Installment Sales Are a Tougher Sell in a High-Interest-Rate Environment

In low-interest-rate environments, estate planning strategies that utilize debt, including installment sales, are remarkably effective wealth transfer mechanisms. If you undertake an installment sale, you sell assets either to your beneficiaries directly or to a trust set up for them, in return for a promissory note. The transaction functions essentially as a loan, as interest payments flow back to you.

Rising interest rates, however, have made installment sales less compelling. Now that interest rates are at a relative high, installment sales may still prove advantageous in some wealth-transfer scenarios, but it is crucial to understand the pros and cons before moving ahead.

Factors Shaping Estate Planning Today

Before early 2022, near-zero interest rates were a key factor driving lifetime gifting strategies. Since then, the Federal Reserve Board (Fed) has kept interest rates relatively high in an effort to tame runaway inflation, and yields have continued to rise.

Fluctuations in the basic exclusion amount have also changed the estate planning landscape. Today, this amount sits at $13.61 million per person, but it is projected to drop to about $7.2 million in 2026.¹ With the exclusion set to halve, you may be tempted to enact aggressive wealth-transfer strategies as quickly as possible. The question becomes, how do you engage in effective estate planning before then—while being mindful that interest rates remain at a relative high?

Should You Revisit an Installment Sale?

An installment sale involves selling assets to your beneficiaries (or to a trust for their benefit). The beneficiaries pay for these assets with a promissory note, typically structured to require annual interest payments and a balloon payment of principal upon maturity.

With loans, of course, comes interest. If you lend money to an heir (or to a trust for such heir’s benefit), you’ll need to charge interest; failure to do so may result in taxable income or other unintended consequences. Transferring money to your beneficiaries—as opposed to making money on interest payments—is likely your goal. This is why most attorneys use the short-, mid-, and long-term Applicable Federal Rates (“AFRs”); these rates determine the smallest amount of interest that must be charged when family members lend each other money.

One consequence of the higher interest rates reflected in increased AFRs is that the cost of capital increases. When AFRs were close to zero, if you felt unsure about whether to give capital valued at the full exclusion amount, you could instead lend that amount to an intentionally defective grantor trust (a “grantor trust”) for the benefit of, for example, your spouse, children, and/or grandchildren. In prior years the cost of that loan, or the interest paid back to you, was so low that it could be thought of as a nearly cost-free means of making your gift more flexible. At any point before 2026, you could choose to forgive the debt, in whole or in part, with the mere stroke of a pen.

How Rate Hikes Have Made Installment Sales More Costly

With today’s higher interest rates, the cost of capital is no longer zero. At best, it is close to 5% per year. The flexibility built into an installment sale no longer comes at a negligible price. Think back to July 2021, when the exclusion amount was $11.7 million and the short-term AFR was 0.12%. If you were not sure whether you wanted to give the entire $11.7 million to a grantor trust, you could have instead structured the transfer as a loan.² In doing so, you would have kept the option to convert the debt into a gift by forgiving the note, in whole or in part, at any point during the loan’s three-year term. The annual cost of capital, also thought of as the cost of this built-in flexibility, was only $14,040. Assuming that the loan is repaid in full, and the loan principal produces a pretax annual return of 6%, the projected amount remaining in the grantor trust after three years would be close to $2.2 million.

Fast forward to today: Assume you lend the same $11.7 million to the same grantor trust in substantially the same way, except that now you have to charge the trust at least 4.66%, the mid-term AFR for June 2024. The annual cost of capital is now a whopping $545,220, nearly 39 times the required annual interest payment for a short-term loan made less than three years earlier (Display).

This higher cost of capital ultimately cuts against your goal of transferring wealth to your beneficiaries. Using the same 6% return, the June 2024 loan would leave the grantor trust with only about $499,000 to distribute. In other words, the June 2024 loan would place only about 23% of the July 2021 loan’s expected return in the hands of your beneficiaries. When using the June 2024 mid-term AFR, you would need to lend more than $51 million to the grantor trust in order to transfer as much projected wealth to your beneficiaries as you could have with the July 2021 loan.

Can Estate Planning with Installment Sales Still Work for You?

Installment sales may still be appropriate in some cases. For example, when loan proceeds are used to purchase assets expected to substantially outperform publicly traded stocks. Historically, publicly traded securities have returned about 10% on average, but Bernstein expects stocks to underperform historical norms by significant margins in the next decade.

Private equity and middle-market direct lending investments, for instance, may be appropriate assets to purchase with the proceeds of an installment note because they may create outsized returns. Founders or company owners may also benefit from outsized returns inherent in their private company stock.

A close analysis of a trust’s projected returns from investments will help clarify whether an installment sale continues to make sense for your estate plan. We strongly encourage you to work with your financial, legal and tax advisors to determine your best course of action.