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PROTECTING AND PASSING ON MY VACATION HOME

by: Thomas D. Begley, Jr.

WHY IS A VACATION HOME SO SPECIAL AND WHAT ISSUES NEED TO BE CONSIDERED?

A vacation home can serve as a magnet to bring the family together.  Children marry and move away and have their own children.  A vacation home is an excuse for them to come back to visit with their parents and to bring the grandchildren with them.  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.

1.  ISSUES

Passing along a vacation home to children and grandchildren can be a complex undertaking from a tax standpoint, a cost of long-term care standpoint, and a management standpoint.  Some of the issues that need to be considered are:

•  Federal Estate Tax. Beginning in January 2006 the exemption from federal estate tax is $2,000,000 per person.  With planning, amarried couple can transfer up to $4,000,000 in assets without incurring any estate tax consequences.  Estate tax rates begin at 45%.

•  Federal Gift Tax. Persons are allowed to give $11,000 per person per year to any beneficiary or beneficiaries selected.  In addition, each person can give away $1,000,000 during their lifetime without paying any gift tax.

•  State Estate Tax. Many states have an estate tax.  For example, the New Jersey estate tax begins at $675,000.

•  Capital Gains Tax. Many vacation homes have significantly appreciated in value.  If and when it is sold, capital gains tax will be an issue.

•  Carryover Basis. If a vacation home is transferred to children and/or grandchildren during the lifetime of the parent, the parent’s cost basis carries over to the children and/or grandchildren, and may result in a significant capital gains tax when the property is sold.

•  Step-Up in Basis. Under current law, on the death of the parent the cost basis in the property for the children and/or grandchildren “steps up” to the fair market value on the date of the parent’s death.  This may result in significant tax savings when the property is eventually sold, however, current law repeals this step up in basis in the year 2010.  Therefore, property transferred upon death after the year 2009 will not receive the step up in basis.  There is speculation that this repeal in the step up in basis will not be permanent, but your estate plan should be based on current law.

•  Principal Residence Exclusion. A single person has an exclusion of $250,000 from capital gains tax on the sale of a principal residence.  For a married couple, this exclusion is increased to $500,000.

•  Estate Tax Freeze. It is possible to transfer a property in such a way that future appreciation shifts mostly to children freezing the value of the parents’ interest for tax purposes.

•  Discounted Gifts. It is possible to transfer assets to future generations in such a way that the gift receives a discount for federal estate and gift tax purposes and New Jersey estate tax purposes.

•  Protection from nursing home claims. If one spouse becomes ill, Medicaid will require that the home be sold and the proceeds used to pay for care.

•  Creditor protection. Certain forms of ownership offer protection from creditors.

•  Control. Does the senior generation want to maintain control during their lifetimes?

2.  STRATEGIES

What strategy do all of these factors dictate with respect to a vacation home?  The answer is different for everyone’s situation.  Each family’s vacation home and overall situation must be examined carefully to determine what strategy is best for that family.  Options include the following:

  • Lifetime outright gift
  • Transfer home during lifetime, but retain a life estate
  • Transfer home during lifetime, but retain a right to use and occupy
  • Qualified Personal Residence Trust (QPRT)
  • Family Limited Liability Company (LLC)
  • Family Limited Partnership
  • Transfer home on death

 

3.   MANAGEMENT ISSUES

No matter which strategy is selected, the following issues should be addressed in a joint venture agreement, an operating agreement, or a partnership agreement among family members:

  • Schedule for use of the property – Who gets 4th of July weekend?
  • Will outsiders be allowed to use the property? – Do we rent?
  • Rules applicable during property use – Are pets allowed?
  • How normal expenses, such as taxes and insurance, will be paid
  • Will special assessments be levied for capital improvements and extraordinary expenses, such as roof replacement?
  • How will family members contribute toward expenses?
  • What happens if a family member fails to contribute towards expenses?
  • Will a manager be selected and, if so, how?
  • What procedure will be used to resolve disputes?

 

 

4.  ADVANTAGES AND DISADVANTAGES OF STRATEGIES

4.1.  Lifetime Outright Transfer

Mechanics. Transfer the home by deed to the children and/or grandchildren.

Advantages.

  • State estate tax – in some states, such as New Jersey, after three years property is no longer included in the estate of the parent.
  • Estate tax freeze – all future appreciation in the  value of the property is not taxed to the parents
  • Medicaid – Accelerates eligibility
  • Creditor protection – Achieved

Disadvantages

  • Federal estate tax – neutral
  • Federal gift tax – limits the amount that can be transferred
  • Discount – not available
  • Step-up in basis – lost
  • Control – Lost

4.2.  Transfer Home And Retain Life Estate

Mechanics. Simply transfer the home by deed to the children and/or grandchildren and reserve a right for the parent to live in the property for life and to receive a portion of the proceeds of sale if the property is sold and to receive rents during the parent’s lifetime.

Advantages.

  • Step-up in basis on death
  • Medicaid – Accelerates eligibility
  • Creditor protection – Achieved
  • Control – Maintained

Disadvantages

  • Federal estate tax – property included in estate
  • Federal gift tax – limits amount that can be transferred
  • State estate tax – property included in estate
  • Capital gains – loss of principal residence exclusion with respect to interest transferred to children
  • Estate freeze – not applicable
  • Discount – not applicable

4.3.  Transfer Home And Reserve Right To Use And Occupy

Mechanics. Transfer the home by deed to the children and/or grandchildren and reserve a right to use and occupy, by not to receive rent or any portion of the proceeds if the property is sold.

