Generation to Generation

The greater the monetary value and appreciation potential of a second home, the greater the challenge of preserving it in the face of federal, state, and local taxes can be. Families must confront the reality of generational mobility and the desire (or lack thereof) to share ownership in - and financial responsibility for - the home. Because all of the strategies available to you will offer unique approaches to preserving access and enjoyment of vacation properties for whomever and whenever you’d like, all family members should be consulted before any final decision.

While your first instinct may be to view the future with rose-colored glasses, don’t. It’s okay to be both realistic and sentimental throughout this process. Although leaving real estate to your family without structure might seem appropriate now, lack of planning for such a large portion of your estate might sour the legacy you hope to create. Circumstances change, relationships evolve (or devolve), and marriages end. You may not be able to predict the future, but you can shape it now with some thoughtful estate planning.  What follows is a brief overview of four estate planning strategies at your disposal:

1. Outright Transfers

A complete one-time gift of the property to children and/or grandchildren offers simplicity but may involve a large taxable gift.  To keep the property out of the donor’s estate, the donor must pay fair market rent for any post-gift use of the property. Advantages: straightforward, unencumbered ownership. Disadvantages: eats up federal gift tax exemption, lacks decision-making structure, no donor control, no creditor protection.

• Variation #1 - Realty Trusts

  In some jurisdictions, realty trusts (or “nominee trusts”) allow owner(s) to hold property in trust and recorded under the trustee’s name with the Registry of Deeds.  Beneficiaries have beneficial ownership, but the trustee(s) hold the legal title.  The trust holds the property until it’s terminated by a unanimous vote of the beneficiaries. Advantages: allows anonymity, clearly defines interests, simplifies transfer process, small percentages may be given over a period of years, possible gift tax valuation discounts. Disadvantages:  inflexible, may only hold real estate, no creditor protection.

• Variation #2 - Gifts of Fractional Interests Over a Period of Years

  In other jurisdictions, a series of gifts of fractional interests can be used to reduce the gift tax impact and permit continued use by the donors in accordance with their retained fractional interests. Advantages:  smaller gifts, possible gift tax valuation discounts. Disadvantages:  multiple deeds and recording fees, no creditor protection.

• Variation #3 - Gifts as Tenants in Common

  Each owner has the right to use the entire property, and co-tenants must unanimously agree to major decisions (renovations, leasing, sale, and partition). Advantages:  uniform access and rights to property. Disadvantages: unstructured ownership, lack of governing documents, no creditor protection, cumbersome partition process.

2. Family Limited Liability Company

An LLC comprised of family members provides structure and rules for who may be a member, the specifics of operation and use of the property, and provides protection against creditors, including divorcing spouses.  Some LLCs are managed by members; others have a designated “Manager.” Advantages: facilitates gifts of small percentage interests (including procedure for transfers at lower cost than deeds of real estate), continued existence, governed by state statutes, choice of jurisdiction, possible gift tax valuation discounts. Disadvantages: one-time and annual state filing fees, requires separate income tax return.

3. Gift to Qualified Personal Residence Trust (QPRT)

In a QPRT, a donor transfers a home (primary or secondary) into the new trust.  The trust exists for a defined term – i.e., 5, 10 or 15 years.  The donor continues to pay the carrying costs of the home, including real estate taxes.  At the end of the term, title to the home passes to the remainder beneficiary or beneficiaries.  Although the donor could continue to use the home after the termination of the QPRT term, he or she would need to pay the children fair market rent so that the taxing authorities recognize the completed gift (and wouldn’t seek to assess estate taxes on the home’s value at the donor’s death).  If the donor died during the term, the QPRT would “fail”, and the home would be included in the donor’s taxable estate.  The shorter the term, the less beneficial the tax result.   Longer QPRTs, although more tax advantageous, must be weighed against the possibility that the donor doesn’t survive the trust term. Advantages: maximizes federal gift tax efficiency, creditor protection for remainder beneficiaries, trust structure can include agreement for future use of home. Disadvantages: can be complicated if mortgage is involved, nothing gained if donor dies before stated term of trust.

4. Gift to “Grantor” Trust

A home can be gifted to an irrevocable trust treated as the donor’s “alter ego” for income tax purposes.  The trust structure can provide rules regarding sharing use and expenses among the beneficiaries.  A variant on this technique is a sale to a grantor trust in exchange for an installment note. Advantages:  spouse may be a beneficiary (permitting donor’s use during spouse’s lifetime), creditor protection, donor could buy home back without incurring capital gains tax. Disadvantages:  consumes portion of lifetime gift exemption; complicated if mortgage is involved.

Tips for Success

The good news: there are many options available when planning for the preservation of heirloom properties.  Naturally, certain options make more sense depending on the particular real estate and specific jurisdiction.  But there is only so much the law can do – don’t forget to identify your goals early and consider the following as you incorporate your second home into your estate plan:

• Family dynamics;
• Circumstances of beneficiaries;
• Possible exit options;
• Anticipated operating costs;
• Intended use and liabilities;
• Desire to keep tangibles and furnishings on the property; and
• Tax consequences for individual beneficiaries.

With some thoughtful planning and a pragmatic approach, you can preserve the property – and the wonderful memories – for years to come.