Earlier this year the stock market entered bear market territory. This happens when the market declines more than 20% or more from its most recent high. The market decline has been attributed to several factors including inflation, interest rate increases, the looming coronavirus (COVID-19) pandemic, and the tragic war in Ukraine. This unsettling environment is changing the dynamic of estate planning and creates new opportunities for high-net worth individuals to take advantage of wealth transfer strategies such as the following:
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Qualified Personal Residence Trust. As interest rates rise, a Qualified Personal Residence Trust (a “QPRT”) is a particularly beneficial estate planning tool. A QPRT permits you to gift your personal residence (or secondary home) to a trust for the benefit of your family at a reduced gift tax cost while retaining the right to live in the home for a term of years. The QPRT works to reduce the size of your taxable estate because it allows you to transfer the full value of the residence out of your taxable estate at a gift tax cost equal only to the remainder value of the residence taking into consideration your right to continue living in the residence for a period of years. The higher the IRS interest rate, the higher the imputed value of your retained right of occupancy, and the less that is deemed transferred as a gift to your family. Because you retain both the right to live in the home for a term of years and a reversionary interest if you die during that term, the value of the gift is a fraction of the value of the entire home.
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Charitable Remainder Unitrusts. If you have charitable inclinations, you may also want to consider a Charitable Remainder Unitrust (a “CRUT”), which is favorable under the current conditions for similar reasons as described above regarding a QPRT.A CRUT is an irrevocable trust established during your lifetime which provides annual distributions to you or to selected beneficiaries during your lifetimes or for a fixed term of years. The assets remaining in the trust at the end of the term are then distributed to chosen charitable beneficiaries. You will be entitled to a charitable income tax deduction in the year you make a contribution to the trust in an amount equal to the actuarial value of the assets which will ultimately pass to charity at the end of the CRUT term. The deduction is calculated taking into account the IRS interest rates in the month the trust is funded (or the prior two months). Higher interest rates increase the imputed value of the remainder interest passing to charity, leading to a larger charitable deduction. An added advantage of a CRUT is that the transferred assets are also exempt from capital gains tax on the sale of those assets. Depending on how the CRUT is structured, the full value of the trust, or the actuarial value of the remainder interest, may be entitled to an estate tax charitable deduction.
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Roth Conversions. Because the income tax on converting a traditional IRA into a Roth is calculated on the value of the marketable securities in the account, it’s best to make these conversions when the market is down.
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Gifts. You can make an annual tax-free gift of up to $16,000 (indexed for inflation) that does not count against your lifetime gift tax exclusion. With depressed stock values, it is a great time to make gifts of low-value stock with high appreciating value. During a bear market, you should also consider making taxable gifts of low-valued assets that exceed the annual exclusion. Even though those gifts would count against your lifetime exclusion, any future appreciation would grow estate tax-free.
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Substitute Assets in Irrevocable Trusts for Estate Tax and/or Income Tax Basis Planning. Given the depressed markets, you should review the value (and basis) of assets already funded in irrevocable trusts. If the trust terms include a power to substitute assets, it may be advantageous to swap out certain low-basis assets in those trusts with assets currently in your taxable estate, so that those low-basis assets are eligible to receive a step up in basis for income tax purposes at death. Alternatively, if the trust does not include a substitute or swap power, so long as the trust is a “grantor trust” for income tax purposes, low basis assets could be purchased out of the trust by the donor.
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