Vacation Area Homes: Tax and Management Issues – Begley Report

By: Thomas D. Begley, Jr., Esquire, CELA

CASE STUDY 1:  VACATION HOME—NO ESTATE PLAN

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

Harry and Sally would like to keep their vacation home in the family, but aren’t sure what to do with the property.  Because they are undecided, they do nothing.  After Harry and Sally die, the children decide they want to retain the home together.  Turmoil ensues when they cannot agree on a schedule for using the home, or when (and if) to make improvements to the property that one child can’t afford.  Eventually, bitterness develops between the children.

Meanwhile, the lawyer probating Harry and Sally’s estate discovers that significant federal and state estate taxes will be due.  Neither child has the money to pay the taxes.  Finally, they agree that the home must be sold.

CASE STUDY 2:  VACATION HOME—ESTATE PLAN

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

Bill and Linda consult an attorney experienced in estate planning and elder law, who helps them determine how the matter should be handled.  They decide to transfer the property to their two children now.  The children and grandchildren sign a Joint Venture Agreement that spells out how a manager will be elected, what powers the manager will have, how a 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 of the families.  Bill and Linda live four more years.  At their death, the vacation home is not included in their estate for either federal or state estate tax purposes.

WHAT ESTATE PLANNING ISSUES MUST BE ADDRESSED WHEN PASSING ON A VACATION HOME?

If you own a home in a vacation area, it may be one of your family’s most cherished possessions.  Your children may have fond memories of times spent there over the years.  And if your children are grown and married, with families of their own, the home may serve as the perfect location for enjoyable family reunions.

Yet, just as a vacation home can enhance family bonds, it can wreak havoc if parents fail to plan appropriately for the transfer of the property after their death.  Passing on a vacation home to children and grandchildren can raise complex issues regarding taxes, maintenance costs, and property management.  An attorney experienced in estate planning and elder law can help you consider such issues as the following:

• Federal Estate Tax. The exemption from federal estate tax is $13,610,000 per person. The tax rate for the excess of this amount is 35%. With planning, a married couple can transfer up to $27,220,000 in assets without incurring any estate tax consequences.
• Federal Gift Tax. Every individual is allowed to give $18,000 a year, per person, to any beneficiary or beneficiaries he or she selects. Individuals are entitled to give away $13,610,000 during their lifetime without gift tax consequences.
• Capital Gains Tax. Vacation homes purchased many years ago may have appreciated significantly in value. If and when the home is sold, there may be substantial capital gains tax due. Capital gains tax issues to consider include:
  • Carryover Basis. If a vacation home is transferred directly to children and/or grandchildren during the lifetime of the parents, the parents’ cost basis carries over to the children and/or grandchildren.
  • Step Up in Basis. When a property passes to children and /or grandchildren at the death of the parents, the cost basis in the property is adjusted (or “stepped up”) to the fair market value as of the date of the parents’ death. This may result in significant tax savings when the property is eventually sold.
  • 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 $500,000. This exclusion does not apply to a vacation home that is not a primary residence.

• 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 for state estate tax purposes, if applicable.
• Nursing Home Claims. If one spouse becomes ill and needs Medicaid to cover medical expenses, Medicaid will require that the vacation home be sold and that the proceeds be used to pay for care.
• Creditor Protection. Certain forms of ownership offer protection from creditors.
• Parents must decide if they want to retain control of the property during their lifetimes.

WHAT STRATEGY WILL HELP YOU ADDRESS THESE ISSUES?

There are many answers to this question, depending on your unique situation.  An attorney experienced in estate planning and elder law can help you carefully review your overall situation and determine the best strategy for passing on your vacation home.  Alternatives include the following:

• Making a lifetime outright gift of the home to your children and/or grandchildren.
• Transferring the home during your lifetime but retaining a life estate.
• Transferring the home during your lifetime, but retaining a right to use and occupy.
• Establishing a Family Limited Liability Company (LLC).

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF VARIOUS STRATEGIES?

 Lifetime Outright Transfer

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

• • Advantages
    • State Estate Tax. Transferring property to children can remove the asset from the estate for state estate tax purposes.
    • Estate Tax Freeze. Future appreciation of the value of the property is not taxed to the parents.
    • Transfers cause a period of ineligibility, but after a certain period of time, eligibility can be established.A lifetime outright transfer accelerates eligibility.
    • Creditor Protection. Achieved for transferor unless transferor has existing creditor problems.

