Estate Planning: Your Definitive Guide To GRATs

In today’s day and age, financial security has become a topic of utmost concern as people struggle to make ends meet. After all, the surging unemployment figures coupled with increased taxation significantly impact an individual’s financial standing. So, the question is how to navigate these challenging economic conditions.

While one can’t escape income and general sales tax (GST), individuals can eliminate hefty capital gains and property taxes with effective real estate planning. Lately, granter retained annuity trust (GRAT) has become immensely popular due to its tax-saving scheme. It enables people to minimize tax expenses on real estate property, thus, allowing investors to save loads of money in the longer run.

If you want to learn more about this, keep reading. Here is a detailed guide to GRATs to help you with real-estate planning.

What is GRAT?

Starting with the basics, GRAT is more like a financial instrument specially designed for real estate planning. It allows people to scale down on taxes on real estate property they have purchased or inherited. In other words, it is an irrevocable trust created for a specific time. During that, you must submit all your assets to the trust. In return, the trustor will pay out an annuity yearly, counted as a return on your assets.

Grantor retained annuity trusts also reduce the tax liability of financial gifts to family members. Thus, if you plan to gift any real estate property to your children, this trust could be the perfect choice.

Once the trust expires, the investor will receive the last annuity payment, and the beneficiaries receive the assets. Since the trust was holding these assets, you won’t be liable to pay any tax charges. GRATs are an incredible option for wealthy individuals looking to maximize their tax liabilities.

You might wonder how GRAT works; let us show you the ropes.

How Does GRAT Work?

As most GRATs are irrevocable trusts, the grantor can pass a massive amount of wealth to the next generation without paying taxes. The purpose is to save money that would have been spent on taxation and property transfers over the years.

When opening a GRAT, you must distribute the assets in the trust. After this, you get the right to receive the original value of assets you contributed to the trust. In addition, you will earn a small return as specified by the Internal Revenue System (IRS). The return might be lower than the rentals you could have earned on real estate. However, massive tax savings will always give you an advantage with GRAT.

Once the GRAT expires, the assets will get transferred to your name or family members’. The transfer amount will account for any appreciation in the original assets, less the IRS return rate. Besides the general tax, you will also escape the capital gain tax on property appreciation.

How to Fund a GRAT?

Funding a GRAT fund is different from financing other trusts. It involves transferring all assets under your name to the trust in exchange for an annuity. These assets include property, plant, equipment, vehicles, fixtures, and fittings. In addition, current assets like cash, inventory, and investments also count as assets. Once you have aligned all assets, ensure the value is sufficient to fund the annuity payments. Grantor receives these payments during the trust term, either monthly or annually.

The grantor can also choose the duration of the annuity term but with subject to certain limitations. You must know that an annuity is a fixed amount and must be the same as the trust term. In addition, it should not exceed the life expectancy of the granter and beneficiaries.

Further, you must calculate the value of your assets after the GRAT expires to ensure the trust matches that amount. For this, you can calculate the present value of retained annuity interest from the initial value of the assets transferred to the fund. If the value is higher, investing in the trust will be profitable.

Once you have transferred the assets, now trustee is responsible for managing them and making annuity payments. However, you must remember that assets in GRAT in low valuations will rise during the term of GRAT, promising a capital gain.

Benefits of Starting GRAT

As GRAT has become a popular estate planning tool, let’s explore its benefits to determine how it is better than standard funds.

  1. Gift Tax Reduction: Grantor-retained annuity trusts effectively reduce gift tax liability through legal means. The retained annuity interest diminishes the gift tax value. If you transfer assets worth $8 million and GRAT retains an annuity of $6.4 million, the gift tax value will reduce to $1.4 million. As a result, grantors can use the remaining gift tax exemption to shelter more assets.
  2. Estate Tax Reduction: GRAT also helps reduce real estate tax liability when transferring assets to family members. After all, the annuity payments pass on to beneficiaries without additional costs.
  3. Income Stream: GRAT provides a steady flow of income through annuity payments. You can calculate these based on the asset’s value transferred to the trust. The higher the value, the higher the annuity payments will be.

Risks of GRAT

By now, opening a GRAT is the best choice, but let’s not forget to consider the risks associated with this fund. As annuity payments come from the interest earned on the assets in the trust, it comprises the total value of the investment. Therefore, the assets become a part of the taxable estate if the grantor dies before the trust expires. In addition, the beneficiaries don’t receive any assets, negating the GRAT’s purpose. However, this risk could be mitigated by choosing a short time frame for GRAT.

Another risk lies in the assumption that assets will appreciate. If any asset starts to depreciate, then GRAT doesn’t work well as the return becomes negative. Therefore, you must select the assets and the GRAT term period carefully to ensure you can make the most out of this trust fund.


Final Thoughts

Grantor-retained annuity trust has been adopted widely as an estate planning tool. It enables the grantor to transfer assets while retaining an income from the trust for a specified period. Besides facilitating the transfer of assets, it helps reduce the tax liability for grantors. Hence, they can save massive amounts of money in the long run.