A common question that arises when someone is trying to organize their estate is, “How exactly should I plan for a second home or vacation home and how is it different from planning for my primary residence?”
If you own a vacation home or second home, or you are planning to purchase another home, there is a good chance you want to maintain that property and pass it on to your loved ones. In order to accomplish this objective in the least expensive and most efficient way possible, you need to be proactive and engage in strategic estate planning now, not later.
Before getting into the proverbial “weeds” about how to title your second home or the best option for transferring ownership, a preliminary question you need to get answered is whether the next generation even wants to maintain ownership over the vacation home or second home after you pass away. Addressing this issue now is extremely helpful for planning your estate. If, for example, you discover that your children or relatives would be more inclined to sell the home rather than use it for family functions, the decisions you make on how to incorporate the second property in your estate plan will be impacted.
The dynamics within your family, such as rivalries among sibling rivalries, contentious relationships between your spouse and your children, disinterest in retaining and using the second home or vacation home, etc., can result in potential conflicts and costly litigation. Instead of a family vacation home keeping the next generation connected with one another, it can have the unfortunate effect of ripping at the fabric of the family. As a result, take the time to have a candid discussion with your loved ones about their preferences in keeping the vacation home or second home in the family. This discussion should also address who would take on the responsibility of actually maintaining the property (e.g., paying the utility bills, performing routine maintenance, paying property taxes, etc.).
If your family discussions indicate that your loves want to keep the vacation home or second home within the family, there are an array of planning options to consider. For example, if you want to reduce your potential estate taxes, consider gifting the vacation home or second home during your lifetime to the next generation.
Depending on the number of loved ones that comprise the next generation and the overall value of the vacation home or second home, gifting can be accomplished on either an incremental basis or all at once. For either scenario, make sure to use the annual exclusion for taxable gifts. For 2022, the annual gift exclusion is $16,000 per donee, per year.
However, before you proceed with gifting your second home or vacation home, you need to determine the ownership structure for the next generation to maintain the property, such as:
- Outright ownership transfer
- Placing ownership of the second property in a trust
- Forming a limited liability company (LLC)
Outright transfers of fractional shares of a family vacation property, or second home, is considered to be simplest estate planning strategy for gifting a piece of property to loved ones. However, it is important to note that this strategy is lacking in that it fails to provide any structure for the actual management and oversight of the property by members of the next generation. As a result, it create the risk that ownership of the property will be transferred, but the second home or vacation home will be neglected and diminish in value.
Depending on the value of the property and the potential tax ramifications of full transfer of ownership, you may want to consider creating a Qualified Personal Residence Trust (QPRT). This is a mechanism by which you can transfer ownership of your second home or vacation home to the next generation through this specialized irrevocable trust.
There are an array of benefits associated with a QPRT. One of the biggest benefits is that a QPRT effectively removes the value of the second home or vacation home, and all future appreciation, from your taxable estate. For example, let's say the vacation home is valued at $500,000. Depending on interest rates, your age, and the retained income period chosen for the QPRT, you could use as little as $100,000 of your lifetime gift tax exemption, to remove a $500,000 asset from your taxable estate, according to The Balance. This is particularly beneficial if the value of the house increases by a significant percentage by the time you pass away.
|Advantages of a QPRT||Disdvantages of a QPRT|
|Tax benefits||Not as flexible as a family-run LLC|
|Asset protection from creditors||Third party "outsider" empowered to make decisions about the property|
|Allows you to continue using the home during your lifetime||Inability to amend terms of irrevocable trust|
Another benefit is that you are allowed to continue using the residence, even after transferring ownership to the QPRT. This is allowed due to the retained income period of the QPRT. You can continue utilizing the residence rent-free and may take all applicable income tax deductions.
A QPRT is an effective strategy for tax planning purposes. However, this form of ownership for a second home or vacation home has some potential pitfalls you need to be aware of. First, there is the risk of losing the transfer tax benefits if the grantor does not outlive the QPRT term. If this were to occur, the second home or vacation home would be brought back into the grantor's estate at death. Second, since a QPRT is an irrevocable trust, it means that the terms of the trust cannot be amended.
Third, all decisions about the property will be made by a designated trustee who will need to be someone outside of the immediate family. As a result, a QPRT does not provide much in terms of flexibility for managing a vacation home. Finally, a QPRT should be considered only in cases where the family is fairly certain that, for the foreseeable future, they wish to keep the property in the home rather than try to sell it.
Another planning strategy to consider is establishing a family-run LLC. This can be an effective way to transfer a family vacation home or second home to the next generation in the form of membership interests within the LLC.
Generally, this type of interest is gifted over a period of years, using the annual exclusion for taxable gifts. Because the gifted interests represent only a portion of the underlying property, and because there are often restrictions on transferring the interests, reasonable discounts in the valuation of the interests can result in a reduction in the overall value of the gift (providing greater flexibility in the gift transfers).
In addition, if the second home or vacation home is located in a state other than the state of your primary residence, and you do not gift all of your interests in the LLC during your lifetime, you still avoid the costly and inefficient probate administration upon your death. Why? Because your second home or vacation home would no longer be considered “real estate” for the purposes of probate administration.
Another benefit of establishing a family-run LLC for your second home or vacation home is that it provides a flexible framework for transferring the property to your loved ones than outright fractional shares or a QPRT. This is primarily due to the fact that LLC documents generally include an operating agreement. The operating agreement typically serves as a blueprint for managing the second home or vacation home, which can be modified over time to address an unexpected change in circumstances.
Generally, an LLC operating agreement will designate managers for the property (usually members of the LLC) who are then empowered to take the following actions:
- Collect “dues” from members
- Paying carrying costs
- Make important decisions regarding home repairs
- Scheduling use of the vacation home or second home by members
- Renting the vacation home or second home to generate additional income
Another benefit is that most operating agreements include protocols for a member to transfer their membership interest, as well as for the LLC to sell the property if a majority of its members desire to do so.
A drawback to creating a family-run LLC is that establishing ownership over the LLC requires a level of upfront expense, along with the administrative burden of having to complete annual filings of partnership income tax returns and possibly state registration fees.