How Rising Interest Rates Affect Estate Planning Strategies

interest rates

Economic indicators and government statements confirm that rising interest rates are on the horizon. The fact became undeniable when the CPI (Consumer Price Index, a measure of inflation) hit a 40-year high in January 2022. Along with the other impacts on business and personal finances, rising interest rates can affect some estate planning strategies, including some types of trusts. For minimizing taxes and preserving assets — two important estate planning goals — certain rate-sensitive planning strategies become more favorable in an economy with high or rising interest rates.

Interest Rate Effect on Estate Planning Strategies

Two federally-established interest rates, the Applicable Federal Rate (APR) and the §7520 rate (named for Section 7520 of the Internal Revenue Code) are set on a monthly basis, based on yields of specific government debt obligations. As interest rates increase, so do the APR and §7520 rates. Both rates affect certain estate planning strategies that are interest-rate sensitive, including some types of trusts.

Generally, the rate that applies to a specific planning strategy is the rate in effect at the time the strategy is initiated. As rates rise, the effectiveness of specific planning approaches changes. Some planning strategies are more favorable in a low-interest rate climate, while others are more beneficial in a rising rate or higher rate environment.

For example, the APR determines the minimum interest rate that is necessary to avoid gift tax on loans between related individuals. As APR rates rise, the allowable minimum interest rate on a family loan increases, which can affect use of intra-family loans as part of an estate plan. Similarly, the §7520 rate is used to calculate taxable values for specific estate planning approaches, including certain types of trusts. A change in the §7520 rate can either increase or decrease the taxable value, depending on the specific strategy or type of trust.

Intra-family loans, Installment Sales to Intentionally Defective Grantor Trusts (IDGTs), Grantor Retained Annuity Trusts (GRATs), and Charitable Lead Annuity Trusts CLTs), are more favorable estate planning approaches during a low-interest rate environment. Those strategies have been popular during the recent period of historically low interest rates.

As interest rates increase, Qualified Personal Residence Trusts (QPRTs). and Charitable Remainder Trusts (CRTs) may provide more benefit in an estate plan than the low-interest rate approaches. These strategies become more favorable in a rising rate environment because higher rates can reduce the actuarial value of the taxable gift.

It is important to note that legislative changes can significantly impact any estate planning strategy. Proposed legislation in 2021 included provisions that would affect some rate-sensitive planning approaches and make significant tax law changes that would broadly affect estate planning. To date, none of those proposed changes have been enacted, but the future of such proposals is always unpredictable.

Qualified Personal Residence Trusts

A QPRT can be used by a senior family member to transfer a residence to younger family members. The approach involves grantor transfer of a personal principal or vacation residence to a trust that benefits the grantor for a specified number of years. At the end of the term, the property passes to a designated remainder beneficiary. During the term of the trust, the grantor may use the property as their own. After the property passes to the beneficiary, the trust or beneficiary may rent the property to the grantor.

The gifted remainder interest retains a carryover basis for income tax purposes, rather than a stepped-up basis that may occur if the property passed after the owner’s death. For the grantor, the initial transfer to the trust is a taxable gift of the remainder interest. Since the value of the grantor’s retained interest is based on the term of the trust and §7520 rate at the time of trust creation, a higher §7520 rate means a higher value for the grantor’s retained right to use the residence, which in turn means a lower value for the remainder interest. In other words, as §7520 rates rise, the taxable gift value of the remainder interest decreases, which may make a QPRT a more beneficial strategy in an environment of higher interest rates.

Charitable Remainder Trusts

A CRT is a tax-exempt lifetime irrevocable trust that distributes a specific annual amount to designated noncharitable beneficiaries, which may include the grantor and the grantor’s spouse. The annual amount typically is a percentage of the trust value, which must be at least 5% but not more than 50% to qualify as a CRT.

The annual payments may be paid for lifetimes of the noncharitable beneficiaries, for a term of up to 20 years, or for the shorter or longer of those two periods. At the end of the specified period, the remainder passes to one or more charitable beneficiaries.

The grantor receives a charitable income and gift tax deduction for the value of the remainder, which is calculated based on the §7520 rate at the time the trust is created. To pass IRS review, the charitable remainder interest must equal at least 10% of the fair market value of the assets contributed to the trust. The higher the §7520 rate, the more likely it is that a CRT will pass IRS review. As such, a CRT may become a more viable planning approach for some individuals as interest rates increase.

Implications of Rising Interest Rates on Your Estate Plan

To implement any of the rate-sensitive approaches mentioned here, guidance from a knowledgeable estate planning attorney is absolutely essential. To be valid, each of these strategies (including intra-family loans) must conform to strict requirements in federal tax law and IRS regulations and policies. You should never attempt to set up any planning strategy without assistance from an estate planning lawyer.

Rising interest rates are one reason why you should count on an experienced, knowledgeable estate planning attorney when you create or update your estate plan. However, interest rates are only one of many factors that enter into establishing the best estate plan structure for your financial and personal circumstances. Your lawyer knows what approaches work better at different interest rate levels and in rising or falling rate environments. With rising interest rates ahead, your lawyer can help you determine whether it is beneficial to lock in the current lower rates or prepare to take advantage of potentially higher rates in the future.

Our estate planning attorneys at Sloan Law Firm work closely with each client to identify their individual goals, both long-term and short-term. With those goals in mind, your lawyer suggests appropriate strategies and options for your estate plan and helps you navigate through the process of making an informed decision about the structure of your plan. All relevant considerations, including the effect of rising interest rates, are part of that process.

Talk With a Kansas Estate Planning Lawyer

Our experienced estate planning attorneys at Sloan Law Firm assist clients wishing to create a new estate plan or revise an existing estate plan. We handle the full range of matters relating to estate planning, including preparation of wills, trusts, powers of attorney, and other important estate plan documents. We assist clients throughout Kansas and invite you to contact us by calling (785) 357-6311 or using our online contact form.