Estate Planning Strategies In A Low-Interest Rate Environment
As the country remains in the grip of an unprecedented pandemic, low interest rates continue at near historical lows and values of assets such as securities and real estate are generally depressed. Although this is a challenging time for the economy, and for the country at large, there are opportunities for clients to engage in estate planning strategies that are most effective when both interest rates and asset values are low, as they are in the current economic climate.
In a previous T&E newsletter we discussed the Grantor Retained Annuity Trust (“GRAT”) as one such option. In this newsletter we will discuss alternative strategies to preserve wealth suited to a low-interest rate environment, namely intra-family loans and sales, and a sale to an Intentionally Defective Grantor Trust (“IDGT”).
Intra-Family Loans and Sales
In the current low interest rate environment, a parent or grandparent might loan money to a child or grandchild for a fixed term in return for a promissory note. The child or grandchild would invest the amount borrowed, pay the loan with interest, and to the extent the return on the investment exceeded the interest rate on the loan, the excess would be retained by the child or grandchild at the end of the term. In effect, this is a method by which the parent or grandparent can transfer money to the child or grandchild without making a taxable gift.
Another wealth transfer strategy when asset values are low, is a sale by a family member (typically an older family member) of an income-producing asset expected to appreciate to another (typically younger) family member. The sale price would be determined by a bona fide appraisal and could take advantage of any available valuation discounts. The seller would take back a promissory note payment. The interest rate is locked-in as of the date the loan is made at the lowest allowable interest rate (the IRS mandated AFR rate) in effect on that date. The repayment schedule can be structured as interest-only payments with the principal due in the final installment. At the end of the term, any appreciation in the value of the assets sold will pass to the younger family member. Using this technique, an individual may effectively transfer assets to younger family members without making a gift, thereby preserving his or her estate and gift tax exemption for future use.
Sale to an Intentionally Defective Grantor Trust (“IDGT”)
A sale to an IDGT is a sophisticated variation of an intra-family sale. An IDGT is a trust created by the seller (the “Grantor”), who typically funds the trust with income-producing assets. The trust is structured as a “grantor trust” so that although the Grantor has made a completed gift of the asset used to fund the trust, and the trust assets are no longer included in the Grantor’s estate, the Grantor is still responsible for any income tax on income earned by the trust. Consequently, the assets are able to grow in trust tax-free, leaving more for the trust beneficiary. Similar to a GRAT, a sale to an IDGT freezes the value of the asset in the Grantor’s estate at the amount of the sales price. Any appreciation in the value of the asset sold to the IDGT is passed on to the trust beneficiary free from gift or estate tax.
Attention should be paid when choosing the asset to be sold. Assets with a low tax basis may be inappropriate since assets owned by the IDGT are not includible in the seller/Grantor’s estate and will not receive a step-up in basis at the seller/Grantor’s death, resulting in potential future capital gain for the beneficiaries of the IDGT.
While each individual’s situation may vary, the strategies discussed in this article are generally appropriate to the low interest rate environment that currently prevails. For certain individuals, intra-family loans and sales, and sales to IDGTs can help to transfer assets within a family while preserving their federal estate and gift tax exemption. In any case, clients should continue to make sure that they have appropriate basic estate planning documents in place – a Will, a Power of Attorney and a Health Care Directive.
Please contact us to discuss whether any of the wealth strategies transfer discussed in this article can be beneficial to you.