• • Disadvantages
    • Federal Estate Tax.
    • Federal Gift Tax. Limits the amount that can be transferred without incurring gift tax.
    • Principal Residence Exclusion.
    • Step Up in Basis.
    • Valuation Discount. Not available.
    • Lost.

 Transfer Home and Retain Life Estate

• Mechanics. Transfer the home by deed to children and/or grandchildren, but reserve the lifetime right to live on the property, receive a portion of proceeds if the property is sold, and receive rents.
  • Advantages
    • Step Up in Basis. Upon death.
    • Transfers cause a period of ineligibility, but after a certain period of time, eligibility can be established.Transferring the home and retaining a life estate accelerates eligibility.
    • Creditor Protection. Achieved for transferor unless transferor has existing creditor problems.
    • Control. Maintained.
  • Disadvantages
    • Federal Estate Tax. The full value of the property is included in the parent’s estate.
    • Federal Gift Tax. Limits the amount that can be transferred without payment of a gift tax.
    • State Estate Tax. The property is included in the parent’s estate.
    • Capital Gains. The principal residence exclusion is lost with respect to the interest transferred to the children.
    • Estate Tax Freeze. Not available.
    • Valuation Discount. Not available for tax purposes.

 Transfer Home, Reserve Right to Use and Occupy

• Mechanics. Transfer the home by deed to children and/or grandchildren and reserve the right to use and occupy the home, but not the right to receive rent or any portion of the proceeds if the property is sold.
  • Advantages
    • Medicaid. Transfers cause a period of ineligibility, but after a certain period of time, eligibility can be established.Transferring the home and reserving a right to use and occupy accelerates eligibility.
    • Step Up in Basis. Upon death.
    • Creditor Protection. Achieved for transferor unless transferor has existing creditor problems.
    • Control. Maintained by written agreement.
  • Disadvantages
    • Management. An agreement must be developed.
    • Federal Estate Tax. The property is included in the parent’s estate.
    • Federal Gift Tax. The property is included in the parent’s estate.
    • State Estate Tax. The property is included in the parent’s estate.
    • Principal Residence Exclusion.
    • Estate Tax Freeze. Not available.
    • Valuation Discount. Not available for tax purposes.

 Family Limited Liability Company

• Mechanics. The business purpose of a limited liability company (LLC) is ownership and management of the real estate.All members have a right to elect managers to govern the LLC. The property is deeded to the LLC, and shares or percentages of the LLC are either given to or purchased by the children and /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 Discount. For gift and estate tax purposes, the value of the property is less than its fair market value because it is held in a family LLC.
    • Estate Tax Freeze.
    • Medicaid. Transfers cause a period of ineligibility, but after a certain period of time, eligibility can be established.Use of a family LLC may accelerate eligibility.
    • Creditor Protection. Achieved for transferor unless transferor has existing creditor problems.
    • Control. Maintained.
  • Disadvantages
    • Federal Gift Tax. Applies
    • Capital Gains Tax. Applies
    • Personal Residence Exemption. Lost, if applicable.

WHAT MANAGEMENT ISSUES NEED TO BE ADDRESSED?

Regardless of the estate planning strategy selected, family members should enter into a Joint Venture Agreement, an Operating Agreement, or a Partnership Agreement that addresses issues such as the following:

• Making a lifetime outright gift of the home to your children and/or grandchildren.
• What schedule will apply for use of the property, e.g. who gets 4th of July weekend?
• Will the property be rented out and /or used by non-family members?
• What rules will apply for use of the property, e.g. will pets be allowed?
• How will routine expenses, such as taxes and insurance, 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 will happen if a family member fails to contribute toward expenses?
• Will a manager be selected and, if so, how?
• What procedures will be used to resolve disputes?

 

Strategy	Federal Estate Tax	Federal Gift Tax	State Estate Tax	Capital Gains Tax	Principal Residence Exclusion	Estate Tax Freeze	Discounted Gifts	Accelerates Medicaid	Creditor Protection	Control
Outright Gift	Neutral	Limiting	Advantage	Disadvantage	Lost	Yes	N/A	Yes	Yes	Lost
Life Estate	Neutral	Limiting	Neutral	Depends	Partial	No	No	Yes	Yes	Agreement
Use and Occupy	Neutral	Limiting	Neutral	Depends	Lost	No	No	Yes	Yes	Agreement
LLC	Reduced	Applies	Reduced	Disadvantage	Lost	Partial	Partial	Yes	Yes	Agreement