Donors can increase their giving by strategizing around federal discount rates.
By Bill Zook, Senior Advisor, Gift Planning
High or low, rising or falling, interest rates in the broader economy can have either a direct or an indirect impact on various charitable giving arrangements. In some cases, the impact can be sizeable, while in others it will be modest at best.
Lower Interest Rates make it a good time to use a CLAT
With the recent announcement of the first round of grantees from the Fund for Inclusive Recovery, donors have expressed a desire to increase their giving. A charitable lead annuity trust (CLAT) is a great way to provide immediate and ongoing support for multiyear initiatives such as the Fund for Inclusive Recovery. In the case of a CLAT, the lower the discount rate discussed below, the higher the deduction. Even now that interest rates are heading upward rapidly once again, establishing such a trust can still be a wise move for donors in many circumstances. Upon request, Seattle Foundation can readily run sample calculations.
Role of the Federal Discount Rate
We first need to hone in on the primary way interest rates manifest themselves, which is through the discount rate used in making present value calculations. Such calculations are required in determining the tax savings associated with different asset transfer techniques—both charitable and noncharitable. Often referred to as the “applicable federal rate” or simply “AFR,” the discount rate is figured pursuant to Section 7520(a) of the Internal Revenue Code and applies to “any annuity, any interest for life or a term of years, or any remainder or reversionary interest.” In fact, it is also sometimes referred to as simply the “7520 rate.”
Regardless of its name, the rate is subject to change each calendar month. That being said, sometimes it remains the same over the course of several months. Significantly, when “an income, estate, or gift tax charitable contribution is allowable for any part of the property transferred,” the donor can select the rate for the month in which a gift is made or either of the rates of the two immediately preceding months. As noted below, this feature can be quite advantageous.
Basic Planning Considerations
At least in the philanthropic context, there are a few realities to bear in mind:
The discount rate influences to a great extent the deduction associated with a gift involving either an annuity interest (whether a charitable gift annuity, a charitable remainder annuity trust, or a charitable lead annuity trust) or a life estate in certain types of real estate (a personal residence or a farm).
By contrast, the discount rate has only a small effect on a gift involving a unitrust interest (whether a charitable remainder unitrust or a charitable lead unitrust).
In the case of several gift arrangements, the discount rate may play either a limited role (as with new pooled income funds) or none at all (as with pretty much any direct charitable transfer of assets, whether during life or upon death).
Of course, when one steps back from the discount rate and looks at the role played by interest rates more broadly in the context of charitable giving, the main consideration will be how changes in interest rates affect the cash flow and the market value of assets owned by the donor or within some structure the donor has created, e.g., a charitable remainder trust. Even though they can be quite important, the numerous associated implications are beyond the scope of this blog post!
The Case of Hawaii Condo Retained Life Estate
Most of the time, the discount rate deserves attention when a donor is contemplating making a brand-new gift — specifically through some sort of partly charitable, partly noncharitable structure. In selected instances, however, a donor will wish to terminate such a structure before it would otherwise end. An early termination can result either in a second charitable gift being made or in the benefits of the original gift being divided on a present value basis between the charitable and noncharitable components as they exist currently.
As an example, back when the COVID-19 pandemic began and interest rates were tumbling, a married couple who in 2015 had made Seattle Foundation the owner of their Hawaii condo — subject to retaining the right to use it so long as either of them was living—decided to give the Foundation their life estate. When they arranged the original gift in 2015, their income tax charitable deduction was, in effect, for the present value of Seattle Foundation’s remainder interest in the property This was partly a function of the discount rate for the month of the gift (or either of the two prior months). At that point, the lower the discount rate, the higher their deduction.
Yet by the point in 2020 when they resolved to give their retained life estate, the lower the discount rate, the lower their deduction. Because they were able to complete the termination of the arrangement before the end of May, they were able to use the March 2020 discount rate of 1.8%, rather than the May rate of 0.8%. In their case, the deduction was almost $150,000 greater than it would have been without the choice of discount rates.
Seattle Foundation welcomes the opportunity to work with philanthropists and their advisors to explore giving options no matter what role interest rates may play. To learn more, contact Bill Zook.