inheritance tax? A qualifying personal residence trust is one of the beneficiaries of higher interest rates.

Here’s how it works: A landlord transfers their residence, often a vacation home, to the trust but retains a “retained interest” that allows them to continue living there rent-free for several years. At the end of the term of the trust, the property reverts to the beneficiaries, its value being equal to what the property was worth at the time the trust was created less the retained interest.

The house was removed from the taxable estate of the creator of the trust. The value of the settlor’s right to live in the home is calculated using one of the IRS’ special interest rates. And “if this rate is higher, the right to reside in the residence during the period is more valuable and the gift of the remaining interest is correspondingly lower”, wrote Dennis Reardon, an estate planning attorney, in the Journal of Financial Service Professionals this month.

A charitable remainder trust is another winner among high interest rates. Like a personal residence trust, it pays income to its settlor over a period of time. At the end of the term, what remains in the entity, which typically holds assets like stocks or works of art, is donated to charity or a donor-advised fund. When the trust is created, the value of what is donated is calculated using one of the IRS interest rates. The donation gives the donor a tax deduction. The higher the IRS rates, the greater the value of the gift and the larger the deduction.