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May 18, 2020

Wealth Transfer Planning in a Low Interest Rate Environment

It is difficult to find a silver lining to the COVID-19 crisis – the virus is causing an extraordinary amount of stress and uncertainty. While foremost concerns are for the health and safety of family and friends, the daily volatility in asset prices gives rise to a different type of anxiety.

The Federal Reserve has announced a number of interventions to help support the economy through the crisis, such as cuts to the Federal Funds Rate and purchases of government bonds. Interest rates are significantly lower as a result of the Federal Reserve’s interventions. Lower asset prices, together with historically low interest rates, create opportunities to transfer wealth with more favorable gift-tax consequences. In this note, we highlight a few strategies advantageous in a low interest rate environment.

Loans to Family Members

The intrafamily loan is often a straightforward and efficient wealth transfer strategy. The minimum interest rate for an intrafamily loan is the Applicable Federal Rate (the “AFR”), which is typically lower than commercially available interest rates and mortgages (See Exhibit I). Yields on government debt and the Federal Funds Rate influence the AFR, and when the Federal Reserve cuts its rate, the AFR likewise decreases.

An intrafamily loan is suitable to support a family member in need, as part of a sale of high performing assets, or to lend cash to allow a family member to acquire property (such as a home). Regarding the latter two, if the asset sold or subsequently purchased outperforms the interest rate of the loan, that outperformance passes to the borrower free of gift tax.

It is prudent to seek help from advisors when executing an intrafamily loan, as lack of appropriate documentation (such as a promissory note), insufficient loan terms and negligent administration may trigger unwanted tax consequences. For example, interest rates below the applicable AFR can result in imputed interest, where the IRS considers interest to have been paid without a transfer taking place. Gift taxes may also apply if the debtor fails to make regular interest payments.

We also note low interest rates provide an opportunity to refinance existing intrafamily loansto lock-in a lower interest rate; however, we caution against refinancing certain loans. For example, yields are low on most fixed income securities, and in some instances a promissory note with a higher interest rate can be a better performing asset.

Installment Sale to Trust

Consider selling assets anticipated to appreciate in value to an irrevocable grantor trust. This strategy is successful where the asset’s appreciation outperforms the interest rate. All appreciation in excess of the interest rate benefits the trust, and the trust’s beneficiaries, free of gift taxes. If the seller outlives the loan, the assets sold are not includible in their estate. Should the seller die before the loan’s maturity, however, their estate will include any outstanding loan balance.

As is the case with the intrafamily loan, be sure to involve your advisors in properly structuring the sale and promissory note. This includes engaging a qualified appraiser to determine the value of sold assets. If the IRS considers the sale a gift in an audit, they may value the sold assets higher than the sale price.

Grantor Retained Annuity Trust (“GRAT”)

A GRAT is an irrevocable trust where the person creating the trust (Grantor) transfers assets to a trust and receives an annuity for a term of years (the annuity period can be any time period, but not less than two years). Any property remaining in the GRAT at the end of the annuity period passes to the GRAT’s remainder beneficiaries (such as a family member) free of gift tax.

The value of the annuities paid to the Grantor is calculated by applying a particular interest rate provided by the IRS – the §7520 Rate – to the value of assets transferred to the GRAT. Like the AFR, the Federal Funds Rate influences the §7520 Rate. The lower the §7520 Rate, the easier it is for the growth of GRAT assets to exceed the annuity payments.

To maximize potential for contributed assets to exceed the §7520 Rate, consider contributing assets with significant growth potential or assets that produce high amounts of income.

Charitable Lead Annuity Trust (“CLAT”)

A CLAT is similar to a GRAT but with a key difference – the annuity payments are made to a charity, not the grantor. Any property remaining in the CLAT at the end of the annuity period transfers to the CLAT’s non-charitable remainder beneficiaries. Like the GRAT, the §7520 Rate is used to calculate the annuity payments. Asset appreciation in excess of the §7520 Rate passes to the non-charitable beneficiaries, free of gift tax. The CLAT includes certain income tax benefits, namely, the grantor may deduct the present value of the annuity payments on the year of transfer. 

The current environment may be suitable for a CLAT. Communities are in need, and a future economic recovery that raises asset prices will make it easier to clear the §7520 Rate.    

Which strategy is best for you?

Creating and choosing the appropriate strategy requires careful analysis of your legacy goals, existing estate plan and balance sheet. The tax and financial planning professionals at Geller Advisors are available to help you choose the most appropriate strategy for you and your family.

The views expressed in this letter reflect those of Geller Advisors LLC as of the date of this letter.  Any views are subject to change at any time based on market or other conditions, and Geller Advisors disclaims any responsibility to update such views.  The information presented in this letter is for informational purposes only.  This letter is not to be construed or relied upon as investment advice, tax advice or accounting advice.  The information contained in this letter does not constitute an offer to sell or the solicitation of an offer to provide investment advisory services or purchase an interest in a fund.  Any such offer or solicitation will be made to qualified investors only under a formal engagement letter and Investment Policy Statement or by means of an offering memorandum and related subscription agreement as applicable.  You should consult your own tax, legal and accounting advisors before engaging in any transaction.