This time of year, those of us who don’t already own vacation homes are sorting out our vacation rentals. Inevitably, our conversations now go to, “Sweetie, we need to get a vacation place”. Buying houses is easy. Not cheap, but not hard to do. Owning houses is hard. That's easy to forget when you’re all excited about watching from your deck as the grandchildren ride horses on the beach, et cetera.
So, since you’re probably going to do it anyway – good idea or not - here's a bit on one of the many things you’ll want to consider. A vacation home warrants thoughtful planning as to its ownership structure. Ownership format can affect legal, financial, and procedural factors. It will impact asset and creditor protection, property management and usage, income tracking, expense disbursing, ownership transfer within and outside of family, and estate and gift tax planning.
Buying houses is easy. Not cheap, but not hard to do.
There are a lot of ways to hold a family vacation property, but the LLC is the most popular. An LLC allows for the tax planning and ownership flexibility of a partnership and the liability protection of a corporation. In most states LLCs can be formed for non-business purposes, including owning a vacation home. Depending on the size and relationships of your extended family, you may not want or need to put your place out as a seasonal rental. An LLC's Operating Agreement spells out management authority, rights, and responsibilities of each LLC member (family member) with respect to the property. It can be binding on heirs who are future owners of the home as well.
Used as an asset protection strategy, the LLC protects its members from lawsuits due to physical injuries sustained by others while renting or visiting the property, and judgments filed against LLC owners for lawsuits unrelated to the LLC (personal judgments). None of this precludes the need for adequate insurance; property and casualty, liability, and an umbrella policy.
Example: Suppose a visitor suffers an injury falling down the front steps of a family’s vacation home and receives a large jury settlement as a result. If the home is held in an LLC, exposure to the settlement would be limited to the LLC — the vacation home itself. Members other assets, including investment assets and business interests, would be shielded from exposure. Another advantage, if the home is owned in an LLC, a creditor cannot force the partition of the home to pay for a settlement owed by an individual LLC member. This is not the case with other forms of ownership, including corporate ownership and joint-individual ownership. Also, the LLC owners are shielded from personal liability for business debts incurred under the LLC umbrella.
A properly drafted LLC operating agreement will prevent disagreements among family members since all terms of the agreement are set out in writing. These terms include who is allowed to use the property (family members only or allowable non-family members); when each member is authorized to use the property (specific weekdays, weekends, holidays); who will be responsible for making legal decisions, acquiring insurance coverage, and making repairs; and when and how management responsibility will be transitioned from parents to other family members.
As an LLC is a separate legal entity, it will have its own bank account with cash to operate the property. Accordingly, the expenses incurred to own and operate the home — mortgage, property taxes, improvements, repairs, legal and accounting services — can be allocated among different family members in proportion to their usage of the home or in any other reasonable fashion agreed to by all LLC members. Income earned from renting the home can also be allocated among family members based upon specifically chosen criteria.
LLCs have a “perpetual existence”, so they can outlive their founders. This enables the inclusion of transfer restrictions in the operating agreement to prevent family members/owners from selling or transferring their interest in the property to someone outside the family. The operating agreement can stipulate who can become an owner (other than family members), circumstances around ex-spouses of members, or adult children of second and third spouses becoming owners, requirements for a professional appraisal whenever the value of the property needs to be determined (for possible sale or for gifting/estate tax purposes), or for the final sales price when the home is placed on the market.
LLC membership interests represent the personal property of the LLC members. Therefore, transfers won’t result in real property transfer fees or taxes, neither will they affect title insurance policies and rights.
Probate can be avoided when a vacation home property is in an ancillary state. If your vacation home is located in a state other than that of the decedent’s primary residence (domiciliary state), the estate executor might be required to go through a lengthy and expensive probate proceeding. LLC vacation home ownership avoids this needless bit of bureaucratic unpleasantness.. Upon death of an LLC owner, heirs will receive a “step-up” in cost basis of the home to fair market value. This reduces the capital gains tax due when the home is eventually sold.
For these and other reasons, the best way to hold a vacation home is in its own separate LLC. LLCs are easy to create and require minimal upkeep. The costs to create an LLC are by far outweighed by the benefits and potential costs savings to the members. You'll need to be certain that an experienced and technically competent financial and legal team is retained to do this work, as every state and family has its own specific requirements for vacation home LLCs.
A vacation home is generally intended to bring families together. Badly handled, it could have quite the opposite effect. You’re going to do this anyway, so you’ll want to dot all of the “I's” and cross all of the “T's”.
William S Jiggetts