Estate planning in different market environments

If you’re a U.S. investor, you may be able to use certain techniques and trusts that take advantage of interest rates to transfer wealth with little to no gift tax consequences.¹ This process would entail you (the lender) “freezing” the value of your assets and passing any “excess” appreciation to junior family members, or to trusts for their benefit. This approach could be especially beneficial if you have already used up the exclusion from gift tax because, if structured properly, the assets being transferred, or the loan being made, to the junior family member or trust can occur free of gift tax consequences.²

The following examples demonstrate estate planning techniques in different rate environments that can help you maximize the wealth available for future generations. Implementation of these strategies often involves complex tax and legal issues, so your attorney and other tax advisors can help you determine whether the ideas illustrated here are appropriate for you.³

Intra-family loans

Whether in a low or high interest rate environment, one useful planning technique involves assets appreciating at a rate in excess of the relevant rate. A simple way to go about this is to make a cash loan to the person you wish to benefit (the “heir”). With the money received from you, the heir can purchase assets. If the total return of the assets is greater than the interest payments the heir is making to you, the difference would effectively go to the heir free of gift tax consequences.

If the interest rate falls during the period of the loan, you and the heir can refinance the loan, enhancing the benefits of this technique. Any refinanced loan should reflect what an arm’s-length negotiation would have produced.

If, however, the assets do not appreciate at the same rate, you may be put in default, so it is important for the borrower to carefully choose the assets acquired to help hedge against this risk.

Example: A $1 million cash loan is made to a child in exchange for a nine-year, 4.42 interest-only note with a balloon payment upon maturity. The cash is invested in an asset that generates a 7% pre-tax annual return. After full repayment of the $1 million loan nine years later, the child has $309,032. In other words, the parent would have managed to transfer that amount to the child without gift tax consequence.

Qualified personal residence trust (QPRT)

A QPRT is a planning technique that works especially well in a high rate environment. While transferring a personal residence to a trust for a specified amount of time, you simultaneously retain the right to live in the residence, rent-free. You are deemed to have made, when the QPRT is created, a gift to your heir of a value equal to the heir’s right to receive, years from now. Appreciation on the property during the specified amount of time in excess of an IRS-determined interest rate (known as the 7520 rate), would, if you survive the term, be removed from your estate. Once the term of the trust ends, ownership of the property transfers to your heir, so if you want to continue living in the residence, you will need to create a lease agreement with your heir.

Example: A parent places a $1,000,000 home in a QPRT for 15 years. Over the 15 years, the home increases in value to $1,500,000. The $500,000 gain would be tax-free, and the parent would have to pay gift tax only on the present value of the heir’s right to receive $1,000,000 15 years from now. With a 7520 rate of 5.4%, that value in May 2024 would be $334,870.

Grantor retained annuity trust (GRAT)

Another option you may consider for transfer of non-cash assets, particularly in a low rate environment (but one that works in any rate environment, as long as the investments outperform the relevant interest rate used), is a GRAT, which is a grantor trust to which you transfer property, such as a single stock or an interest in a closely held business. You receive a payment of a fixed amount each year for a set term. The present value, computed by reference to the 7520 rate, of those payments usually equals (or almost equals) the value of the property gifted, making the actual gift, for tax purposes, close (or equal) to zero. If any property remains in the GRAT at the end of the term (usually two to five years) because the assets appreciated more than the 7520 rate, the property will pass to the heir (outright or in trust) free of gift tax. If the assets do not appreciate more than the 7520 rate, the assets would be returned to you, putting you in the same position you were in prior to creating the GRAT. In other words, a GRAT can be, in purely economic terms, a no-lose gifting technique with significant potential upside.

Example: A gift is made to a five-year GRAT of a partnership interest with a net asset value of $1.5 million and a discounted value of $1 million, with a 5.4% “hurdle” rate.⁵ The partnership interest is reinvested in an asset that generates an 7% pre-tax return. After five years, the remainder beneficiaries should have $760,823. In other words, the donor managed to transfer to the trust beneficiaries that amount with no gift tax consequences.

We can help

The choice of which technique to implement will be influenced by your specific planning goals and overall wealth structure. For more information and additional considerations related to any of these strategies, contact your J.P. Morgan team.