Taxes

Charitable Remainder Unitrust Planning Under Rising Interest Rates

The recent rising 7520/AFR interest rate impacts the present value of a fixed annuity, and what this has implied as yields on mid-term Treasuries rose rapidly in recent months for tax planning involving charitable gift annuities and charitable lead or remainder annuity trusts.

But, of course, not every planned gift involves a fixed annuity. We have charitable remainder unitrusts, we have remainder interests in personal residences or farms, and we have at least a handful of pooled income funds. How will rising 7520 rates and increasing table life expectancies affect the tax incentives for those gifts?

The first thing to note here is that changes in the 7520 rate have literally no effect at all on the present value of a remainder after a unitrust with an annual payout. And a moment’s reflection explains why: if we assume a higher or lower rate of return, a fixed percentage payout will rise or fall proportionately, and the consequences will be shared proportionately by the “income” and remainder interests.

In the more typical case of a quarterly payout, however, an increase in the 7520 rate will assign slightly more value to the unitrust interest and less to the remainder, simply because the more frequent payout is diverting to the “income” beneficiary amounts that would otherwise have remained invested for growth, some portion of which would have eventually been distributed to the charitable remainderman. But only slightly.

The effects of fluctuations in the 7520 rate are considerably more pronounced in the case of a gift of a remainder after a reserved life estate in a residence or farm. Here, a higher 7520 rate will assign more value to the retained “income” interest and less to the deductible remainder — the opposite of what occurs with the gift annuity or the charitable remainder annuity trust. This is because a higher rate of current return will accrue primarily to the benefit of the “income” beneficiary, and again, the two values can only ever add to a hundred percent.

And the effect can actually be more dramatic than in the case of a fixed annuity. It would be difficult to run a side by side comparison in this space, because the calculation of the present value of a remainder after a life estate in a residence or farm would take into account the allocation of value between depreciable and nondepreciable components of the subject property and the useful life of the depreciable component.

But to give the reader a sense of the relative strength of a rising or falling 7520 rate on the gift of a remainder after a retained “income” interest versus a fixed annuity, let us assume on the one hand a five percent annuity over the life of an individual aged 70, and on the other hand a remainder after a reserved life estate in raw farmland, with no depreciable component, again over the life of an individual aged 70.

Not by any means the typical case, but we are trying to compare an apple to something resembling an apple. With the 7520 rate at 4.6 percent, where it is at this writing in January 2023, the present value of the remainder in the annuity trust would be about 51.0 percent, whereas if we were still using the 3.6 percent 7520 rate from September, just four months ago but a hundred basis points lower, the present value of the remainder would be about 47.2 percent, a decrease of 380 basis points.

By comparison, with the 7520 rate at 4.6 percent, the present value of the remainder after the reserved life estate would be about 55.8 percent, whereas if we had used the 3.6 percent 7520 rate from September, the present value of the remainder would be about 62.6 percent, an increase of 680 basis points.

We cannot run a meaningful comparison between a charitable remainder annuity trust and a pooled income fund, because the present values of the income and remainder interest in a pooled income fund depend only on the assumed rate of return in the fund, not on fluctuating 7520 rates, and because in any event the assumed rate of return will often be much lower than the five percent minimum payout from the annuity trust.

But we should note that rising and falling 7520 rates do, at least indirectly, have an effect on the valuation of income and remainder interests in a newly created pooled income fund. The assumed rate of return in an established fund is the average rate of return over the preceding three tax years, but since a newer fund does not yet have this history, the tax Code assumes a rate of return based on the highest average of 7520 rates over each of the preceding three years, minus one point. The assumed rate of return for a newer fund in 2022 was 1.6 percent, down from 2.2 percent the previous year, a lagging indicator of falling rates through 2019. The assumed rate of return for a newer fund in 2023 is back up to 2.2 percent, reflecting last year’s rapid rise in rates.

The average of 7520 rates was below one percent in both 2020 and 2021, and if rates in 2022 had not recovered, the assumed rate of return for a pooled income fund created in 2023 would literally have been zero. The deduction for a contribution to such a fund would have been one hundred percent. But because the average of 7520 rates for the first seven months of this year is already over 2.5 percent, those two years will almost certainly drop out of the calculation.

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