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Consider these four strategies before interest rates rise

Bill Cass

Bill Cass , 2/15/2017


Investors are expecting more interest-rate hikes from the U.S. Federal Reserve in 2017. The Fed raised the federal funds rate in December and noted that several more increases are possible.

With many financial plans tied to Internal Revenue Service (IRS) interest rates, there are several strategies that investors may want to consider implementing while rates are still low.

Two key IRS interest rates that influence financial planning:

Applicable Federal Rate (AFR). The IRS publishes three interest rates each month: a short-term (under three years), mid-term (3 to 9 years), and long-term (over 9 years) rate, based on average market yields from securities of different maturities (U.S. Treasury bills). The AFR is used as a guideline for determining interest rates on private loans as well as for many other tax-related applications.

IRS section 7520 rate. Published monthly, this rate is equivalent to 120% of the federal AFR mid-term rate rounded to the nearest two-tenths of a percent. The rate is often referred to as the “discount” or “hurdle” rate for determining the value of certain property interests in split interest trusts, including charitable trusts and Grantor Retained Annuity Trusts (GRATs).

Planning considerations

Intra-family loan. With interest rates at historically low levels, the cost of financing a family loan is relatively inexpensive. To be considered for a loan, the IRS requires a formal promissory note and repayment schedule. The AFR represents the minimum interest rate to be used by the lender to avoid triggering a gift tax liability. The lender can charge a higher interest rate than the current AFR. If the rate is lower, however, the IRS will consider a portion of the loan to be a gift, to be applied against the lender’s annual gift tax limit. To structure the loan appropriately, families may want to consult with a professional advisor or tax expert.

Grantor Retained Annuity Trust (GRAT). The lower the IRS 7520 interest rate, the more attractive a GRAT strategy may be. A GRAT can be funded with a range of investments, including ownership shares in a business. Over the term of the trust — typically 2 to 5 years — annuity payments are executed from the trust back to the grantor, based on the value of the assets initially transferred to the trust and the prevailing IRS interest rates. At the end of the term, if the assets have appreciated more than the IRS interest rate, the remaining value is effectively transferred to beneficiaries free of gift and estate taxes.

Installment sale of a business. Transitioning a family business can also be cost effective when interest rates are low. An installment sale strategy — where the business is transitioned by a series of payments made over a period of time using loan notes — would be considered a low-interest loan. The cost of financing an installment sale would be low in the current environment.

Charitable Lead Trust (CLT). In this structure, property is granted to a trust that provides annuity payments to a charity over a term of years. After the trust term has expired, the remaining property passes to beneficiaries. In a low interest-rate environment, if assets inside the trust grow faster than the prevailing IRS 7520 interest rate, the additional assets are passed to the beneficiaries free of gift and estate taxes.

Legacy and estate planning can be complicated, especially if there are potential tax law changes on the horizon. While lower interest rates may present a window of opportunity, investors may want to consult with a financial advisor or legal expert before deciding to incorporate advanced strategies such as trusts into their financial plan.

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