A number of my clients have family vacation homes or cottages that they and their children have enjoyed for many years. After getting so much enjoyment from owning the cottage those clients often ask how they can set up their estate planning documents to ensure that when they die, that ownership experience passes onto their children and grandchildren. While, in theory, this may be a good idea, it often creates significant problems if a not fully thought out and planned.
One issue that often causes an issue is the gift tax consequence of transferring a valuable piece of property. However, because of the most recent tax legislation, most people have a sufficient exemption amount so that gift tax is not an issue.
Transferring cottages to other family members can create thornier issues because of personal relationships. While family members may have enjoyed their time at the cottage, for many reasons they may have no interest in owning the cottage with their siblings or other family members. Issues that can arise include:
- What is the most efficient manner of ownership of the cottage?
- How to insure that the cottage remains in the "family"?
- How to establish rules for the management and use of the cottage?
Generally, traditional forms of joint ownership, such as tenancy in common and joint tenancy with rights of survivorship, are inefficient methods for family ownership of the cottage. The primary risk in these types of ownership is that over time the ownership interest is subdivided or fractionalized as it is passed down to subsequent generations. While it is the dream or wish of the parents that the children continue to enjoy the cottages they have in the past, as family members grow into adulthood they may have different ideas. A family member might not have had a great experience at the cottage, may live too far away to be able to enjoy it, cannot afford the share of the cottage expenses, or may simply prefer the value of the cottage in cash to use as they may choose. With tenancy in common or joint tenancy, a family member may try to use his or her partition rights under state law, forcing the sale of the cottage or vacation home.
Co-ownership of the cottage may lead to other conflicts, such as:
- Who controls the operation of the cottage?
- How are operating, maintenance or repair expenses shared?
- Who determines when and what improvements to make and how to pay for those improvements?
- How are the most desired dates for cottage use determined or allocated among family members?
- Are pets allowed?
- Can family members rent their time to third parties?
- Are nonfamily members, such as spouses and siblings, allowed to own an interest in the vacation home?
- What happens if a family member wants to sell his interest in the cottage?
While many of these issues do not exist while the parents are alive because the parents pay all expenses of the cottage and determine how it is used, after the death of parents, these issues and others can create family disagreements or even permanent rifts.
If the parents are still interested in trying to establish a "family cottage," a limited liability company (LLC) is an ideal ownership vehicle. An LLC has a perpetual existence. Parents can transfer the property to an LLC and then gift interests in the LLC during lifetime or at death to other family members. The LLC as an entity can protect owners from lawsuits by users of the cottage if injured on the premises. It can also prevent owners from being able to use the right of partition in order to sell the property. If used with a properly structured operating agreement, it can promote shared use and fair governance of the property.
It is possible to use an LLC operating agreement to meet the goals of the family, and should include:
- A determination of who is the manager of the LLC--all members or a named managing member.
- A procedure for determining what maintenance or improvement is to occur on the property and a method of allocating associated expenses.
- A method of equitably allocating among family members the dates for using the cottage, especially during holidays, school vacations and most ideal seasons.
- Rules for members using the cottage, including restrictions on allowance of pets, ability to invite guests, and the ability to rent out the member's time to outside parties.
- A method for penalizing a member for violation of usage rules and/or failure to pay the required contribution for expenses.
- A method for determining the transfer of member interests, including price and terms, for any member desiring to sell their interest. This could include a restriction on any sale to a non-family member.
While gift and estate taxes are unlikely to cause an issue, the consequences in regards to property taxes should not be forgotten when considering the transfer of a vacation home. Under Michigan law, if you convey less than 50% of ownership in real estate to others, there is no change in the property tax assessment rules for determining taxable value. Parents can gift up to 49% of the property to family members without any real estate tax consequence. If they prefer, the parents can first transfer the property to an LLC and then transfer 50% of the LLC to family members.
Because property values are still somewhat depressed, this is an opportune time to transfer the vacation property to family members and move value and future appreciation to family members and out of the parents' estate, while continuing to allow parents to maintain control of the asset.
While parents have the best interests of their family at heart, trying to maintain a vacation home in the family for a number of generations can create a nightmare scenario. It makes good sense to discuss this strategy with qualified counsel and the family itself to make sure there is sufficient interest to maintain the family cottage for future generations and to properly structure the transaction.