Estate Planning for the Vacation Home

 

 

I.              INTRODUCTION.

A.           The Parents’ Dream.  Many people who own a vacation home dream that their children and grandchildren will keep the home in the family forever and that this special home will continue to be a source of family unity and enjoyment.

B.           Some Dreams Come True…  Our goal is to help clients determine if there is any possibility that the dream can come true.  If so, how do we structure the plan to achieve it?

II.            PRELIMINARY CONSIDERATIONS.

A.           Does the family get along?

B.           Which family members are involved with the home?

1.            Everyone participates in use.

·        Can they afford their share of the upkeep?

·        Will they contribute their efforts to the maintenance and work involved?

·        Will they follow established or agreed upon rules for use?

2.            Only some children participate due to interest, location, time, etc.

·        Consider leaving other assets to the non-participating children.

·        If there are insufficient assets to equalize, consider leaving the home to the participating children if they obtain a mortgage or other funding to pay off the non-participating children.

C.           Should the transfer of the home occur at death or during the life of the parents?

·        Do the parents need financial assistance?

·        Do the parents need physical assistance with the home?

·        Do the children use the home more than the parents?

·        Do the parents have an estate where they need to minimize estate taxes at death?

III.           CORE ISSUES TO COVER IN THE GOVERNING DOCUMENT.

A.           Terms of use generally – Who may use the property and under what circumstances?

1.            Exclusive or shared use?

2.            How is use determined – by calendar, informal communication, set schedule?

3.            Only children or extended family members?

4.            What about companions or significant others?

B.           Expenses.

1.            Who controls the checkbook?

2.            How is money collected?

3.            Is there a written budget and reporting?

4.            What if the manager is not handling his/her responsibilities?  Can he/she be changed – how?

C.           Sale of property and buy/sell provisions.

1.            Should a family member have an option to sell or is the interest in the home merely the right to use the home (no transferable value)?

2.            Consider allowing a family member the right to be bought out or to force the sale of the home if no one will buy him/her out.

·        Circumstances can change due to divorce, death, financial hardship, family disharmony, etc.

3.            Include provisions for failure to abide by the rules of operation or failure to contribute – consider giving the other children the right to buyout the violator.

4.            Include provisions for the death of a child – can the child leave his or her interest in the home to his/her family or should there be an option for other participants to buyout the deceased child’s interest?

5.            Include buyout provisions if a child has creditor issues or files bankruptcy.

D.           Remodeling – Who can make decisions to remodel or improve?  Majority or unanimous decision?

IV.          ESTATE AND GIFT TAX CONSIDERATIONS.

A.           Estate tax.

1.            Federal exemption (per person)

YEAR

EXEMPTION

2005

$1,500,000

2006-2008

  2,000,000

2009

  3,500,000

2010

   Unlimited

2011

  1,000,000

 

2.            Wisconsin’s exemption is $675,000 per person through 2007.

3.            Assets transferred at death have a stepped-up basis.

B.           Gift tax.

1.            Annual exclusion gifts – Outright gifts of $11,000 per donee are exempt from gift tax.

2.            Gifts in excess of the annual exclusion are exempt from gift tax up to a total of $1,000,000 but are added back in for estate tax purposes.

3.            Assets transferred by gift have a carryover basis.

V.           POSSIBLE FORMS OF OWNERSHIP FOR THE FAMILY HOME.

A.           Co-ownership among individuals.

1.            Tenants in common.

a)            Undivided interest in the whole property.

b)            Can transfer interest during life or at death.

c)            Subject to claims of creditors (joint and several).

d)            This is the classification of commonly owned real estate absent wording indicating survivorship.

2.            Joint tenants.

a)            Undivided equal interest.

b)            Passes automatically to the surviving joint tenant(s) at death.

c)            Can transfer interest during life.

d)            Subject to claims of creditors (joint and several).

