Protecting Your Vacation Home from the Grim Reaper

A common estate planning question that needs to be resolved is "who gets the vacation home?" The answer to this question should take into account the economic, managerial, and psychological issues inherent in this type of asset. For example, will your heirs be able to agree on a viable method of contributing to the payment of real estate taxes, insurance, maintenance, and other costs associated with the property? What about making needed restoration or improvements to the property? Who will accept the burden of paying the bills and keeping records? Even if questions of sharing burdens are resolved, what about the benefits? If more than one heir wants to occupy the Florida winter home, but there is not enough space for more than one family, who decides which heir will occupy the residence and how is that to be decided? All of these are real issues that can influence how your vacation home is transferred. Like a business, the summer beach house and winter cottage present a host of problems, the greatest of which may be the psychological impact of one family member owning the property instead of another.

Typically, a married couple owns real property in some form of joint ownership with survivorship rights (such as tenants by the entireties). Such property passes to the surviving spouse at the first spouse's death without probate proceedings. Generally, only one-half of the value of the property will be included in the deceased tenant's gross estate. Of course, the passage of that one-half interest may qualify for the marital deduction and any estate tax would be deferred until the death of the surviving spouse.

If your spouse does not have sufficient assets to utilize the $202,050 unified credit in 1998 (i.e., exempt the first $625,000 of property you transfer during lifetime or at death), it may be advantageous for you to transfer the vacation home solely to your spouse or title the property as tenants in common so that your spouse could fully utilize her credit, especially if your estate exceeds $625,000 and would be subject to estate tax.

For example, if you die with assets worth $1.25 million held jointly with rights of survivorship your entire estate would pass to your spouse tax free, but your unified credit would not be utilized. Maximizing the unified credit often involves transferring assets out of joint tenancy. Generally, this should be done with assets other than your personal residence; however, if the estate does not contain sufficient assets, consideration should be given to transferring the personal residence into tenancy in common or directly to your spouse.

If your estate is large enough and you and your spouse have sufficient assets of your own to fully utilize both of your unified credits, your focus should be on lifetime transfer strategies designed to reduce your overall estate tax exposure. Your options could include giving the property away during your lifetime to your heirs or selling the property directly to your heirs prior to death. Holding the property until your death and transferring the property through a testamentary disposition could result in adverse estate consequences, especially if the property is rapidly appreciating.

Transferring the vacation property to your heirs during lifetime could minimize the related transfer tax costs. A lifetime gift allows any future appreciation to escape estate tax. However, the income tax impact on your heirs should also be considered. Since their basis in the home will equal your basis, additional income tax could result if your heirs later sell the property. If the property remained in your estate at your death, the basis would be stepped up to fair market value, which could mitigate the income tax exposure on a future sale.

Another option is to give away or even sell to your heirs undivided interests in the vacation home. Discounts may be available when you initially transfer or sell the property interest to your children due to the less marketable nature of such fractional interests.

Another option available is the Qualified Personal Residence Trust (QPRT). It is possible to transfer up to two personal residences, including a vacation home, to such a trust.

QPRTs provide a way to transfer a residence to your heirs at a discounted transfer tax value while retaining the right to live in the property for a period of time.

Ownership of the home is placed in trust for the future benefit of your children or heirs. The trust lasts for a set number of years (the trust term). The tax benefit arises because gift tax is calculated using a discount on the home's full value. The discount is allowed because the heirs receive nothing until the trust term ends.

If you survive the trust term, the value of the gift is "frozen" when the home is transferred to the trust, so any appreciation that occurs after the transfer escapes transfer tax. Once the trust term expires, ownership passes to the trust beneficiaries, who may occupy the house. In some cases, the trust document may give the heirs the option to allow their parents to remain in the home in return for fair-value rental payments. The major disadvantage of the QPRT, the inability to obtain a stepped-up basis, may not be as important in the case of a vacation home if the property is expected to remain in the family and not be sold. It is important to note that the President's budget proposal seeks to eliminate QPRTs.

Finally, a vacation home may be transferred to you family member through a family limited partnership. Such a vehicle is particularly well suited if the property is a rental property. The partnership could be structured to provide centralized and continuous management of the property with some degree of asset protection. Limited partnership interests could then be at a discounted value to family members.

Many planning opportunities exist for shielding the vacation home from substantial income, gift, and estate taxes.

Note: This article is intended for general information only. It is not intended to give legal advice for specific situations. As always, readers should consult an attorney for specific legal guidance.