A sound financial strategy should be well equipped to shift gears when markets fluctuate. Unfortunately, the circumstances we currently find ourselves in were almost impossible to predict, and many of the approaches we followed for years will no longer serve us. Though the markets have been recovering since the initial plummet in late February/early March, they are not back up to pre-COVID-19 rates, and individuals are having to come to terms with the fact that their investments may not make a quick recovery.
When COVID-19 became part of our everyday verbiage, we knew things would change. And although your financial strategies will likely need to be fluid for the time being, there are positive steps you can take now that will help secure the financial futures for both you and your loved ones.
Gift Depreciated Assets
Gifting assets when their trading values are low is an age-old tax saving strategy, and it holds true in the post-coronavirus era. It is an effective way to transfer value to your family members while preserving your unified gift/estate tax credit. For tax year 2020, the unified credit is a whopping $11.58 million, so while you are unlikely to exhaust your credit under current law, you want to limit your use of the credit in case tax laws change. The unified credit has largely grown over the past few decades, but there have been times when Congress slashed the benefit for a year or two. Taxpayers who died in those years were more likely to pay estate taxes compared to individuals who passed away in years when the credit was larger. By limiting your use of the unified credit or by keeping gifts below the annual $15,000 per-person gift exclusion, you can save that credit to apply against your estate.
If you are not ready to gift assets directly, you can instead establish a trust to benefit your loved ones. Grantor retained annuity trusts (GRATs) are wealth-preserving tools that donors often use to transfer low-valued assets that are expected to appreciate over time.
To establish a GRAT, you as the grantor would contribute assets into an irrevocable trust that would provide you with an annuity for a set number of years. Your annuity would be funded by the assets themselves, and at the end of the term, any assets remaining in the trust would be transferred to your beneficiaries gift tax-free.
The gift is taxable to you when you transfer assets into the trust, and income anticipated to be generated by trust assets are taxable income to you as the grantor. But Section 7202(b) of the U.S. Tax Code establishes that the value of the annuity stream you receive reduces your taxable gift. If you contribute $50,000 into the trust and your annuity stream is valued at $48,000, only $2,000 of the gift would be taxable. The present value of the annuity stream is calculated using IRS interest rate tables in effect at the time of the transfer, which – at the moment – are the lowest they’ve been in years. As long as the assets in your trust outperform IRS interest rates, you will be able to gift your assets without incurring additional transfer taxes. Because IRS interest rates are low and most financial assets are expected to appreciate, this method works especially well under current market conditions.
Loan Money to Family Members
Intra-family loans are another way tax-savvy individuals can capitalize on a depressed market. Like GRATs, the tax savings comes when asset growth outperforms the stated interest rate. The simplest intra-family loan may look like this:
Parent loans Child $100,000 using an interest rate dictated by the IRS, at a time when interest rates are low. Child purchases a depressed asset with those loan proceeds. Over the loan period, the asset’s appreciation outperforms the interest rate stated in the loan. The difference between the loan’s interest rate and the rate of return on Child’s investment is free from transfer taxes.
Intra-family loans must be completed using interest rates that meet or exceed current Applicable Federal Rates (AFRs), and because interest rates have dropped, now is a great time to consider using this strategy.
While this method can be employed without a trust, utilizing a trust enhances the benefits. Instead of loaning money directly to your family member, you would transfer those funds into a trust to benefit your family member in exchange for a promissory note. If the assets held in trust outperform the stated interest rate, any property remaining in the trust can be transferred to your family member (the trust’s beneficiary) free from transfer taxes.
While both scenarios benefit you from a gift/estate tax perspective, income tax should still be a concern, and this is where trusts come out on top. In both scenarios, the loans must be repaid, and when intra-family loans are performed without the use of a trust, the interest is taxable to you as the lender. If you instead utilize a grantor trust to make the intra-family loan, the interest income will not be taxable to you because the IRS will consider the grantor trust to be the same tax entity as its creator – you.
Employ Swap Powers
If you hold assets in an irrevocable trust, you may be able to use swap powers to reduce your transfer tax liability. Swap powers, if written into the trust documents, allow you to swap personally held assets with trust assets if they are of equivalent value. Most taxpayers utilize swap powers when their trust holds highly appreciated, low-basis assets. By exchanging low-basis assets with high-basis assets relative to their fair values, you transfer more unrecognized appreciation into your estate. Upon your death, this appreciation will be washed away when the value is “stepped up” to fair value. Assets held in irrevocable trusts are not considered part of your estate, and your beneficiaries will adopt the bases you held in those assets, exposing them to higher capital gains when they later sell those assets.
A dip in the market can be seen as an opportunity rather than a setback if you know where to look. If you would like to discuss how your tax planning strategy should change to adapt to current market conditions, contact us today.