By: Randall A. Denha, J.D., LL.M.
A number of families I represent have vacation homes, ranging from homes in Northern Michigan to Florida getaways to Mexican villas. If you have a vacation home, chances are that family vacations and get-togethers run smoothly with the children and grandchildren sharing the home without conflict. A vacation home is an excuse for them to come back to visit and is almost the proverbial magnet for the family. The home is a place full of special memories. Perhaps the children even grew up enjoying the vacation home. Conversely, vacation homes can destroy a family if advance planning does not avoid friction. Whether you’re contemplating the purchase of a vacation home and don’t know how to take title in the property or you now own a vacation home and are thinking about giving it to your children, here are several estate planning issues to consider.
1. Title Issues. Once the vacation home is purchased, you’ll need to decide how to hold title to it. Should title be held in your own name? Or jointly with a spouse or other individuals? And if jointly, should it be held with rights of survivorship (meaning if one co-owner dies, the remaining co-owners automatically inherit the decedent’s share) or as “tenants in common” (meaning on the death of one of the property owners, the decedent may name who inherits his or her share of the property in the decedent’s will)? Should it be owned by a trust or a limited liability company?
The answer will depend on several factors and in fact there’s no single correct answer. A few considerations include the relationship between co-owners, whether the proportionate ownership interests of the co-owners will reflect the portion of the consideration each provided (if not, gift tax issues may arise) and whether each co-owner has sufficient other property to take advantage of his or her remaining federal or state estate tax exemption amounts.
2. Location of the Vacation Home. You’ll want to be even more careful about how you hold title if your vacation home is in a different state (the “ancillary state”) than your primary home (your “domiciliary state”). If at the time of your death you own real estate or tangible property (such as furniture) in an ancillary state, the executors of your will may be required to go through a second probate proceeding in such state with respect to such property (as well as a full probate proceeding in your domiciliary state). Strong consideration should be given to owning the property in trust or in a LLC. Doing so in this manner will avoid ancillary probate in another state thereby saving your family costs and aggravation.
3. If Your Vacation Home Is in a Different Country. Owning real estate in a foreign country can be a great experience. Depending on the laws and practice of the specific country, however, you may either feel “at home” with the acquisition process, titling considerations and how the property passes at your death or you may feel you’re dealing with rules from another planet, not just another country. Because local laws vary significantly on recommended, tax-efficient manners to title and structure ownership of your foreign vacation home, it’s essential to involve local experts. In addition to seeking advice on the purchase, you may also want to ask your local expert about any restrictions regarding the disposition of property upon your death and the country’s estate or inheritance tax regime.
For example, some countries have “forced heirship” laws that do not permit you to choose who inherits local property and instead mandate that a surviving spouse and children inherit it in set percentages. In addition, outside of “common law” jurisdictions (generally, countries that trace their legal heritage to England), many countries do not recognize trusts. This means that if you leave your foreign vacation home to a trust for the benefit of your family, local law may disregard the trust and instead deem the property to pass to other beneficiaries under your will, or outright to the trust’s beneficiaries, or via intestacy. Due to this, and because foreign laws governing wills are often very different from U.S. laws, it is often advisable to have a separate will prepared by a local lawyer to dispose of your foreign real estate.
Finally, if you are a U.S. citizen or resident, your worldwide assets are subject to U.S. estate tax. A foreign vacation home and its contents may also be subject to that country’s estate or inheritance tax. Estate tax treaties and foreign tax credits may prevent double taxation.
4. If You Rent Your Vacation Home to Others. If you rent your vacation home, you should consider holding the property in a manner that may reduce your personal liability should a renter bring a claim against you, for example if a renter is injured at the vacation home. Under the law of most states, the personal exposure of members in an LLC is limited to their investment in the LLC. In other words, if you hold your vacation home via such an entity and a renter brings a successful claim, to the extent not covered by insurance you may risk losing your vacation home, but your primary home and other investments should not be at risk.
5. Gifts of Vacation Homes in General. You can give your children (or whomever you wish to benefit) all of your vacation home or only partial interests in it; you can make outright gifts or gifts in trust; and as described below, you can place your home in an LLC or other entity and then make gifts of those interests. The tax cost basis of the vacation home in the hands of the recipients will be the same as your basis, plus the amount of any gift tax paid. If you die owning the vacation home, under current law its basis would be stepped up to fair market value.
6. Gifts to a Qualified Personal Residence Trust. A qualified personal residence trust (QPRT) is an irrevocable trust to which you transfer ownership of your vacation home; you retain the right to use your home for a term of years and, assuming you survive the term, pass your home to your children in equal shares (or in such alternative manner as you may decide before funding the QPRT). Under current law, you can retain the right to live in the home by renting it for a fair market rental following the end of the term. If you die before the end of the QPRT term, your interest in the property would revert to your estate and then pass in accordance with the terms of your will.
Generally, the taxable gift value of a personal residence transferred to a QPRT is not the fair market value of the property, but such value reduced by the value of your retained term of years. Your retained interest is calculated by looking at your age, the length of the term, the actuarial likelihood you’ll survive the term and the applicable IRS-published interest rate for the month in which you create the QPRT. Using a QPRT allows you to obtain a reduction in the gift tax value of your vacation home and, accordingly, the gift tax itself in connection with its ultimate transfer to your children, albeit at the risk that the gift fails and your home is included in your estate at its fair market value should you die during the QPRT’s term.
The rules about QPRTs and what property may be contributed to a QPRT are complex, and not all vacation homes would be suitable.
7. If Your Vacation Home May Stay in the Family for Multiple Generations. In addition to structuring the gift, you may want to create a written agreement for your heirs to minimize the likelihood of disagreements. The agreement can be completed and signed by the heirs as a part of the gift process and can include rules governing the use and operation of the property. If you and other family members have already inherited a vacation home without having an agreement in place, you may want to try to work together to create your own agreement – before you really need one. You and your co-heirs could form an LLC and create an agreement to govern usage, funding costs of repairs, etc. Details of an agreement may include the following:
• Who can use the vacation home and when?
• Who pays for what?
• Who manages improvements and decides on home furnishings and décor?
• Who makes legal decisions?
• What insurance coverage should be maintained?
• Can an interest be sold? On what terms?
One other issue to consider is the use of conservation easements, particularly if there is a significant amount of land involved. If you would like the property to remain “as is”, you could donate the development rights to a qualified charity that would preserve the natural habitat or open space. This would qualify you for an income tax deduction and would also decrease the value of the property for transfer tax purposes. If an easement meets the IRS’ criteria for a qualified conservation easement (such as furthering the goal of preserving open space, a significant natural habitat for flora or fauna, or even a certified historic structure), in addition to potential transfer tax benefits, you may also be able to take an income tax deduction for the value of the easement given to charity. The IRS recently began to subject conservation easements to increased scrutiny, in part to combat perceived abuse of the technique. Nevertheless, the importance of conserving appropriate property remains, as does favorable tax treatment for qualified conservation easements meeting the IRS’ requirements.
8. If You Would Rather Make Gifts of Cash Than of Your Vacation Home. Sometimes it just doesn’t make sense to give your children your vacation home (even should you then rent it from them for fair market value so you can continue to use it), but you may feel pressure to do so to take advantage of your remaining federal gift tax exemption. Instead of giving your vacation home to your children, you may be able to borrow from your bank using your vacation home as collateral and then make cash gifts to your children. With interest rates at historical lows, you may wish to increase your liquidity through such strategic use of credit.