It is summertime and the family vacation home is a busy place. But fall will be here before we know it and we’ll be winterizing the summer place once again, wondering where the summer went. But winterizing is typically the easy part. Doing the planning to keep the vacation home in the family for the next generation can be a much greater challenge. But it is not an insurmountable challenge. How can we prepare a plan so we can keep making those cherished memories?
Have a conversation
Like so many family matters, successful transitions of vacation property begin with meaningful conversations. It is important to be mindful of the interests of each of the family members and the practical logistics of the long-term shared use of the property. A conversation involving the entire family is a great way to start the planning process and get everyone on the same page.
Begin with the question of whether the family wants to keep the property. Is keeping the property the parent’s preference, but not the children’s? Do only some of the children want to keep the property, but not others? Yes, everyone has many happy memories associated with the vacation home, but there may also be reasons not to keep the property – family members have moved further away, they would prefer to travel more, or the finances don’t work out.
If the collective decision is to keep the property, there are many choices to discuss and decisions to make. How should the property be owned? Who will use it and when? Who will manage the property? When is the right time to transfer ownership of the property? While the vacation home is a haven for creating lasting memories, thoughtful planning and diligent follow-up are essential to maintain the property across generations.
Decide how to own the property
How to title the property is a fundamental consideration. It has implications on how the property will pass when there is a death in the family, exposure to creditors and more.
Tenancy in Common
One option for the vacation home is to be owned as “tenants in common.” A tenancy in common is a type of shared ownership of property. Each co-tenant owns a share of the entire property. The ownership interests among the co-tenants can be equal or unequal. With this type of shared ownership there are no rights of survivorship as there are with joint tenants with rights of survivorship. This means an individual co-tenant’s interest will transfer according to his or her will or trust or pursuant to the state laws of intestacy if the co-tenant does not have a valid will or trust in place at the time of their death.
All co-tenants in a tenancy in common, regardless of the size of their individual ownership interest, are entitled to occupy and use all of the property. In addition, each co-tenant has certain rights – the right to freely sell, pledge or dispose of his or her ownership interest in the property to whomever he or she chooses, for whatever reason, without consent from any other co-tenant(s). Additional risks to consider involving co-tenants include the vacation home potentially being subject to creditors’ claims, divorce or even court-ordered partition of the home asset resulting from one or more dissatisfied co-tenants who wish to exit the tenancy in common and effectively “cash out.” This could result in a forced sale of the vacation home despite the remaining co-tenants’ wishes not to sell. Tenancy in common may be simple at the outset, but become more complicated as circumstances change.
Qualified Personal Residence Trusts
Another alternative is a Qualified Personal Residence Trust (QPRT). The owner transfers property to a trust for the benefit of the family, designates a trustee to administer the trust and retains the right to use the property for a predetermined number of years. They no longer own the property, rather they are now the settlor of the trust with certain rights to use the property. At the end of the term the property either passes outright to the family beneficiaries or continues to be held in trust for their benefit.
QPRTs are used to transfer property during life at a reduced gift tax cost and are only appropriate where there is a need and desire to reduce gift and estate taxes. The value of the gift made by the transfer of the property to the QPRT is the full fair market value of the property minus the value of the interest retained by the settlor. The remaining value transferred to the beneficiaries is determined based upon the interest rate specified under Section 7520 of the Internal Revenue Code, which is used to value certain split interests at the time of transfer (2.2% in August 2019). Any future appreciation of the property’s value benefits the trust and the beneficiaries and won’t be considered an additional gift by the settlor, provided the settlor survives the original term set for her retained use of the property. QPRTs are more beneficial from a gift tax planning perspective when interest rates are low.
A couple words of caution regarding QPRTs. If the settlor does not survive the initial term, the property will be included in her estate for estate tax purposes at its full value. Thus, no gift and estate tax benefit will have been accomplished. If the settlor survives the term and expects to use the property on an ongoing basis, she should expect to pay full fair rental value to use the property, otherwise the property will be brought back into her estate for tax purposes when she dies.
There are also other variations of long-term trusts that may be established to hold family vacation property that do not have the same tax benefits of the more technical QPRT. Trusts generally can be a useful vehicle to provide for the ownership, management, use and transition of vacation property.
Limited Liability Company
Another alternative is a limited liability company (LLC). In the context of vacation homes, LLCs are especially useful for dividing interests in the LLC among family members and providing for ongoing management of the LLC. For purposes of vacation home management, the “operating agreement” is an essential feature of the LLC. The operating agreement governs the management of the LLC as well as its members’ financial and managerial rights and duties. A well-crafted agreement clearly defines the rights, powers and entitlements for members while also setting forth the operating rules for management of the family vacation home, which may include provisions for funding, maintenance and repairs. Language regarding transfer restrictions on ownership may be incorporated into the operating agreement as well to ensure ownership remains in the family. In an effort to maintain flexibility for the LLC and its members, amendments to the operating agreement are generally permitted at any time as stipulated by the agreement.
A vital component of the operating agreement for shared family vacation homes is scheduling use of the property. At a minimum, it’s imperative for the sharing system to address how time is divided and who may use the vacation home, including parents, surviving spouses, pets, cousins, renters, friends and other guests. A workable and lasting system for shared vacation home usage is fair, simple, clearly stated and aligned with family traditions and culture.
Transfer as a Lifetime Gift or Bequest at Death
Vacation homes may be transferred to the next generation by lifetime gift or bequest at death. Family traditions and dynamics will inform when a home is transferred as the timing of the transfer will impact decision-making and control of the property. Taxes are also a consideration.
While transfers may be made at any time, one important distinction between a lifetime gift and bequest at death is that with a lifetime gift, the donor’s basis in the property generally carries over to the donee. With bequests at death, on the other hand, the basis of the property is adjusted to its fair market value at death. This is a difference with little consequence if the expectation is that the property will not be sold. But if the property will be sold, holding the property to death, obtaining the basis adjustment, and then selling will reduce the tax cost to the family beneficiaries if the property has appreciated. Income, gift and estate tax rates, exemptions and exclusions tend to change from time-to-time as evidenced by the Tax Cuts and Jobs Act in 2017. Assessing the tax consequences of a proposed plan is imperative
Purposeful planning and open communication among family and advisors will best position the family to preserve cherished memories, provide for future enjoyment of the family vacation home and spend less time worrying about it over the long-term. For this summer, keep plenty of sunscreen on hand and a supply of cookies for the constant inflow of family and guests. Suzanne Shier