PLANNING FOR A VACATION HOME

by Thomas D. Begley, Jr., CELA

What Estate Planning Issues Must Be Addressed When Passing on a Vacation Home?

If the client owns a home in a vacation area, it may be one of the family’s most cherished possessions. The client’s children may have fond memories of times spent there over the years. And if the client’s 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 on them 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 the client consider such issues as the following:

• Federal estate tax. Estate tax rates start at 40%. The exemption from federal estate tax for 2024 is $13,610,000 per person. With planning, a married couple can transfer up to $27,220,000 in assets without incurring any estate tax consequences. The exemption is scheduled to be reduced on January 1, 2026, to approximately $5,500,000 or $11,000,000 for a married couple, indexed to inflation. With inflation, this may be somewhere around $7,500,000 or $15,000,000 for a married couple.
• Federal gift tax. Every individual is allowed to give $18,000 a year, per person, to any beneficiary or beneficiaries he or she selects. In addition, individuals are entitled to give away $13,610,000 during their lifetime without gift tax consequences.
• State estate tax. New Jersey has repealed its estate tax.
• State inheritance tax. New Jersey has an inheritance tax for beneficiaries who are not spouses or lineal ascendants or descendants. Pennsylvania has an inheritance tax.  There is no tax on transfers to a surviving spouse or to a parent from a child aged 21 or younger.  The tax is 4.5% on transfers to direct descendants and lineal heirs, 12% on transfers to siblings, and 15% on transfers to other heirs, except charitable organizations, exempt institutions, and government entities exempt from tax.
• 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 to children and/or grandchildren during the lifetime of the parents, the parents’ 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. Currently, when a property passes to children and/or grandchildren at the death of the parents, the cost basis in the property is adjusted (commonly referred to as “steps 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. It most cases this exclusion does not apply to a vacation home, since it typically is not the 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 the proceeds 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 lifetime.

Which Strategy Will Help Address These Issues?

There is no one answer to this question. An attorney can help the client carefully review his overall situation and determine the best strategy for passing on the vacation home. Alternatives include the following:

• Making a lifetime outright gift of the home to the client’s children and/or grandchildren.
• Transferring the home during the client’s lifetime but retaining a life estate.
• Transferring the home during the client’s lifetime but retaining a right to use and occupy it.
• Establishing a Qualified Personal Residence Trust (QPRT).
• Establishing a Family Limited Liability Company (LLC).
• Establishing a Family Partnership.
• Having the home transfer upon the client’s death.

What Management Issues Need to Be Addressed?

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

• What schedule will apply for use of the property (e.g., who gets the Fourth of July weekend)?
• Will the property be rented out and/or used by non-family members?
• What rules will apply to 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?