Rising Interest Rates Will Make Certain Gifts More Costly

Rising Interest Rates Will Make Certain Gifts More Costly

Rising interest rates in the Treasury market is a warning that it is about to become more costly to make certain gifts or to sell assets to related parties.

The yield on Treasury securities is used as a yardstick for setting the interest rates that related parties must charge one another when transferring property in a sale.  These rates also establish the annuity that must be paid when using a Grantor Annuity Trust (GRAT) or Charitable Lead Annuity Trust (CLAT).  The benchmark rates, known as the Applicable Federal Rates (AFR), are published monthly. The benefit of low interest rates was the asset being transferred did not have to generate a great deal of income to make the payment required. Tax planners often refer to the AFR as the hurdle rate for this obvious reason.

Where there is an inter-family sale of an asset, a higher interest rate means the asset must produce more cash or income to make the required payment. Another drawback to an increase in interest rates is that there is less debt service coverage. The income and estate tax consequences of higher payments are also greater because more money is being returned to the seller thereby increasing the size of the estate.

When property is transferred to a GRAT at a time when the AFR is low, the annuity is fixed at a low amount.  An increase in the future performance of the asset means there will be an increase, in excess of the required annuity payment, and the excess inures to the benefit of the heirs.  Today is a very favorable time to use a GRAT to transfer income producing real estate or a business that are expected to do well in the coming years.

The same reasoning applies to a CLAT which is a trust that pays an annuity to charity for a term of years.  The heirs will receive the remainder at the end of the term and any increase in income becomes part of the remainder.

Inflation in asset values is another reason to act today to remove the increase from your taxable estate and pass the increase to your heirs.