Estate Planning Opportunities in a Poor Economic Environment
It’s The Best Of Times; It’s The Worst Of Times!
The Estate Planning Group at Santen & Hughes is dedicated to helping our clients create, protect, and preserve a plan for a tax-efficient distribution of their estates. We often utilize a variety of planning tools in designing an estate plan that is appropriate for each client’s individual situation.
While estate planning may not be at the top of everyone’s “To Do List” during a time when unemployment is high, the housing market is depressed and many have lost substantial wealth in the stock market, this time actually presents a number of strategic planning opportunities. Specifically, interest rates this year are the lowest that they have been in years. The existence of these rates provides opportunities to leverage various wealth transfer techniques through the use of two estate planning strategies- Grantor Retained Annuity Trusts and Intra-Family Loans.
The lower the rate of interest, the greater the effectiveness of these techniques. The Applicable Federal Rate (AFR) or Section 7520 Rate published monthly is utilized to determine the amount of gift, if any, made in the process. Essentially in each of these strategies, if the rate of return can exceed the applicable rate, wealth is transferred free of gift tax. The Section 7520 Rate for December is 2.4%; and the Applicable Federal Rates are as follows:
| Term | Annual Payments | Semi-Annual Payments | Quarterly Payments | Monthly Payments |
|---|---|---|---|---|
| Short (0-3 yrs) | 0.81% | 0.81% | 0.81% | 0.81% |
| Mid (3-9 yrs) | 2.06% | 2.05% | 2.04% | 2.04% |
| Long (>9 yrs) | >3.57% | 3.54% | 3.52% | 3.51% |
Grantor Retained Annuity Trust (“GRAT”)
A GRAT is set up by the contribution of assets to a trust which provides that the creator of the trust (the “Grantor”) receives periodic annuity payments over a certain term of years. The amount of the annuity payments is determined by an interest rate prescribed by the U.S. Treasury (the “Section 7520 Rate”) at the time the GRAT is funded. Typically, the arrangement is structured so that there is no reportable gift at its inception, but at the end of the term any assets remaining in the trust pass to the beneficiary free of gift tax. In essence, the assets remaining in the trust at the end of the term will be the return realized by the investments in the GRAT to the extent the return exceeds the Section 7520 Rate at the time the trust is funded. If the assets in the GRAT depreciate in value during its term, no wealth will be deemed to pass to the beneficiary of the GRAT but there will be no penalty imposed on the Grantor. If the Grantor dies before the end of the term, the assets in the GRAT are included in the Grantor’s estate without penalty.
By way of example, assuming a Section 7520 Rate of 2.4% (the Section 7520 Rate for December 2008), one could set up a two year GRAT funded with $1,000,000.00 in securities which, if properly designed, would not constitute a taxable gift to the beneficiary upon creation but would result in a tax-free gift of $76,476.00 to the beneficiary at the end of the term assuming combined growth and income of 8% annually. During the term of the GRAT, the Grantor would receive periodic payments totaling $1,031,056, which are tax-free except to the extent of income and capital gains generated. The annuity payments may be made with the same securities that were initially transferred to the GRAT at its inception.
Low Interest Family Loans
Low interest rates also suggest another technique for the transfer of wealth free of any gift tax. The federal tax law allows you to make loans to family members at lower rates than those charged by commercial lenders without it being deemed a gift. Interest free gifts may constitute a gift, but loans at the Applicable Federal Rate (“AFR”) are gift tax free. Loans at the AFR rate are much lower than at commercial loan rates.
The ability to shift wealth occurs when the loan is made to a family member and they earn a greater return on the amount borrowed than the AFR applicable to the term of the loan. For example, if a parent makes a nine year loan to a child of $1,000,000.00 at an AFR of 2.06%, the child may invest the loan proceeds. If the child earns an 8% annual rate of return, he or she will have accumulated $720,000.00 throughout the term of the loan, from which only $185,400.00 in interest was paid. The child is entitled to retain the difference of $534,600.00 without any gift tax consequence.
Intra-family mortgage lending may also be beneficial to a family unit. With this arrangement, a parent can lend a child or grandchild the same amount of funds that he would otherwise have been borrowed from a mortgage company or financial institution. The child or grandchild is charged the AFR applicable for the term and frequency of payments existing at the time of the loan, which is secured by a mortgage so that he may deduct the interest. Currently the AFRs are substantially lower than rates charged by commercial lenders but higher than the rate of interest currently being paid on 30 year U.S. Treasury Bonds. In most instances, the actual monthly payments will be at least 20% less than those charged by commercial lenders. By way of example, a $500,000.00 mortgage at 6.0% interest and thirty year amortization requires monthly payments of $2,997.75. However, a mortgage at the long-term AFR rate for January 2009 (3.51%) would be only $2,248.02 per month, generating a savings of almost $750.00 per month.
This strategy may also enable a family member who has a poor credit history to buy a home and avoids much of the normal expenses incurred with loans, such as administrative costs, closing costs and appraisal fees.
The following attorneys in Santen & Hughes’s Estate Planning Group are happy to review with the above-referenced options with you: James J. Chalfie, Katrina Z. Farley, C. Gregory Schmidt, William J. Liss, Charles M. Meyer, C. Gregory Schmidt, Andrew W. Weisenberger and James P. Wersching.