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If you have property that's rapidly appreciating or generating high earnings, and you're ready to pass it down to your children or other heirs but want to continue receiving income from the property for a period of years a grantor retained annuity trust (GRAT) may be a great strategy for you. The goal of a GRAT is to transfer property with minimal gift tax consequences.

A GRAT is an irrevocable trust into which you make a onetime transfer of property, and from which you receive a fixed amount each year for a specified number of years (the annuity period). At the end of the annuity period, the property remaining in the trust (the remainder interest) is distributed to the beneficiaries you've named in the trust document.

Potential tax benefits of a GRAT

A transfer of property to an irrevocable trust is a taxable gift. The value of the gift on which gift tax is imposed is generally its fair market value. However, because you retain an interest in a GRAT, the value of the transfer is discounted; gift tax is imposed only on the remainder interest (and any gift tax due may be sheltered by your applicable exclusion amount).

This taxable value is calculated using an interest rate provided by the IRS (known as the discount rate or Section 7520 rate), which is based on current interest rates and changes monthly. This interest rate assumes the GRAT property will earn a certain rate of return during the annuity period. Any actual return that exceeds the assumed return passes to the remainder beneficiaries free from gift and estate tax. Investment performance, therefore, is central to this strategy.

Tip: The current low Section 7520 rates are very beneficial for GRATs.

… and the catch

The catch to this strategy is that you must outlive the annuity period. If you die before the annuity period expires, the value of the property in the trust on the date of your death will be included in your estate for estate tax purposes. This, however, merely puts you in the same position you would have been in had you not used the GRAT (except for the costs to create and maintain the trust).

Tip: In order to reduce the risk that the grantor will not outlive the annuity period, annuity periods as short as two years are often used. Sometimes a series of these short-term GRATs are used.

Note: It may be advisable for the remainder beneficiaries to buy life insurance on your life (the life of the grantor) so that funds will be available to pay the estate taxes in case the GRAT property is included in your estate due to your early death.

The risk

The key to this strategy is investment performance. If the trust property does not outperform the discount rate, there will be no excess return, and no tax savings will be achieved.

… and other drawbacks

Gifts of present interests qualify for the annual gift tax exclusion. But, because the gift to the remainder beneficiaries is a future interest, not a present interest, transfers to a GRAT do not qualify for the annual exclusion.

Additionally, a GRAT is generally not appropriate for making gifts to grandchildren or other skip persons (persons who are more than one generation below you). That is because there are rules that prevent you from allocating your generation-skipping transfer (GST) tax exemption until the annuity period expires. Because you cannot effectively leverage your GST tax exemption, a GRAT should not be used for generation-skipping transfer tax planning.

Finally, property transferred by reason of your death will receive a step-up (or step-down) in income tax cost basis (i.e., the property's value will generally be increased to its fair market value on the date of your death); property that is transferred during your lifetime by gift does not receive a step-up in basis. Losing the step-up in basis may mean significant capital gains taxes for the remainder beneficiaries.

A GRAT that is structured so that the annuity payments to you are high enough to result in a gift valued at zero is known as a "zeroed out" GRAT. With this type of GRAT, since there is no gift, no gift tax is due and no applicable exclusion amount is used.

Other considerations

Some property that may be appropriate for a GRAT includes:

  • High-yield or high-growth investment portfolio
  • Commercial rental property
  • Closely held stock
  • Family limited partnership (FLP) interests
  • Any property with appreciation potential, such as real property, precious metals, and artwork

A GRAT is usually considered a grantor-type trust for income tax purposes. All income, gains, deductions, and losses flow through to you on your personal income tax return. The GRAT document must be precisely drafted for the property to receive GRAT tax treatment. You should consult an experienced estate planning attorney if you are considering this strategy.