B.           Trust.

1.            Example – Parents leave their summer home in trust for their 4 children and numerous grandchildren.  The parents’ primary goal is to keep the home in the family for whoever wants to use it.  The parents recognize that some children/grandchildren will benefit more than others but that is of lesser importance to them.

2.            Concerns.

a)            The trust needs to include liquid assets to pay expenses or provide another mechanism for obtaining the funds.

b)            The trustee has a difficult role in balancing the beneficiaries’ interests and may face some fiduciary liability without exculpatory language in the trust.

c)            Need to include a termination date for the trust.

d)            Need to include provisions for selling the home if inadequate resources or interest in the property.

e)            Generally can’t use annual gift tax exclusions to minimize tax.

C.           Family Limited Partnership or Limited Liability Company (LLC).

1.            Provides a vehicle to transfer assets while retaining control.

a)            Parents can retain control.

b)            Business model is more commonly understood than a trust model.

c)            Interests of children are generally restricted in some manner.

2.            Consolidate ownership.

a)            The LLC keeps the ownership of the home in an entity – avoids fractional interests among numerous people.

b)            Allows for coordinated management of the home and avoidance of administrative difficulties.

3.            Facilitates gifts.

a)            Interests in the LLC can be easily gifted to family members – avoiding multiple deeds of fractional interests.

b)            Annual exclusion gifts can be made as well as larger gifts using the lifetime gift exclusion.

c)            In some situations, the transferred interests may qualify for discounts for gift/estate tax purposes due to lack of marketability or minority interest.

4.            Protection from creditors and failed marriages.

a)            Creditors do not become members - rather they are usually assignees who can receive distributions, if made, but otherwise not much else.

b)            The LLC agreement can contain provisions triggering a buyout if a child’s interest is involuntarily transferred to a creditor.

c)            The LLC agreement can provide protection in the event of a divorce by triggering a buyout of the ex-spouse.

d)            The LLC provides protection in the event of a divorce because the LLC agreement provides a convenient means of insuring the child does not co-mingle his/her individual property with the spouse.

5.            Flexibility.

a)            Can be modified or amended.

b)            Can be terminated.

6.            Example –

·        Mom and Dad have a summer cottage appraised at $200,000 which is rapidly appreciating.

·        Mom and Dad have 3 adult children.

·        Mom and Dad create the Smith Family, LLC and transfer the cottage to it.

·        Mom and Dad then transfer a 10% member interest in the Smith Family, LLC to each of their children using their annual gift tax exclusions.

·        Mom and Dad file gift tax returns on the transfer even though they are not required to in order to start the 3 year gift tax statute of limitations running.

·        The Smith Family LLC provides the following:

o   The LLC is managed by Mom and Dad until their resignation, incapacity or death.  At that point, child 1 is designated as the manager.

o   The manager is to provide a budget each year and notify the members regarding the assessment for expenses required for the year.

o   If a member fails to pay the assessment, use of the property is suspended and interest accrued.

o   A member has the right to be bought out after the death of Mom and Dad or force the sale of the home.

Note:  If Mom and Dad have exclusive use – they will need to pay rent.

Result:  Assume Mom and Dad continue with the gifting program and at their death only retain a 10% interest in the LLC.  The home has appreciated to $400,000.  Only 10% will be included in their estates for estate tax purposes and $360,000 will have passed to the children tax free.

D.           Qualified Personal Residence Trust (“QPRT”).

1.            Concept – Mom and Dad transfer the home to a QPRT. The QPRT provides that Mom and Dad keep the right to live in the home for a certain number of years. At the end of the term the children own the home.  The primary goal is to transfer the home to the children at a very discounted value for gift tax purposes.

2.            Requirements.

a)            A QPRT is an irrevocable trust meaning that it cannot be changed.

b)            The only permitted assets are 1 residence (or a fractional interest in 1 residence) and cash in very limited situation.

·        An individual may only have 2 residences in QPRTs at any time – his or her principal residence and 1 other residence but they must be in separate QPRTs.

·        An “other residence” can include a property used by the donor at least 14 days of the year or if greater, at least 10% of the number of days it is rented out.