Advantages.

  • Medicaid – Accelerates eligibility
  • Step-up in basis on death
  • Creditor protection – Achieved
  • Control – Maintained

Disadvantages

  • Management – agreement must be developed
  • Federal estate tax – property included in estate
  • Federal gift tax – property included
  • State estate tax – property included in estate

4.4.  Qualified Personal Residence Trust

Mechanics. The property is transferred to a trust.  The parent reserves the right to use the property for a period of time designated by the parent.  The parent must outlive the term of the trust for this strategy to work.  After the term of the trust, the parent must pay a fair market rental value to use the property.

Advantages.

  • Federal estate tax – reduced or eliminated
  • State estate tax – reduced or eliminated
  • Medicaid – Accelerates eligibility
  • Creditor protection – Achieved

Disadvantages

  • Federal gift tax – applies
  • Capital gains tax – parents’ cost basis carries over to the children and the advantage of step-up in basis is lost
  • Principal residence exemption – lost, if applicable
  • Estate tax freeze – yes
  • Discount – yes
  • Must outlive term, after term, must pay rent
  • Control – Lost

4.5.  Family Limited Liability Company

Mechanics. The business purpose of the limited liability company would be ownership and management of the real estate.  All members would have a right to elect managers to govern the LLC.  The property would be deeded to the LLC and shares or a percentage of the LLC are either given to or purchased by the children or grandchildren who are interested in owning or maintaining the vacation property..

Advantages.

  • Federal estate tax – may be reduced or eliminated.  Minority and marketability discounts may be available.
  • State estate tax – may be reduced or eliminated
  • Valuation Discounts – for gift tax purposes and estate tax purposes the value of the property will be less than fair market value of the property because it is held in a family LLC
  • Estate tax freeze – applies
  • Medicaid – may accelerate eligibility
  • Creditor protection – Achieved
  • Control – Maintained

Disadvantages

  • Federal gift tax – applies
  • Capital gains tax – applies
  • Principal residence exclusion – lost, if applicable

4.6.  Family Limited Partnership

Mechanics. The family limited partnership operates in much the same way as the family limited liability company.  There must be a business purpose for the partnership.  Deed the property to the family limited partnership.

Advantages.

  • Federal estate tax – reduced or eliminated
  • State estate tax – reduced or eliminated
  • Valuation discount – applies
  • Estate tax freeze – applies
  • Medicaid – may accelerate eligibility
  • Creditor protection – achieved
  • Control – maintained

Disadvantages

  • Federal gift tax – applies
  • Capital gains tax – applies
  • Principal residence exclusion – lost, if applicable

4.7.  Transfer on Death

Mechanics. The property is transferred to future generations by the terms of a will or living trust.

Advantages.

  • Capital gains tax – a step-up in basis is achieved
  • Principal residence exclusion – would be maintained if parents change mind and decide to sell
  • Control – maintained

Disadvantages

  • Federal estate tax – entire value of property, including appreciation, included in parents’ estate
  • Federal gift tax – not applicable
  • State estate tax – applies
  • Estate tax freeze – not available
  • Discount – not available
  • Medicaid – property exposed to claims of Medicaid
  • Creditor protection – lost

5.  CASE STUDIES

5.1.  Case Study #1

Harry and Sally own a vacation home on a barrier island.  They bought the house many years ago for $50,000 and now it is worth $1,000,000.  Harry and Sally have two children and five grandchildren.  The children visit on alternating weekends bringing the grandchildren with them, and each of the children spends two weeks during the summer at the vacation home.  Both children would like to have the home after Harry and Sally die.

Harry and Sally are not sure what to do with their home.  They would like to keep it in the family.  Because they are undecided as to what to do, they do nothing.  Eventually, when Harry and Sally die, the children decide that they would like to use the home together.  Turmoil ensues when a schedule of use cannot be agreed upon.  One child wants to make improvements to the property, the other does not have the money to afford the improvements, and bitterness develops between the children.

The lawyer probating the estate indicates that significant federal and state estate taxes will be due.  Neither child has the money to pay the taxes, so finally it is agreed that the home should be sold.

5.2.  Case Study #2

Bill and Linda own a vacation home on a barrier island.  They bought the house many years ago for $50,000 and now it is worth $2,000,000.  Bill and Linda have two children and five grandchildren.  The children visit on alternating weekends bringing the grandchildren with them, and each of the children spends two weeks during the summer at the vacation home.  Both children would like to have the home after Bill and Linda die.

Bill and Linda consult an attorney experienced in the area of estate planning and elder law and determine how the matter should be handled.  They decide to transfer the property to their two children now, and the children and grandchildren sign a Joint Venture Agreement spelling out how a manager will be elected, the powers that the manager will have, how the schedule for use of the property will be developed, what rules will apply to use of the property, how normal operating expenses (such as taxes and insurance) will be paid, and what will be done in the event of the need for capital improvements.  The agreement is drafted to give protection to all five families.  Bill and Linda live for four more years.  Upon death, the home is not included in their estates for either federal or state estate taxes.