Issue 21: 2012

SUCCESSION PLANNING

Saving the Family Cottage

Careful planning can help ensure a smooth — and tax-efficient — transfer of your family residence to the next generation.

Photo by Andy Ryan

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Family cottages, cabins, compounds and vacation homes are often special, cherished places. Many owners like the idea of keeping the property in the family and passing it down through multiple generations. This is a wonderful idea, but careful (and preferably early) planning to address potential gift and estate taxes and property management issues ? not to mention possibly thorny personal and family issues ? is essential to a smooth transfer of ownership and preservation of the family home as a source of enjoyment and treasured memories. This year, in particular, may be a uniquely advantageous time ? from a tax standpoint, at least ? to consider transferring your family residence.

The Gifting Options

The federal lifetime gift-tax exemption stands at $5.12 million for 2012, the highest it's ever been. (It's the same for estate and generation-skipping transfer, or GST, taxes.) Perhaps even more important, it's slated to drop to $1 million next year (as is the estate tax exemption, while the GST exemption would fall to $1.4 million). Whether this will actually happen is impossible to predict, but as the law stands now, making a gift of all or a portion of your family property this year can make good sense from a federal tax vantage point (only Connecticut imposes a state gift tax). For a married couple, the combined exemption of $10.24 million can cover a lot of house.

So how do you gift a residence? The seemingly most straightforward option, particularly given the sizable gift-tax exemption, is simply to gift an ownership interest in your property outright to your children or others you designate. Generally, all this requires is that your lawyer draft (and record) a new deed reflecting the new ownership percentages. Many states also require the filing of a real estate transfer tax form, even if no tax is due. One potentially cumbersome and expensive aspect to this strategy, especially if you transfer ownership in stages over time, is that it requires new deeds for each transfer and multiple recording fees. Moreover, this approach can be complicated if transfers are intended to be made to minor children, since they lack legal capacity to own real estate in their own names, a trust or custodial account provides an easy solution. Using the serial approach can provide tax advantages, since transferring noncontrolling fractional interests in a property makes it less marketable, and so the value of each gift can be discounted for gift-tax purposes.

Taxwise, it is a good year to consider gifting your family residence.

In many cases, gifting through a structure can make the most sense, particularly if you're giving the property to more than one child or among multiple generations. Usually, this means that you first transfer the property to a limited liability company (LLC) or family limited partnership (FLP), in return for ownership in that entity. Thereafter, you may choose to gift ownership interests in the LLC/FLP to family members, rather than ownership in the property itself. As a result, there is no need for a new deed every time there's a transfer. Beyond providing efficiency from a gift perspective, this approach has several practical advantages. These structures offer the ability to centralize control of the property in one or more managers (named by you), rather than with multiple owners. Not only can you name the managers and their terms of service, but you can also create management rotation among various family members at specific times. Who pays real estate taxes and carrying charges and who coordinates shared usage can be determined while minimizing the potential for discord. Such an arrangement can make the management and upkeep of the property much more straightforward.

Some property owners would nevertheless like to continue using the property for some time, even after giving away all or some of it to family members. This needs to be carefully thought out to avoid a hornet's nest of estate planning pitfalls. In some cases, retained use would be consistent with a retained ownership interest in the property; in other instances, it may be wise to pay rent for the use of the property. Either way, expert advice and counsel should be sought out.

Whether a transfer is made by direct gift or indirectly through an LLC or FLP, it is important to consider the loss of a step-up in tax basis. If the property has a low tax basis, that low basis carries over, and there could be some detriment to that ? although in some instances, this can be solved through appropriate planning. In any event, a stepped-up basis may not be important in the case of a vacation residence if you're expecting the property to remain in the family.

An effective transfer plan and use agreement aid in keeping your property within the family name.

Other techniques can be used to transfer a family residence. One popular method, particularly for those who want to keep using their property for some time, is a Qualified Personal Residence Trust (QPRT). The QPRT could offer significant leverage for gift-tax purposes, since the property's value is reduced by the value of the retained right to live in it during the term of the trust. Maybe you give the home to your children but keep the right to live in the house for the next 10 or 15 years (you must outlive the term; otherwise the value of the property comes back into your estate for tax purposes), at which point the property passes to your children outright or in further trust. But will you have to move out? Not necessarily. At the end of the term, the trust can be structured to continue for your children and also allow you to rent the property for its then-market-rental value. The bottom line is that such an arrangement reduces the value of the house for gift-tax purposes. It's an attractive way of transferring your house at a discount while retaining the right to live in it for the term of the trust.

One issue needs to be considered. Real estate values are generally well off their peak, so it's a good time to be gifting real estate. But interest rates are at record lows. When rates are low, the value of the retained use of the residence is also low. You have to run the numbers with your advisor to determine the best approach.

Beyond Taxes: Sharing the Property, Keeping the Peace

So you've handled the transfer of your property to your heirs from a tax standpoint. You've even managed to work out how you'll continue to use the property (if that's what you want). Now, the major issues often revolve around the sharing of the property. Decisions need to be made regarding collective use. Will all of the children or other owners use the property simultaneously? Who gets to pick first? Does it rotate each year? Who pays the expenses? Who decides on repairs? How is money gathered?

THE USE AGREEMENT: POTENTIAL ISSUES TO BE ADDRESSED Click to expand
THE USE AGREEMENT: POTENTIAL ISSUES TO BE ADDRESSED
  • Who can use the vacation home and when? How will you handle holidays? A rotating schedule?
  • Who is allowed to use the home? Stepchildren? Unmarried couples? Ex-spouses? Friends?
  • Who pays for what? Taxes? Other expenses?
  • Who chooses ? and pays for ? furniture and other matters of interior decoration?
  • What happens when maintenance/improvements are needed? What, if any, are the voting procedures? Who are voting members ? children, grandchildren?
  • What are the standards of conduct? Pets allowed? Smoking? Other matters of personal importance?
  • Who makes legal decisions?
  • What insurance coverage should be maintained? Who decides?
  • Can an interest in the property be sold? How? Are there buyout provisions?

To avoid conflict, it can be helpful to create a detailed written agreement about matters pertaining to the use and sharing of the property. This can be incorporated into the LLC documents, if you're using such a vehicle, but it can even be created as part of the gifting process if you've decided an outright gift is more appropriate. The point is to create a document that everyone agrees on before you really need one.

At every stage of this process, from the best way to transfer your property to grappling with high-emotion issues of property use and management, it is important to work closely with experienced planning professionals. Here at U.S. Trust, we have deep expertise in providing advice on the creation of trusts, LLCs, and other structures for gifting real estate, and we have long experience working through the complex details of property use agreements with our clients. In addition, the professionals of our Specialty Asset Management group manage a large number of beneficiary-occupied residences, vacation houses and second homes across the country, in addition to commercial properties. The bottom line? Creating an effective transfer plan, along with a clear and comprehensive use agreement, is the key to ensuring that your vacation home is enjoyed today and for generations to come.

IMPORTANT INFORMATION

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust, Merrill Lynch and its representatives nor its financial advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.