Interest rates are still pretty attractive compared to previous decades. In fact, today’s low interest rates provide some opportunities that may not come around again for a very long time, potentially in our lifetimes. What seems certain, at this point, is that interest rates will not remain low forever – in fact, they could start to trend higher yet this year.
This raises some important questions. How can one take advantage of low interest rates? What strategies might work for your goals? What steps might you take now that might not be available or attractive in the coming months and years? Will you miss out on some great opportunities?
In working with wealthy families over the last few years, we have utilized four strategies that work very well in a low interest rate environment. Will one or more of these ideas work for you or your family and in what way? Let’s explore this together.
The four strategies
The strategies that we have identified might help you achieve different goals. The one thing they all have in common is they are attractive in the current low rate environment. Here are the four strategies:
- Bank mortgages
- Grantor Retained Annuity Trust (GRAT)
- Intra-family loans
- Charitable Lead Annuity Trust (CLAT)
In the past few years since the financial crisis, rates have been forced lower by Federal Reserve dovish policy and various means of monetary stimulus. As a result, mortgage rates continue to be at historic lows. One of our ideas for capitalizing on low rates is to take out a mortgage on one or more of your homes. This works well when structured as a cash-out refinance of a home with no existing mortgage. Locking in a low fixed rate to invest over the long haul has the potential to grow your balance sheet by using the bank’s money.
For example, if the value of your primary residence is $2 million, you could mortgage as much as 70-80% and invest the proceeds. With mortgage rates at or below 4%, you could construct a portfolio that over the long-term could perform much better than the after-tax cost of the mortgage. When utilizing a mortgage in this way, you convert mortgage interest into investment interest expense. Depending upon your tax situation, the investment interest expense deduction could be worth more than mortgage interest – investment interest directly offsets net investment income. If you are at or near the top bracket, investment interest is deductible against interest, dividends, short-term capital gains and even the 3.8% Affordable Care Act high income tax. The true cost of the mortgage, in some cases, could drop by 40 – 50%!
- Lock in a fixed long-term rate and invest the proceeds.
- Deduct the interest against net investment income which reduces the cost of up to 40-50% depending on your tax bracket.
- Grow your balance sheet with the bank’s money.
GRAT - Grantor Retained Annuity Trust
Another strategy which works well in the current environment is a Grantor Retained Annuity Trust (GRAT). A donor makes a gift into an irrevocable trust. The trust is set up as an annuity whereby the donor receives an annual payment for a specified period of time. Typically, a gift value is calculated based on the term of years and the initial contribution less the annuity payments plus interest – the interest rate is the Section 7520 rate (120% of the mid-term AFR rate established by IRS regulations – 2.2% in July).
The technique I would like to describe is an estate freezing technique. The sum of the annuity payments is calculated so that it equals the initial contribution plus 7520 rate thereby making the gift amount zero. This type of GRAT is often called a “zeroed-out GRAT.” For example, you own $10 million of a company’s common stock. You believe it will appreciate over the next few years. On the other hand, it’s not your only asset and your family’s gross estate is now more than the exemption amount. Wouldn’t it be great to somehow transfer assets to your children estate and gift tax free?
- Transfer $10MM of stock to a GRAT.
- Fix a 2 year term.
- Establish your children as beneficiaries of the trust.
- Pay yourself back all of your stock plus interest.
- If the growth of your stock exceeds 2.2%, all remaining shares of stock transfer to your children estate and gift tax free
In the previous example, we used common stock as the asset transferred. One could use many different types of assets including:
- Stock options
- Diversified portfolio
- Private company stock
- Single asset-class portfolios (or multiple single-asset class portfolios)
In summary, if you have an asset that you expect will appreciate in price and would also like to gift the growth to your family tax free, a GRAT could be a wonderful tool to do just that. And, depending on structure, you could make the GRAT a grantor trust and have the ability to substitute assets and pay the taxes on all trust income during the term (thereby amplifying the success or even “locking” in gains early).
