With the arrival of warm weather, you may be dreaming about
upcoming travels to a beach, lake or mountainside home. Whether you
are considering purchasing 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 some estate
planning issues to consider.
1. General Title Issues. After you've decided
to buy a vacation home, 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)?
There's no single correct answer. The right answer for you
will depend on your specific circumstances, and most estate
planners recommend clients consult with them about how to title
property before finalizing a purchase. General 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.1
For spouses purchasing property jointly, the law of many states
often defaults to a form of joint ownership with survivorship
rights unless otherwise specified. An advantage of this
"survivorship" ownership is that upon the death of the
first spouse, the property immediately and automatically passes to
the survivor without being subject to probate court proceedings.
The primary disadvantage is that if property passes automatically
to the surviving spouse, the decedent can't use this property
to take advantage of his or her remaining estate tax exemption
amounts.
2. If Your Vacation Home Is in a Different State.
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).
While ancillary probate is not bad in and of itself, structuring
your assets in a manner to avoid it may save time and expense in
the administration of your estate. One manner by which to avoid
ancillary probate was described above: holding property jointly
with rights of survivorship. A second option that may permit the
use of your remaining estate tax exemptions upon your death is to
hold your vacation home, as well as its tangible contents, in
trust. You can coordinate the trust's provisions with your will
and other estate planning documents and may retain the power to
change the trust's terms.
Remember that even if you make plans to avoid ancillary probate,
your vacation home and its contents may be subject to estate tax in
the ancillary state.
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 or
certain partners of limited liability companies (LLCs) or limited
partnerships (LPs) is limited to their investment in the LLC or LP.
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.
Depending on how the entity holding your vacation home will be
structured and whether there will be more than one owner of the
entity, there may be income tax consequences you should discuss
with your tax adviser.
5. Gifts of Vacation Homes in General. Similar
considerations apply to gifts of vacation homes as to gifts of any
other property. While the possibilities are too numerous to
describe at length here, a few examples are that 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 LP and then make gifts of those interests. If you are
married, you may be able to split your gift with your spouse.
Appreciation in the value of the home after the date of the gift
should escape the estate tax.
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.
Similarities aside, there are special opportunities with respect
to gifts of real property. If your domiciliary state imposes a gift
tax (such as Connecticut) but you have a vacation home in a state
that does not (such as Massachusetts), you may be able to make
gifts of interests in your vacation home without using your
domiciliary state gift tax exemption or generating a state-level
taxable gift. Regardless of state gift tax considerations, remember
that such gift would be subject to the federal gift tax regime
(meaning you would either have to use any remaining federal gift
tax exemption or pay gift tax). In addition, with gifts of real
estate it may be possible to reduce the value of gifts of certain
fractional interests in your vacation home by applying minority
interest discounts.
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. We often have special relationships
with vacation homes and hope our children, grandchildren and
generations beyond will continue to gather in and share the home in
years to come. Much of the time, this may not be feasible as
generations spread geographically, diverge economically or prefer
to acquire a new vacation home. Other times, it's worth
planning for the complexities of multigenerational joint ownership
of property, leaving the decision to future generations.
One strategy is to transfer the vacation home to an LLC. The
LLC's operating agreement could provide general mechanisms for
managing and maintaining the property, and for more specific issues
that come up such as scheduling use by family members and perhaps
others, raising funds for improvements, withdrawing from the LLC,
restricting transfers of LLC interests to family members only and
requiring a supermajority or unanimous consent of the members to
sell the property outside the family. Senior generations (be it you
or, down the road, your children) may give, sell or leave LLC
interests under their estate plans to their children and may retain
control over the LLC's management by acting as its managers.
There may be differing gift and estate consequences of each
decision.
Another option to encourage the continued ownership and use of
your vacation home by children and grandchildren is to leave a
"vacation home endowment" (and perhaps but not
necessarily the vacation home itself) to a trust for the benefit of
your family. The endowment trust could make distributions to family
members to help pay for the vacation home's property taxes,
maintenance and improvements, and perhaps even travel to the home.
It may, however, be difficult to create a large-enough endowment,
especially considering that unless you allocate your
generation-skipping transfer (GST) tax exemption to the endowment
trust, the assets may be subject to GST tax at each generational
level.
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.
9. If You're Interested in Preserving Your Property
for Charitable or Historic Purposes. Under real estate
law, you can perpetually preserve and protect your vacation
home's natural features by negotiating and giving a
"conservation easement" to a charity or governmental
entity. Because doing so restricts the ability of future owners of
your vacation home (as well as you) from significantly altering the
property, such easements reduce its value and thereby may reduce
the cost of transferring it to your children.
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.
Footnotes
1. The current federal exemption amount is $5.12 million. In 2013, the federal estate tax exemption is scheduled to revert to $1 million unless there is a change in the law. Current state estate tax exemption amounts vary, with Massachusetts' and New York's being $1 million and Connecticut's $2 million.
www.daypitney.comThe content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
