Time Your Gifts To Gain Maximum Tax Benefits

Estate Planner Jul-Aug 1997
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The goal of any gifting plan is to remove the most value from your estate at the least tax cost. Many estate planning techniques are interest-rate sensitive — the perceived benefits increase or decrease as interest rates change.

The applicable federal rate (AFR) is determined by the U.S. Treasury each month, based on the US average market yield on outstanding marketable obligations with remaining periods to maturity for each of three types of terms: 1) short-term — not more than three years, 2) mid-term — more than three years but not more than nine years and 3) long-term — more than nine years. These rates may change each month depending on what happens with market interest rates.

Projecting whether the AFR will go up or down often will help you better choose among different types of gifting programs. All planning techniques involving annuities, interests for a term of years, interests for life, or remainder or revisionary interests require valuations. The valuations are based on tables that use an interest rate of 120% of the mid-term AFR for the month of the value date (or, for valuations involving charitable contributions, for either of the two months preceding the transfer date).

For noncharitable trusts, you want the value of the gift for gift tax purposes to be as low as possible so it will cost you less in taxes. For charitable trusts, on the other hand, you want the value of the gift for gift tax and income tax charitable deduction purposes to be as high as possible so you can remove more from your estate gift tax-free and receive a higher income tax deduction.

Let’s look at some estate planning ideas and see whether it would be better for you to plan when interest rates are higher or lower.

Qualified Personal Residence Trust (QPRT)

Under a QPRT, you transfer your principal residence or vacation home into a trust for the benefit of your children or others while retaining the sole right to use the residence for a specified term. The value of your gift is equal to the current fair market value of the residence less the present value of your right to use the property during the reserved term. You use present value tables to leverage your gift and shift all future appreciation out of your estate.

Example: You have a residence or vacation home worth $500,000. You want to transfer it to a QPRT, retaining the right to use the residence for a term of 10 years (with no reversion if you do not survive).

If the 120% AFR is The value of your retained interest The value of your gift
6% $220,803 $279,197
10% $307,229 $192,771
14% $365,128 $134,872

Conclusion: QPRTs are more efficient when interest rates are higher.
Grantor Retained Annuity Trust (GRAT)

Under a GRAT, you transfer property that you believe will appreciate into a trust for the benefit of named or identified beneficiaries. You retain a right to receive an annuity from the trust for a set number of years. The annuity is a set percentage of the value of the property at the time of the transfer. Again, you are leveraging your gift and shifting future growth to your children or other beneficiaries. The value of your gift is equal to the property’s current fair market value less the present value of your right to receive the annuity for the trust term.

Example: You transfer investment real estate worth $500,000 to a GRAT in exchange for the right to receive 8% ($40,000) per year for 10 years.

If the 120% AFR is The value of your retained interest The value of your gift
6% $294,404 $205,596
10% $245,784 $254,216
14% $208,644 $291,356

Conclusion: GRATs are more efficient when interest rates are lower.
Charitable Remainder Annuity Trust (CRAT)

Under a CRAT, you transfer property into an irrevocable trust from which a set amount is paid each year to one or more beneficiaries (which can include you) for any term up to 20 years or over the life or lives of one or more of the beneficiaries. The property remaining in the trust at the end of the term passes to charity. The value of your gift to charity (the remainder interest) for gift tax and income tax charitable deduction purposes is equal to the fair market value of the property at the time of transfer less the present value of the payment rights reserved to the beneficiaries.

Example: You are 51 years old and transfer securities worth $500,000 to a CRAT in exchange for the right to receive an annuity of 8% ($40,000) per year for your lifetime.

If the 120% AFR is The value of your retained interest The value of your gift
6%* $493,268 $ 6,732
10% $344,148 $155,852
14% $260,480 $239,520

* Illustration purposes only because it fails the “5% test”

Conclusion: CRATs are more efficient when interest rates are higher.
Charitable Remainder Unitrust (CRUT)

A CRUT is similar to a CRAT, except, instead of a set amount being distributed, a fixed percentage of the net fair market value of the trust property, revalued annually, is paid each year to one or more beneficiaries (which can include the grantor). The term of the CRUT interest may be for the life or lives of one or more of the beneficiaries or for a fixed number of years (not to exceed 20). The remainder at the end of the term is paid to charity. The value of your gift to charity for gift and income tax charitable deduction purposes is equal to the present value of the remainder interest, which will take into account the reserved term or life interests.

Incidentally, CRATs and CRUTs are tax exempt. If appreciated property is transferred to them, the sale of the property by the trust will not be subject to capital gains tax. The annual distributions to the beneficiaries, however, may be subject to tax.

Example: You are 51 years old and transfer securities worth $500,000 to a CRUT in exchange for the right to receive an annuity of 8% per year for your lifetime. The 8% is recomputed each year based on the fair market value of the trust property. Assume one payment is made annually and the trust is revalued one month prior to payout.

If the 120% AFR is The value of your retained interest The value of your gift
6% $415,645 $84,355
10% $415,290 $84,710
14% $414,930 $85,070

Conclusion: CRUTs are not significantly affected by changes in the interest rates.
Charitable Lead Annuity Trust (CLAT)

A CLAT is like a CRAT except the set amount paid out of the trust each year goes to one or more charities and the trust assets remaining at the end of the trust term go to your children or other named beneficiaries. The value of your gift to charity for gift and income tax charitable deduction purposes is the present value of the stream of payments to be made to charity over the term.

Example: You transfer securities worth $500,000 to a CLAT for a 15-year term and direct that 10% ($50,000) be paid out annually to a named charity.

If the 120% AFR is The value of your retained interest The value of your gift
6% $14,390 $485,610
10% $119,695 $380,305
14% $192,890 $307,110

Conclusion: CLATs are more efficient when interest rates are lower.
Charitable Lead Unitrust (CLUT)

A CLUT is similar to a CLAT except, instead of a set amount being distributed, a fixed percentage of the net fair market value of the trust property, revalued annually, is paid each year to the charities. The value of your gift to charity for gift and income tax charitable deduction purposes is the present value of the stream of payments to be made to charity over the term.

Example: You transfer securities worth $500,000 to a CLUT for a term of 20 years and direct that 10% of the annual value of the trust be paid out each year to a named charity.

If the 120% AFR is The value of your retained interest The value of your gift
6% $61,465 $438,535
10% $61,893 $438,107
14% $62,293 $437,707

Conclusion: CLUTs are not significantly affected by changes in the interest rates.
Fine-Tune Your Gifting Program
As interest rates rise, the value of term and lifetime annuity payments decrease and the value of remainder interests increase. You may benefit from gifting at the best time.