Some of the most popular tax strategies to pass to wealth to heirs are being pressured by rising interest rates.
Some of the most popular tax strategies to pass to wealth to heirs are being pressured by rising interest rates.

Higher interest rates have kickstarted a clutch of increased costs on everything from mortgages and credit card balances to car loans and revolving credit lines. They've also reshuffled the tax strategies wealthy investors favor to pass assets to their heirs.

After three federal rate increases so far this year, certain techniques are winning, while others are losing. Wealth advisors caution that as the nation's central bank signals more hikes are yet to come, many previously established estate plans can yield unwanted surprises. Meanwhile, some plans drawn up during the past 15 or so years, when interest rates were mostly near zero , may have to be rejiggered or dumped in favor of  new plans.

"It's making people think about the strategies they haven't used in the past, and it's making us think a little bit harder about things that have been sort of no-brainers in the past," said Bryan Kirk, the director of financial and estate planning at Fiduciary Trust  International in San Mateo, California.

Advisors find clever ways to use the tax code to pass as much of a client's money on to heirs tax-free. A single person can shield an estate of just over $12 million (just over double that for married couples) from the 40% estate and gift taxes.

But the strategies are also highly sensitive to changes in a consequential figure that affects everyone: the benchmark interest rate, or the amount that commercial banks charge to borrow and lend money to each other overnight. That core rate, the main driver of government efforts to steer the pandemic economy, affects the prime rate, which governs the cost of consumer and business loans. But it also directly drives the economics of many estate planning techniques involving trusts and loans.

That's because the Internal Revenue Service sets its own interest rates for cash and other assets that trusts and family members lend to other family members or donate.

'Bank of me' loses
In a typical intrafamily loan, a parent lends money to a child, who then invests it in appreciating assets. Tax rules require that the money be repaid with interest in order not to be considered a taxable gift by the parent. Meanwhile, appreciation of the invested cash moves out of the parent's taxable estate and goes to the child who "borrowed" the money.

Mallon FitzPatrick, a managing director and the head of wealth planning at Robertson Stephens in New York, called it "a tax-free gift." While the repaid money and interest stay in the lender's taxable estate, the future appreciation of the loaned money doesn't cut into the parent's lifetime estate tax exemption.

For such loans, the IRS sets various rates that are tied to the benchmark interest rate. Those "applicable federal rates," which change monthly, exist in order for the loan not to be considered a taxable gift, and vary according to whether loans are short, mid-term or long-term. For October 2022 , the rate on a long-term loan of more than nine years to a family member is 2.6%, compounded annually.

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The rate on a loan already made is generally locked at the time of the transaction. Today, such a loan would have to be repaid with higher interest than before the Fed's interest rate hikes, making it less attractive to both lender and recipient. Future IRS rates will increase after the Federal Reserve raised by three-quarters of a percentage point the federal funds rate to 3.25% on Sept. 19, the third increase so far this year.

"The good news is that intrafamily loans may be refinanced, but there can be gift and income tax consequences," FitzPatrick said.

The same consequence ensues when the equivalent of an intrafamily loan takes place through a popular type of trust. When the owner of an intentionally defective grantor trust lends it money to buy an appreciating asset, like securities or property, the goal is for the asset's growth to outstrip the interest rate on the deal. But because the owner, or grantor, must pay federal income tax on the interest earned, higher interest rates translate into a higher income tax bill. Still, interest payments on the loan by such trusts can be deductible.

Indirect hits
The Fed's moves to right the economy also impact estate plans in indirect ways.

Take trusts that give assets such as a business interest or property to heirs while establishing a stream of payments to the trust's grantor. The latter must establish a value for the IRS of what she's given away and what she has retained. That's calculated by taking 120% of the applicable federal rate for mid-term loan. Any appreciation of an asset above that rate, known as 7520 for a section of the tax code, goes to the trust's beneficiaries without triggering gift taxes.

The strategy allows a trust donor to shift "the entire value" of appreciation in the transferred assets to beneficiaries without triggering gift taxes, according to Morgan Stanley . Higher IRS rates, thanks to the Fed's rate hikes, "will likely reduce the amount of appreciation and the amount passed to beneficiary's gift tax free," Robertson said.

One of the most popular types of such trusts in recent years has been a grantor-retained annuity trust, known as a GRAT. The grantor puts assets that are expected to swell in value into an irrevocable trust, which then pays an "annuity" to the grantor consisting of principal and interest. Growth in excess of the annuity payments can go to beneficiaries tax-free.

Wealthy investors like to use "zeroed-out" GRATs, sometimes by setting up trusts every two years, so that the annuities equal the value of what was originally put into the trust. The strategy, a staple with the 1% wealthiest Americans, allows trust assets to appreciate over time and move out of an estate to heirs.

"In the case of zeroed-out GRATS, it is harder to reduce gift tax cost as interest rates rise," Robertson said.

That's some of the bad news for estate planning strategies. But there's good news, too.

Two trusts for the win
Want to ensure that your vastly appreciated home goes to your heirs while not triggering gift and estate tax? A qualified personal residence trust is one of the beneficiaries of higher interest rates.

Here's how it works: A homeowner transfers his residence, often a vacation home, to the trust but keeps a "retained interest" that allows him to continue to live there rent-free for a number of years. When the trust's term ends, the property goes to beneficiaries, with its value equal to what the property was worth when the trust was created minus the retained interest.

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The home has been moved out of the trust creator's taxable estate. The value of the trust grantor's right to live in the home is calculated using one of the IRS's special interest rates. And "if that rate is higher, the right to reside in the residence during the period is more valuable and the gift of the remainder interest is correspondingly lower," wrote Dennis Reardon, an estate planning lawyer, in the Journal of Financial Service Professionals this month.

A charitable remainder trust is another winner amid high interest rates. Like a trust for personal residences, it pays income to its grantor for a period of time. At the end of the term, what's left over in the entity, which typically holds assets like stocks or artwork, is donated to charity or a donor-advised fund. When the trust is set up, the value of what's donated is calculated using one of the IRS's interest rates. The donation gives the grantor a tax deduction. The higher the IRS's rates, the greater the value of the donation and the larger the deduction.

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Tax Wealth management Tax planning Estate planning Trusts Interest rates IRS
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