Certain planning techniques involve the use of interest rates to value interests being transferred to charity or to private beneficiaries. While the use of these techniques does not necessarily depend on the interest rate, low interest rates may increase their value.
Taxpayers can obtain a deduction by giving a partial interest in property to a charity, using a trust. Two types of trusts for this purpose are charitable lead trusts and charitable remainder trusts. In a charitable lead trust, the taxpayer funding the trust gives an income interest to charity and the remainder interest to a family member or other preferred beneficiary. In a charitable remainder trust, an individual receives trust income and a charity is entitled to the remainder interest.
The IRS’s applicable federal rate (AFR) is used to value these different interests in trusts. Right now, AFRs are relatively low. For example, for December 2012, the AFR for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest is only 1.2 percent, a very low rate.
When AFRs are low, certain transfer mechanisms become even more useful. In a charitable lead trust (CLT), a low AFR increases the present value of the charity’s income interest. This increases the value of the charitable deduction for the income interest, and reduces the value of the remainder interest passing to private individuals. (For a charitable remainder trust, the same mechanism increases the present value of the individual beneficiary’s income interest, and reduces the value of the remainder interest going to charity.)
Another device is a personal residence trust (PRT), where the grantor retains the right to live in the house, instead of receiving income payments, and gives the remainder interest in the property to charity. This provides a current charitable deduction. The amount of the charitable contribution is the fair market value of the property, discounted by the AFR. The lower the AFR, the higher is the value of the remainder interest, and the greater the charitable deduction.
A PRT can also be used to give the remainder interest to a family member or other individual. In this case, the transfer of the remainder interest is subject to gift tax. The lower the AFR, the greater is the value of the remainder interest, and the greater the gift tax.
Loans to family members
Another situation in which low interest rates can work to a taxpayer’s advantage is a loan between family members. For the loan to be bona fide, interest generally must be charged on the loan. However, the lower the AFR, the lower will be the market rate for interest that has to be charged to the borrower. If the interest rate is too low, the IRS may impute a higher rate of interest on the loan, which could result in a gift of the foregone interest to the borrower. Again, when the AFR is low, the lender can make a loan at a lower interest rate.
If you are interested in exploring further how any of the above-mentioned planning techniques can benefit your tax situation especially while interest rates remain low, please do not hesitate to contact this office at (908) 725-4414.