The recent 7520/AFR interest rate increase impacts the current value of a fixed annuity, and what this has meant, as medium-term Treasury yields have risen rapidly in recent months for tax planning that involves charitable gift annuities and principal or remainder charitable annuity trusts.
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But of course, not all planned gifts involve a fixed annuity. We have charitable carryover trusts, we have carryover interests in personal residences or farms, and we have at least a handful of pooled income funds. How will increasing 7520 fees and increasing table life expectancy affect tax incentives for those gifts?
The first thing to note here is that changes to the 7520 rate have literally no effect on the present value of a carryover after a trust with an annual payment. And a moment’s reflection explains why: if we assume a higher or lower rate of return, a fixed percentage payment will increase or decrease proportionately, and the consequences will be shared proportionately by the remaining “income” and interest.
However, in the more typical case of a quarterly payment, an increase in the 7520 rate will assign slightly more value to the trust interest and less to the rest, simply because the more frequent payment is diverted to the beneficiary of “income” amounts that otherwise they would have remained invested for growth, a portion of which would eventually have been distributed to the charitable remainder. But just a little.
The effects of fluctuations in the 7520 rate are considerably more pronounced in the case of a gift of a carryover after a life reserve in a residence or estate. Here, a higher 7520 rate will assign more value to the “income” interest retained and less to the deductible remainder, the opposite of what happens with the gift annuity or charitable remainder annuity trust. This is because a higher current rate of return will accrue primarily to the benefit of the “income” beneficiary, and again, the two values can only add up to one hundred percent.
And the effect can actually be more dramatic than in the case of a fixed annuity. It would be difficult to make a side-by-side comparison in this space, because the calculation of the present value of a carryover after a lifetime estate in a residence or farm would take into account the allocation of value between the depreciable and non-depreciable components of the subject. property and the useful life of the depreciable component.
But to give the reader an idea of the relative strength of a rising or falling 7520 rate on the gift of a carryover after retained “income” interest versus a fixed annuity, let’s assume, on the one hand, a five percent annuity. during life. of a 70-year-old and, on the other hand, a remainder after a lifetime estate set aside in raw farmland, with no depreciable component, again for the life of a 70-year-old.
This is by no 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 as of 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 7520 rate of 3.6 percent September, just four months ago, but down a hundred basis points, the current value of the remainder would be around 47.2 percent, down 380 basis points.
By comparison, with the 7520 rate of 4.6 percent, the present value of remainder after life estate set aside would be about 55.8 percent, whereas if we had used the September 7520 rate of 3.6 percent , the present value of the remainder would be about 55.8 percent. 62.6 percent, an increase of 680 basis points.
We cannot make a meaningful comparison between a charitable carryover annuity trust and a pooled income fund, because the present values of income and interest carryover in a pooled income fund depend only on the assumed rate of return on the fund, not of fluctuating 7520 rates. , and because, in any event, the assumed rate of return will often be much lower than the five percent minimum payment from the annuity trust.
But we should note that rising and falling 7520 rates do have, at least indirectly, an effect on the valuation of the income and interest remaining in a newly created income-sharing fund. The assumed rate of return on an established fund is the average rate of return over the previous three fiscal years, but since a newer fund does not yet have this track record, the Tax Code assumes a rate of return based on the higher average of 7520 rates on each of the three previous years, minus one point. The assumed rate of return for a newer fund in 2022 was 1.6%, down from 2.2% a year earlier, a lagging indicator of falling rates through 2019. The assumed rate of return for a fund newer in 2023 it rises again to 2.2%, reflecting the rapid increase in rates last year.
The average of 7520 rates was below one percent in both 2020 and 2021, and had rates in 2022 not recovered, the assumed rate of return for a blended income fund created in 2023 would have been literally 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 not be included in the calculation.
