How You Can Take Advantage Of Today’s Low Interest Rates For Wealth Transfer Purposes

Written by: Fargo Inc

Most business people are familiar with today’s low interest rate environment. The Treasury Department released the November Applicable Federal Rates (AFR) – which are also known as the Section 7520 rates – and the rates are extremely low.

  • 2019 – 2.0 %
  • 2018 – 3.6 %
  • 2017 – 2.4 %

Today’s low interest rate environment, coupled with very high gift and estate tax exemptions, presents a unique time period, which holds many advantages for those interested in transferring wealth.

What do the low AFR rates mean for someone who is interested in wealth transfer strategies?

Interest rates are important to take into consideration for wealth transfer purposes because the AFR affects the valuation of some wealth transfers for tax reporting purposes. 

What strategies are available to me if I am interested in transferring wealth?

 Here are a few strategies that can be used to take advantage of the low rates for the purposes of transferring wealth:  

  1. Related-Party Loans: One of the easiest and simplest forms of wealth transfer is a Related-Party Loan.  First, if you are participating in a Related-Party loan, it is extremely important to properly and fully document the loan. The IRS establishes interest rates for these loans that are usually considerably lower than the average 30-year mortgage rates.
    • For example, your son wants to buy a home. And he needs to borrow to pay for the home. You have enough cash to cover the purchase price of the home. The minimum AFR for November that parents have to charge their son, so that the loan is not considered a gift is 1.92 percent for a 30-year note. 1.92 percent! This means that the total interest expense over the life of the loan stays within the family, instead of being paid to the bank. It also allows children with no credit history to buy a home, and it allows families to avoid expenses for administrative costs, such as closing costs and appraisal fees. In addition, if a parent wants to, he or she can forgive part of the loan each year up to the annual gift tax exclusion amount ($15,000 per individual; $30,000 for a married couple), without gift tax consequences. This will lower the outstanding principal balance of the loan, which in turn, reduces the amount of interest owed.
  2. Grantor Retained Annuity Trust (GRAT): A GRAT is an irrevocable trust into which the grantor (the individual who creates the trust) transfers assets in exchange for payments of a fixed-dollar amount (known as the annuity) for a specific term of years (known as the GRAT term). At the end of the GRAT term, the assets remaining in the trust can pass to the designated beneficiaries, tax-free.  
    • Why do we care about interest rates for purposes of using a GRAT? The IRS assumes that the assets transferred to the GRAT will grow at a rate set at the time the trust is established (known as “the 7520 rate” or “the hurdle rate”).  The IRS does not consider the actual growth of the assets transferred to the GRAT. So whatever asset growth or appreciation above and beyond the hurdle rate is transferred to the trust beneficiaries free of gift and estate taxes. You can think of it as an interest rate arbitrage. For example, you own a 50 percent interest in Make Me Money Real Estate LLLP (an entity that owns rental real estate). You create a GRAT and transfer your ownership in the LLLP to the GRAT.   You name your daughter as the beneficiary of the GRAT. The distributions from the LLLP are now paid to the GRAT. 
      The GRAT pays you $X every year (the annuity) for the next three years (the GRAT term).  The IRS assumes that the LLLP interest is going to appreciate at 1.92 percent annually. But in fact, at the end of the three-year GRAT term, the LLLP grew at 6.5 percent annually. What remains in the GRAT at the end of the three years transfers to your daughter free of gift and estate tax. The use of GRATs are an excellent wealth transfer strategy in a low interest rate environment.   There are also income tax advantages in using a GRAT. A GRAT is known as a “grantor trust”. That means that for income tax purposes, the grantor is treated as the owner of the trust assets for income purposes, and therefore, pays all of the income tax owed by the GRAT.  This is a further tax-free gift to the trust beneficiary, because the underlying trust assets are not reduced for income tax payments, and therefore further the growth even more. The income tax payment by the grantor is also gift tax free.
  3. Selling Assets to a Grantor Trust: If an individual has assets that are expected to appreciate, those assets are ideal for a sale to a grantor trust in a low-interest environment. This strategy involves the grantor selling the likely-to-appreciate-assets to a grantor trust in exchange for a promissory note.  The promissory note includes interest payments at today’s low interest rate. As with the strategies listed above, if the assets sold to the trust earn a higher rate of return than the interest payable on the promissory note, the excess is transferred to the trust tax-free. However, this strategy does require that the assets sold to the trust generate enough cash flow to pay down the note. 
    • When employing this strategy, I recommend that the grantor gift sufficient funds to use as a cash down payment for the trust purchase of the likely-to-appreciate assets.  This helps establish the sale as genuine. At least 10 percent of the assets transferred to the trust in total should be a gift by the grantor. The remaining 90 percent can be sold for the promissory note. The promissory note can be structured as an installment note with an interest-only note and a balloon principal payment at the end of the note term. This will allow the principal to remain in the trust, and to continue to appreciate in value for the longest time possible. For example, if you own farmland valued at $500,000. You are currently leasing the land for rental income. You believe that the land is likely to appreciate, as it could easily become developed land. You create a grantor trust of which your daughter is the beneficiary of, and gift 10 percent of the farmland to the trust. You sell the remaining 90 percent of the farmland to the trust in exchange for a nine-year annual interest-only note, with a balloon payment at the end of the nine-year note. The trust is now the owner of the farmland, so the rental income is paid to the trust.  The trust uses that rental income to make the annual interest-only payment back to you. At the end of the nine-year note, the farmland is valued $6,000,000 and is owned by the trust of which your daughter is the beneficiary.  All of the appreciation in the farmland was transferred gift and tax free (with the exception of the initial 10 percent interest in the farmland (valued at $50,000).

Will the grantor have to pay capital gains tax on the assets sold to the trust?

If the trust is drafted properly, the answer is no. The grantor is treated as the owner of the trust for income tax purposes – so essentially it is a sale to yourself. In addition, the interest payments made to the grantor are not considered taxable income. The grantor is responsible for paying the income tax, which means the trust property continues to appreciate income-tax free.

In addition, if the grantor outlives the term of the promissory note, the assets are completely excluded from his or her estate for estate tax purposes.

Interest rates are just one of the factors that go into an individual’s decision to gift.  These strategies may not be for everyone. But one thing is for sure, we are in a very unique time with a very low interest rate environment and high gift and estate tax exemptions.  The two coupled together create some great wealth transfer opportunities for those who want to and can take advantage of them. 

Jessica Foss, Fredrikson & Byron estate planning attorney
Jessica Foss is an estate planning attorney with Fredrikson & Byron. She’s a regular resource for Fargo media on estate planning topics. You can contact her at [email protected].

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