Planning for Family Vacation Homes
| Citation | Vol. 14 No. 3 |
| Publication year | 2008 |
| Author | By Nancy G. Henderson, Esq. and Kristen E. Caverly, Esq. |
By Nancy G. Henderson, Esq. and Kristen E. Caverly, Esq.*
As many as 13 percent of all homes purchased in recent years may be second homes acquired primarily for personal use, such as weekend and holiday retreats or family vacations. Many vacation-home owners hope to pass their properties on to their children or other family members. This article addresses the challenge of planning for such gifts, beginning with a consideration of some of the taxes that affect gifts of real property.
For most clients, the federal estate tax is the primary impediment to transferring a valuable property to children and grandchildren. Since EGTRRA 2001, state inheritance taxes may also be a concern. Gift taxes are another worry, as is the generation-skipping transfer tax. The problems these transfer taxes create are not peculiar to gifts of vacation homes, however, and other authors have done them justice. This article therefore, while addressing the basic transfer tax issues involved (see Section IV), will also address those taxes of particular concern to transfers of real property - income, capital gain and property taxes.
A. Income and Capital Gains Tax
Treasured family properties are often held for a long period of time and therefore may be highly appreciated. As a result, when planning the transfer of such a property, the planner must balance the estate tax savings inter vivos gifts may offer against the loss of the basis step-up available if the property is included in the owner's gross estate at death.1 Further, any strategy that contemplates a sale of the property, other than a sale to a defective grantor trust2 or a sale taking place during postmortem administration (after the property has secured a new tax basis), will generate capital gains and possibly the recapture of certain income tax deductions taken by the seller if the property was at any time held for the production of rental income.
When planning for a property the donor uses as a principal residence, the planner should consider the impact the transfer might have upon the availability of the $250,000 capital gains tax exclusion for the sale of a principal residence.3
Encumbered property also presents income tax considerations. First, a transfer of encumbered property to a trust, to a partnership, or to a limited liability company could impact the ability of the donor to deduct payments of mortgage interest as the property may no longer be treated as the donor's personal residence. In addition, if the debt is assumed (or deemed to be assumed) by the donee, the transfer could generate capital gains tax to the donor.
A final income tax consideration is whether the property will be maintained as an investment property or as a personal use property, a distinction that affects income tax deductions for such ongoing expenses as repairs, maintenance, advertising, cleaning fees, utilities, and depreciation. Although a detailed discussion of the rules concerning these deductions is outside of the scope of this article, the planner should understand how the donor has treated the property for income tax purposes in the past and should contemplate how the gift strategy will affect the deductibility of the expenses for owning and maintaining the property.4
B. Property Tax
In many states, property tax value is not impacted by conventional estate planning for real property. However, some states provide exclusions or reductions in property tax value for certain owners (such as senior citizens or disabled individuals) that may be sacrificed if the property is transferred to children, to trusts, or to a family-owned entity such as a family partnership or LLC. This is particularly true in California, where Proposition 13 limits the ability of county tax assessors to revalue property unless and until there is a "change of ownership" in the property or some other event permitting reassessment (such as construction of certain types of improvements to the property).5 In California, the property tax value of real property can be dramatically lower than the actual fair market value. Further, in certain circumstances, it is possible to preserve the favorable property tax basis of California real property, in whole or part, when transfers are made between parents and chil-dren.6 Therefore, whenever engaging in succession planning for California real property, it is critical to consider the impact of the plan upon the property tax and to consider options that could preserve a favorable property tax basis for the next generation.
Succession planning for a valued family property should be approached with careful and detailed consideration of all relevant facts. Family homes are unique assets in estate planning; they are associated not only with significant monetary value, but often represent sentimental value to the donor and the donor's family as well. Family homes, unfortunately, also carry burdens in the form of management and ongoing expenses. Further, the very use of the property by family members can become burdensome if it creates disputes among family members regarding use of the property, involves expensive travel to reach the property, or will require working family members to consume limited personal vacation time to make use of the property. Finally, family members may have conflicting feelings about the property. If these issues are not considered in the planning process, even the best tax plan for the property can ultimately be a wasted effort. It is therefore important to first conduct a feasibility study to determine whether it is reasonable or practical to plan to preserve a particular property, and, if so, what issues must be addressed in order to accomplish the successful transition of the property to the next generation.
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While the scope of a feasibility study will certainly be driven by the size of the property, and its importance in the context of the client's overall estate plan, in nearly every case the study will help identify planning issues that would otherwise have been overlooked and could be much more difficult to address after the donor's death. Further, as its name implies, both the client and the advisor should approach the feasibility study with the understanding that they may conclude that preserving the property for the next generation is not a practical objective.
A. First Step: Understand the Significance of the Property as an Estate Asset
Determining the relative significance of the property in the overall estate plan requires examining all of the donor's assets and determining the value of the property relative to the value of the entire estate. Even if the economic value of the property is not significant, the sentimental value of the property needs to be considered. Some members of the next generation may have a deeper connection to the property than others. If so, rather than leaving the property to all of the donor's children, a better plan might be to leave the property to those children who are interested in retaining the property. Such planning, however, can create resentment, either because certain family members feel they are being unfairly excluded, or because the family members who would inherit the property may feel that other family members stand to get more valuable assets (such as income-producing property).
B. Second Step: Identify and Understand the Nature of the Property
The second step in the feasibility study is to understand the nature of the property itself. Are there are any legal impediments to a succession plan?
The following summarizes a number of property types or characteristics and the legal and practical issues to which they give rise. Importantly, a particular vacation property could possess several of the following characteristics.
1. Single Family Residences and Condominiums
The most common form of vacation property is the single-family residence. Important in planning for such a property is whether the property is part of a homeowners' association or is subject to a zoning ordinance restricting the use of the property as a vacation home. For example, CC&Rs may require the property to be owner-occupied, may prohibit "transient" use, or may prohibit renting the property.
2. Long-Term Leaseholds
Occasionally, vacation home are constructed on land subject to a long-term leasehold (typically 99 years or more), rather than land the home owner owns. Before planning for such property, the planner must review the underlying lease agreement to determine the years remaining on the leasehold, as well as the rights and responsibilities of the lessor and the lessee when the lease ends. Commonly, the lease provides the lessee an option to renew the lease, either for the historic rental amount or some adjusted amount. It could, however, provide a reversion to the lessor, with or without compensation to the lessee for the value of his or her improvements.
3. Cooperatives
A vacation home could be represented by stock in a cooperative rather than a deed to real property. Planning for co-ops requires a review of the articles of incorporation, the bylaws, the CC&Rs, and other corporate documents to determine whether there are restrictions on ownership and use that could affect the plan for the property.
4. Multi-Parcel Properties
A vacation property may consist of a residence located on one of several adjoining (or otherwise related) parcels, some of which are undeveloped. Such multi-parcel properties present unique challenges and opportunities.
a. Can Parcels Be Sold to Pay Expenses and Taxes?
An important question presented by multi-parcel properties is whether one or more of the parcels could be sold to pay estate taxes or expenses without negatively impacting the desired use of the remaining property by the next generation.
b. Can Different Parcels Be Allocated to Different Children?
In some cases, the land has far greater value to...
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