Intra family loan
The third strategy is also an estate freezing technique used by wealthy families. It involves setting up a loan to your children or grandchildren for which your goal is to have the growth of the assets transfer tax free. You structure a loan using the applicable federal rate (AFR rate) for a certain number of years and invest accordingly.
For example, you have a trust set up for your grandchildren and would like to see those assets grow more quickly. You loan the trust $2 million by having an attorney draft a promissory note with a 9-year term utilizing the July mid-term AFR rate of 1.77%. As long as the annual return of the portfolio exceeds the AFR rate, the growth in excess of 1.77% will transfer to the grandchildren’s trust at the end of the term. In order to avoid IRS scrutiny, we suggest using an attorney to draft the note and make certain to make the annual payments to hold up the structure as a loan, NOT a gift.
- Transfer funds to a trust for the benefit of children and/or grandchildren.
- Use AFR rate which corresponds to the term of the note (mid-term loan would be up to 3 years, not to exceed 9 years).
- Make certain to transfer interest back to the parent setting up the loan and include it as interest on the parents’ tax return. However, if the loan is made to a grantor trust, whereby the trust and the grantor are treated as the same taxpayer, there would be no tax on the interest coming back to the lender.
- Administer the loan and invest appropriately
- Excess growth goes to children and/or grandchildren gift tax free.
Charitable lead trust
A charitable lead annuity trust (CLAT) is designed to provide income payments to a qualified charity for a fixed number of years, the lives of one or more individuals, or a combination of the two. Once the term ends, the remainder interest (if any) transfers to the beneficiaries gift tax free. There are different types of CLATs but I want to focus on a qualified non-reversionary grantor lead trust. Simply stated, it is a trust that qualifies for a charitable income tax deduction, pays an income stream to a qualified charity and, at the end of the term, the remainder interest transfers to the beneficiaries named in the trust instrument (most likely children or grandchildren).
Since the CLAT is structured as a grantor trust, the grantor will be considered the owner of the trust’s income. Since the income flows to the grantor’s tax return, it qualifies for the charitable income tax deduction.
Provided the grantor does not retain any rights which would cause the gift to be considered incomplete, or retain estate tax interests, the trust will not be includible in the grantor’s estate. CLATs are complicated and donors should be certain to work closely with their legal and tax advisors.
For example, we had a client who had a great year and made $5 million. After updating the tax projection, we calculated that in order to erase all income in the 39.6% bracket, we could set up a CLAT and contribute $2 million (which reduced his effective tax rate by over 12%!). The client had several goals:
- Tax efficiency
- Charitable giving
- Bringing his children together for a common purpose
- Professional investment management
- Gift tax free wealth transfer
By using a CLAT structured as a grantor trust, we were able to help our client reach his goals:
- He was able to wipe out all income in the top bracket in the year of the gift.
- He will have transferred over $2 million to various charities at the end of the term.
- By designating his children as successors to his donor-advised fund, his children will be able work together to give money to charities after his death. By choosing a donor-advised fund as the qualified charity, our client was not forced to choose one charity to receive the income stream and has added flexibility on timing of payments.
- We constructed a portfolio which provides income and total return with the goal of exceeding the Section 7520 rate (2% at the time). So far, we are way ahead of our 2% hurdle rate and have made multiple payments to the qualified charity.
- At the end of the term, any remainder interest flows to a trust for his children gift and estate tax free.
How might these four strategies apply to your situation?
Which of these strategies might be right for your family? That is difficult to say without a more in-depth conversation. I don’t know when rates will rise. No one does. However, I can assure you this is a great time to evaluate these and other strategies in the current interest rate environment.
If these strategies pique your interest, let’s have a conversation to discuss your current situation and long-term goals. I can then help you devise the right strategy for your needs. I look forward to hearing from you.
The information contained in this article is provided for informational purposes only. No illustration or content in it should be construed as a substitute for informed professional tax, legal, and/or financial advice.