Positive Effects of Low AFRs on Planned Gifts
This year, the Applicable Federal Rate (AFR) has reached a historic low of 0.4%. The AFR is used in the IRS’ prescribed present value calculations to determine the charitable deductions for various types of planned gifts. It is sometimes referred to as the Sec. 7520 rate or the rate of the month.
For planned gifts that provide a stream of income to individuals, a lower AFR will generally lead to a lower charitable deduction. However, there are some benefits to donors when the AFR drops. Let’s take a look at three of those situations.
Charitable Lead Trusts
The first and likely most obvious planned gift that benefits from low AFRs is the charitable lead trust. The lead trust donor’s goal is often to maximize the charitable income tax, gift tax or estate tax deduction.
As the AFR drops, the present value of the payout stream rises. Donors’ interest in the idea of creating a charitable lead trusts also rises when the AFR falls.
For example, consider a non-grantor lead trust funded with $1,000,000 with a 3% payout over 25 years. If this trust were set up during a time when the AFR was 2%, there would be a $414,295 taxable transfer to family and a $585,705 charitable gift tax deduction. If, instead, the trust were funded today, with a 0.4% AFR, the taxable transfer would be $287,635 and the deduction would be $712,365. That $126,660 difference makes the lead trust much more attractive today than ever before.
Retained Life Estate
Another charitable gift that benefits from low AFRs is the retained life estate. Older individuals with charitable intent may consider donating the remainder interest in their homes while retaining the right to stay in the home for life. This arrangement is an exception to the usual prohibition against taking a deduction for a partial interest gift. The donor conveys a future interest in the property to a charitable organization and retains a present interest. The value of the future interest is deductible. That future interest value increases as the AFR decreases.
For example, an 80-year old donor with a home worth $500,000 may choose to deed the remainder interest in his home to charity. He can stay in the home as long as he would like and take a charitable income tax deduction. With a 2.0% AFR, the deduction would be $401,940. However, with the much lower 0.4% AFR, the deduction rises to $455,031, a benefit of over $53,000.
Charitable Gift Annuities
Charitable gift annuities (CGAs) provide income for one or two lives. A lower AFR will provide a smaller charitable deduction for the donor.
Donors who set up charitable gift annuities generally fund them with smaller amounts than would be used to fund a charitable remainder trust or charitable lead trust. The thresholds may differ from one organization to the next, but often times, charities will set a minimum funding amount for CGAs around $25,000. Charitable trusts, on the other hand, are usually funded with hundreds of thousands or even millions of dollars. Many gift annuity donors, therefore, may find themselves in a situation where the charitable deduction is not large enough for them to itemize. These donors may benefit from today’s historically-low AFRs.
While low AFRs bring reduced CGA deductions, they also increase the tax-free portion of the gift annuity payout. The taxation schedule for a CGA is set at the time the gift annuity is funded. Each year’s payout is part ordinary income and part tax-free return of principal. (If an appreciated asset is used to fund the CGA and the donor is receiving the payouts, there will also be a capital gain portion of the payout.) With lower AFRs, the tax-free portion of the payout is higher than it would be with higher AFRs.
For example, let’s say a married couple sets up a two-life CGA with $75,000. Each spouse is 70 years old. If this CGA were funded today with cash, using the current 0.4% AFR, the donors would receive a deduction of $18,535, which falls short of the current $24,800 standard deduction for married couples filing jointly. The payout would be $3,150 annually. With a 2.0% AFR, the deduction would be $26,845, just over the standard deduction amount. With a 0.4% AFR, the $3,150 payout breaks down to $396.90 ordinary income and $2,753.10 tax-free. At the 2.0% AFR, the donors would get $800.10 of ordinary income and $2,349.90 tax-free.
While interest rates remain low, it is helpful to understand the potential benefits to donors. Understanding the positive aspects of low AFRs will aid gift planners in finding creative solutions for donors looking to establish planned gifts this year.