The recent dip in interest rates has created a golden opportunity to save taxes while giving income-producing assets to your heirs. You can do this with a “grantor retained annuity trust,” or GRAT. It allows you to continue receiving income from the property for a number of years, and you can then give it to your heirs while dramatically reducing your estate and gift tax.
The amount of taxes you can save is determined by a federal interest rate, known as the “7520 rate.” The lower the rate, the more you can save. And that rate is at one of the lowest points its been in many years.
The donor of a GRAT creates a trust and funds it with income-producing assets. The donor then keeps the right to receive a certain amount of income from the trust each year. Generally, the donor gets the same amount each year, but the amount can vary within certain limits.
When the trust expires, the assets go to the beneficiaries of your choice. Why is this good? Well, lets say you put $1 million worth of assets into a 10 year GRAT, and at the end of that time the value of the assets has increased to $2 million. If you simply kept the property for 10 years and then gave it to your heirs, you’d be subject to gift tax based on the $2 million. But if you put the assets into a GRAT now, your gift tax is based on the present value or $1 million.
But even better, that $1 million is further reduced by the present value of the income stream you’ll receive over the 10 years.
And here’s where the 7520 rate comes into play. This is the interest rate the Internal Revenue Service uses to calculate the present value of your income stream. A lower rate is better, because lower rates mean a lower valuation of your total gift for tax purposes.
A variation on the GRAT is a “grantor retained unitrust,” or GRUT. This is the same thing, except that instead of the donor receiving a fixed amount of income each year, the donor instead receives a fixed percentage of the current value of the assets.
There’s one large drawback to GRAT’s and GRUT’s: If the donor dies before the term of the trust expires, then the trust assets are added back into the donor’ estate, and the tax advantages are lost.
For this reason, choosing the term of the trust requires some thought. The longer the term, the greater the tax savings, but the greater the risk that the donor will pass away and the savings will be lost.
There are several ways to hedge against this risk. One is with “layered GRAT’s”. For instance, instead of setting up a single 10-year GRAT, a donor could put 10 percent of the assets into a one-year GRAT, 10 percent into a two year GRAT and so on until there are 10 GRATS. Then, if the donor died after the fifth year, the family would still get the half the tax benefits of the 10-year GRAT- and the donor could lock in today’s low 7520 rate or all the GRATs.
Another option is “cascading GRATs.” The idea here is that you create a short-term GRAT of two or three years (thus reducing the risk of the donor passing away), and use the annuity payments to create additional short-term GRATs. You would then use the annuities from those GRATs to create further GRATs, and so on.
The advantage is that as the donor ages or becomes ill, he or she can stop creating the GRATs, thus reducing the risk of losing the tax savings. This method will not lock in the current low 7520 rate for all future GRATs, but in some cases it can be the best approach.