Take advantage of the recession to lock in estate planning gains

Nobody likes a recession, but any time when real estate values, stock prices and interest rates are low is a great time to do estate planning.  You can transfer assets to your heirs now at a low value and save them a huge estate tax bite later.

One way to do this is with a “grantor retained annuity trust” or GRAT.  The idea is that you create a trust and fund it with income producing assets, while keeping the right to receive a certain amount of income from the trust each year.  When the trust expires after a certain number of years, the assets go to whatever beneficiaries you choose.

When interest rates are low, as they are now, a GRAT can dramatically reduce estate and gift taxes.  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.

How that present value is determined is based on an IRS interest rate called the 7520 rate.  The lower the rate, the better.  And right now, the 7520 rate is the lowest it’s been in a generation – making this an excellent time to take advantage of this technique. 

There’s one large drawback to a GRAT which is that if you die before the trust expires, the trust assets are added back into your 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 you will pass away first. You can protect against this risk somewhat by using “layered GRATs”.  For instance, instead of setting up a single 10 year GRAT, you could put 10% of the assets into a one year GRAT, 10% into a two-year GRAT, and so on until there are 10 GRATs.  If you died after the fifth year, your heirs would still get the tax benefits from five of the 10 GRATs – and you could lock in todays low 7520 rate for all the GRATs.

Some clients create short-term GRATs with very high payouts to lock in any investment gains quickly for the beneficiaries. 

Another option is to “zero out” a GRAT.  That means you set up the trust so that when it expires, the amount paid out is equal to the value of what you originally put in.  As a result, no gift or estate tax is owed at all, and any appreciation goes to the beneficiaries completely tax free. 

A variation on the GRAT is a “charitable lead annuity trust”.  The idea is the same, but instead of the trust income being paid to you each year, it goes to charity. 

If you set up a charitable trust, you can take a deduction right away for the value of the gift to charity.  This can be a great way to reduce income taxes if you have a large tax bill in the first year- for instance, if you cashed out a lot of stock options or have some other windfall.

If you take a charitable deduction, though, you will then have to pay tax each year on the trust’s investment gains.  As a result, many people forego the first year deduction in order to avoid paying tax later on.  Both kinds of trusts can also be set up as “unitrusts.” Instead of paying a fixed amount of income each year, a unitrust will pay a percentage each year of the total value of the trust.

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