The Effect of Interest Rates on Estate Planning

We often advise our clients with taxable estates to consider gifting strategies that will reduce the portion of their estate subject to estate taxes and also meet their charitable or family goals. The recent rise in interest rates has made one such strategy, gifting future interests, a lot more compelling. In gifting a future interest, you retain certain rights associated with an asset, such as receiving the income. At a specified time in the future, the remaining value of the asset passes to the beneficiary. There are many techniques for gifting future interests, all of which are affected by changes in interest rates. In this article, we will review two such techniques: the Charitable Remainder Trust (CRT) and the Qualified Personal Residence Trust (QPRT).

The Charitable Remainder Trust (CRT) is a technique used by clients who want to benefit a charity, reduce their current income taxes, and avoid future estate taxes. Here’s how it works. You donate assets (usually highly appreciated assets) to an irrevocable trust. You receive income during your lifetime, and the remaining assets go to your designated charity upon your death. The advantages of a CRT are many. Appreciated assets transferred to the trust can be sold without any capital gains taxes. Therefore, you generate a higher income stream from the full value of the assets placed in the trust. The value of those assets is removed from your estate, eliminating estate taxes. Finally, the gift qualifies for a current charitable deduction based on a calculation of the remainder interest, essentially what the assets will be worth when they ultimately pass to the charity.

The calculation of the remainder interest is based on current interest rates. When interest rates are low, the IRS assumes the trust earnings will be low, decreasing the amount that will go to the charity. This means you do not get much of an income tax deduction for your charitable gift. Conversely, the higher the interest rates, the higher the deemed value of the remainder interest going to the charity and the higher your deduction. In July of 2003, the IRS rate hit a low of 3%. For June 2006, that rate was up to 6.0%, making the CRT much more attractive again.

The Qualified Personal Residence Trust (QPRT) is appropriate for clients who wish to pass on the family home to the next generation, but want to retain the right to use the residence for a specified time, and want to minimize estate and gift taxes. Here’s how the QPRT works. You place your home in an irrevocable trust and continue to live there rent free for a specified period of time. After this period of time, the home passes to your heirs. Transferring your home to a QPRT removes the current value, as well as any future appreciation, of your home from your taxable estate. This transfer is considered a gift, so it will use up some of your $1 million gift tax exemption (and $2 million estate tax exemption), but the gift will be valued at less than the current market value of your home, because you have retained the right to live there rent-free.

The calculations involved in determining the value of the gift are complicated. Factors affecting the calculation include the term of the trust (how long you retain the right to live in the house), current interest rates, and your life expectancy. All other things being equal, the higher interest rates are, the higher the value of your retained interest and the lower the value of the gift. The difference between transferring a home with a QPRT as opposed to leaving it in your estate can be dramatic. For example, assuming you remain in your home 10 years, you might be able to exclude as much as 50% of the value of your home from any gift and estate taxes.

QPRT’s do have some risks. If you do not survive the term specified in the trust, the home reverts back to your estate. You are not harmed in any way, but you did not accomplish the goal of the QPRT. In addition, when you gift assets such as your home during your lifetime, your heirs keep your cost basis and have to pay taxes on capital gains. When assets pass to your heirs through your estate, they receive a step up in cost basis, thereby eliminating capital gains taxes. Therefore, you should weigh the potential capital gains taxes your heirs may have to pay against the estate tax savings you can achieve with a QPRT.

Estate planning is a dynamic process affected by everything from changes in estate tax law to changes in interest rates. Make sure you review your plan regularly with your advisor to determine the best strategies for your current situation.