·        The residence may include adjacent land not in excess of that reasonably appropriate for residential purposes.  Factors to include in determining if a property will qualify include:

o   Compare lot size to neighbors.

o   Actual use of property for residential purposes – hiking, wildlife watching, etc.

o   Long-term treatment of property as residence.

o   Is there more than 1 tax parcel?

·        Residences subject to a mortgage are a problem because principal payments on the loan constitute additional gifts to the QPRT.

o   If the Grantors must retain a mortgage, convert to an interest only loan.

3.            Term of QPRT – The Grantor of the trust retains the right to live in the home for a certain period of years.  The goal is to set the term as long as possible but with reasonably certainty that the Grantor will survive the term.

·        If the Grantor does not survive the term, the residence reverts to the Grantor’s estate and there is no tax savings.

·        May use different terms for spouses with significant age differences (this will require a separate QPRT for each spouse).

4.            Operation of QPRT.

a)            The Grantor pays all expenses during the term of the QPRT.

b)            A QPRT is a “Grantor Trust” for income tax purposes.

·        No EIN is required.

·        The Grantor continues taking income tax deductions for the property taxes.

·        The Grantor continues to be eligible for exclusion of gain on the sale of a primary residence.

c)            Improvements during the term of the trust constitute additional gifts.

5.            Termination of QPRT.

a)            At the end of the term, the home passes to the named beneficiaries or trust(s) for their benefit.

b)            The Grantor may then lease back the home if desired or even buy the home back.

·        Lease must be fair market rent – obtain written documentation if possible.

6.            Tax Issues.

a)            The value of the gift is determined by using the applicable federal rate (§7520 rate) and IRS tables.

·        Basically, the value of the gift to the children is the value of the property less the parent’s retained use of the property and the value of the possible reversion of the property to the parent (if he dies during the QPRT term).

·        The higher the interest rate, the smaller the gift.

·        The longer the term, the smaller the gift.

b)            A gift tax return must be filed for the creation of the QPRT disclosing the gift.

·        An appraisal of the property is required.

·        If a fractional interest discount is taken, written documentation of that is also required.

c)            All appreciation on the property avoids gift or estate taxation.

d)            The children receive a carryover basis in the property.

7.            Examples:

a)            Tom and Debbie (ages 55 and 50 respectively) each set up a QPRT and contribute 50% of their Lake home to his or her respective trust.  Assume that the residence is worth $700,000 and that each spouse can discount the value of a 50% interest in the residence by 10%.  Further assume each spouse retains the right to live in the residence for 15 years.

Tom

Value of 50% interest in residence (after 10% discount)   $315,000

Amount of gift (calculated by using IRS tables)                 $127,695

 

Debbie

 

Value of 50% interest in residence (after 10% discount)   $315,000

Amount of gift (calculated by using IRS tables)                 $153,468

 

Result:  Tom and Debbie can transfer an asset worth $700,000 to their children by using only $281,163 of their combined estate tax exemption.  In addition, all future appreciation in the residence is removed from their estate.

b)            Assume the same facts as above except that Tom only retains the right to use the home for 13 years (to age 68) and Debbie retains the right for 17 years (to age 67).

 

Tom: 

Value of 50% interest in residence (after 10% discount)  $ 315,000

Amount of gift (calculated by using IRS tables)                $ 146,664

 

Debbie:

 

Value of 50% interest in residence (after 10% discount)  $ 315,000

Amount of gift (calculated by using IRS tables)                $ 121,502

Result:  Tom and Debbie can transfer an asset worth $700,000 to their children by using only $268,166 of their combined estate tax exemption.  In addition, the likelihood of both spouses surviving the respective terms is greater.

This document provides information of a general nature.  None of the information is intended as legal advice.  Additional facts and information or future developments may affect the subjects addressed in this document.  You should consult with a lawyer about your personal circumstances before acting on any of this information because it may not be applicable to you or your situation. 

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