How to Ensure Your Vacation Home Feels Like a Vacation
You’ve always dreamed of a second home — a home away from home. It’s the place where you can leave behind work, household chores and errands, and just relax. But it may be hard to truly relax if you haven’t properly planned for owning another property.
Let’s suppose you have three siblings, and the four of you jointly own a house in Carmel Valley, Calif., overlooking the beautiful Pacific Ocean. You and your siblings generally get along, but your respective families are growing, so an increasing number of people use the house. And as you look down the road, you want to be sure you can transfer your interest in the house to your children while minimizing estate and property taxes. There are many things to consider to ensure that the next generations can maintain family harmony and keep this retreat for years to come.
We just recently helped a family in a similar situation where a vacation home held for more than 20 years was passed from three separate family members to the next generation of each of their immediate families. For them, we:
- Transferred the ownership interest into a trust to minimize gift, estate or generation-skipping transfer tax on future generations
- Created a limited liability company for liability protection
- Helped craft an LLC operating agreement that provides for family governance, payment of expenses, usage of property, and buy-outs of family members
- Structured transactions to avoid property tax reassessment
3 key considerations
Before you buy a second home, it’s important to consider key issues such as how the title will be held, dealing with multiple owners (if applicable) and possibly renting to non-owners.
When you purchase a vacation home, think about how the title will be held. For many people, it may be sufficient to own the property in your individual name or inside your revocable trust if there’s no concern of liability and no need to reduce potential estate taxes.
However, if you intend to rent out the property or have household employees, then you should consider owning the property in a limited liability company (LLC) to limit your exposure in case of a lawsuit. If you currently have or expect to have a taxable estate, then you may want to talk to a lawyer about owning the property in an irrevocable trust that is not subject to estate tax.
In each of these options, you should weigh the advantages and disadvantages. For example, before you decide to put the property into an LLC, you will want to consider things like the annual fee (in some states), gross receipts tax (as applicable), and LLC administration versus relying on an umbrella policy to cover potential liability.
For our clients, we transferred the property to an irrevocable trust. This way, the property is not subject to estate taxes when the parents and their kids die. It passes on to the grandkids using their generation-skipping transfer tax exemption.
In addition, if you’re transferring only a fraction of the property, as we did in this case, consider hiring an appraiser. You may be able to apply a discounted value since a partial interest is less desirable to a buyer.
2. Multiple owners
If you own a vacation home with others (whether family members or not), several potential complicating factors come into play. Depending on how title is held, certain aspects of ownership should be hashed out through a Tenants-in-Common Agreement or an LLC Operating Agreement.
Controversy among multiple owners often erupts over things such as how expenses get paid, who manages the property operations, who gets to use the property when, and what happens when one or more owners want to sell their interest.
In terms of expenses, there are standard expenses — property taxes, homeowner’s insurance, HOA fees, upkeep of major appliances, etc. — which presumably will be borne proportionately by the owners. Other expenses tie more closely to usage, such as utilities. The owners can decide at the outset whether all expenses will be pro-rata or if some will be paid by the occupant based on usage. It can also be helpful to provide consequences if a co-owner doesn’t pay expenses according to the agreement, for example, they don’t get to use the property until their share of the expenses is paid.
Debate among co-owners can also arise about the use of the property. If you have several owners who all want to use the home during peak seasons, such as summer and the holidays, how do you avoid fights and make things fair? You may want to maintain a family calendar and allow owners to sign up for a certain number of days during each season.
In our client’s situation, the property was originally owned by three siblings, but it’s passing down to their children’s families — so now there are 12 owners. We helped craft an agreement that named a manager of the LLC who oversees the calendar. It sets policy on the number of days and holidays each family member can use the property.
Selling interests down the road is another substantive issue, especially when it’s important that the property stays within the family. In the owner’s agreement, you may include provisions requiring the selling owner to offer their interest to certain existing owners, and then their immediate family, before others. You can also set offer terms, such as the price at which others can buy the selling owner’s interest and how that purchase price gets paid.
The takeaway is that the more mechanics that can be agreed upon up front by all owners, the less controversy and more enjoyment you’ll likely have down the road. It will help to set the expectations for future generations to follow.
3. Renting out your property
Many owners choose to rent out their vacation home when they’re not using it to offset some of the expenses. Or there could be multiple units that would be rented to staff and caretakers.
However, renting out a property, especially one that you use personally, is not hassle-free. You will want to consider the appropriate rental value, as well as the terms for renters. It’s good practice to get a signed contract from any short-term or long-term renters so the cost and expectations are agreed upon by all parties.
Note that if you choose to own the vacation home in a vehicle that is not part of your own estate, such as in an irrevocable trust, you must pay rent to the trust when using the home since you are no longer the owner. If rent is not paid by a non-owner, you may jeopardize the estate planning. In our client’s case, paying rent is beneficial as it allows the parents to infuse money into the property without gifting to the kids.
You should be aware of a few other issues when owning a vacation home. These include obtaining a mortgage, homeowner’s insurance and property tax reassessment.
Be aware of specific tax rules that apply to a mortgage on a second home such as deduction limits and who can take the deduction. In terms of homeowner’s insurance, you should ensure your policy covers the additional home and extends to its titleholder (whether it’s a trust, LLC or other entity).
When renting out property, there’s always additional liability exposure. Thus, you should talk to your tax advisor, legal counsel and insurance agent to determine the best way to hold and insure the property to limit your losses in case of an unforeseen incident.
Finally, whenever you purchase or transfer a property, you will want to consider the relevant state’s property tax rules. In California, for example, there are a number of ways to avoid a property tax hike when transferring a property.
A vacation home should offer years of enjoyment and happy memories for the entire family. Just be sure to talk to your financial advisors at the outset to help avoid potential cracks in the ownership foundation.