Being the youngest of four children, I wore hand-me-downs quite a bit. Whenever Benton received the gift of a new winter coat, I paid attention, knowing that one day, it would be mine. I hoped he would outgrow it before destroying it! A hand-me-down is a bit like a split-interest gift—any gift where one party enjoys the current use of an item or asset, and another party receives the final residual value. Big brother held the “present interest” in that nice new jacket, and I was the owner of the often-threadbare “remainder interest.”
In the world of wealth transfer planning, a split-interest gift is deliberately created via trust language that carefully defines the terms of two distinct interests. The three variables that determine the value of the present interest and the remainder interest include:
the precise use of the asset by the person with the present/retained interest,
the length of time that the person retains that use/access, and
the rate of interest used to calculate the present value of the retained or remainder interest—the Section 7520 rate. The rate is published monthly by the IRS and was 5.2% in December 2022.
In 2021, my colleague Jen Muckley penned the article Planning in a Low-Interest Rate Environment, in which she described how low rates make Grantor Retained Annuity Trusts (GRATs) and Intra-Family Loans attractive to folks aiming to transfer wealth to heirs. While those strategies aren’t completely off the table, today’s higher interest rates make other strategies, including Qualified Personal Residence Trusts and Charitable Remainder Trusts, much more compelling than they have been in some time. Here are two examples:
The 15-Year QPRT
This month, Taxpayer Tom (60 years old) transfers an interest in his $3,000,000 vacation home to a Qualified Personal Residence Trust (QPRT). The terms of the QPRT state that Tom has exclusive use of the property for 15 years, after which the home will transfer to his children. Based on the three above variables, the value of Tom’s retained interest is $1,966,350, and the present value of the remainder interest—the portion that is reportable as a gift to the children—is $1,033,650. One can imagine how attractive this sort of planning is; at the end of 15 years, the home with modest appreciation may have doubled in value to $6,000,000 and passes to the children with no additional gift reported. Tom has removed a $6,000,000 asset from his estate having only reported a gift of $1,033,650. Tom may rent the home from his children beyond the trust term.
And what difference do today’s higher interest rates make? Exactly 24 months ago, in December 2020, this precise fact pattern would have created a reportable gift almost twice as large, $2,021,340!
The 8%, 15-Year CRAT
This month, Taxpayer Tim transfers $3,000,000 of highly appreciated stock to a Charitable Remainder Annuity Trust (CRAT). The terms of the CRAT state that Tim receives $240,000 per year for 15 years, after which the balance remaining in the trust passes to Tim’s favorite charity. Based on the three variables referenced above, the value of Tim’s retained interest is $2,457,792, and the present value of the remainder interest—the portion that is deductible on Tim’s income taxes as a gift to charity—is the balance, $542,208. Assuming Tim’s effective tax rate is 40%, the deduction will yield savings this coming April of $216,000. Tim may also save taxes by spreading the huge capital gains out over 15 years rather than realizing them all in one tax year. At the end of 15 years, Tim will have received $3,600,000 back from the trust, and, assuming the trust averages a 6% return per year, his charities receive $1,600,000.
And what difference do today’s higher interest rates make? Exactly 24 months ago, in December 2020, this precise fact pattern would have created an impossible trust—one that yields $0 tax deduction and is therefore disallowed under the Internal Revenue Code.
It is important to note that in the case of the CRAT, only people with genuine charitable intent should pursue charitable trust planning; hating taxes is not enough! Also, there are many ways to structure split-interest trusts such as QPRTs and CRATs; we are only presenting two samples here so that you can focus on the main point of the article: Higher interest rates make QPRTs and CRATs something worth discussing with your advisors.
If you’d like to discuss wealth transfer and charitable planning ideas like these, please give us a call. We look forward to hearing from you!
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.