Your centerpiece for family gatherings can also be the subject of effective cross-generational planning.
Vacation homes can provide a beautiful backdrop for family gatherings and memories shared among multiple generations. Time spent at vacation homes can enhance family dynamics and strengthen bonds among family members. Particularly when family members are dispersed geographically, the vacation home can be the magnet that pulls the family together.
However, as you enjoy spending time with family at your beach house, mountain cabin or lakefront retreat this summer, an unwelcome thought about the future of your property may intrude upon your vacation: How will your children and grandchildren continue to enjoy this property after you are gone?
As the owner of a vacation home, you may wish to keep the property in the family after your death so that the vacation home can continue to serve as a nexus of connection, providing opportunities for descendants to gather in the future. Although having multiple family members own the property outright may seem like the simplest solution, outright ownership of real property by multiple individuals can create discord and spur disagreement among family members if there is no governance structure in place. It is not difficult to imagine siblings arguing over everything from payment of expenses to unequal usage of the property to pet policies and nonfamily guests.
Structuring Home Ownership: LLCs
Given these issues, we believe that you may wish to consider a limited liability company (LLC) structure for ownership of the vacation home. The LLC’s operating agreement can provide a framework for management and use of the property. It can offer procedures for payment of maintenance expenses, property taxes and insurance, rules around shared usage of the property, and restrictions on transferees of the LLC interests to ensure that the property stays in the family. It can also include procedures for buying out a family member’s interest where continued ownership would be impracticable and can delineate circumstances in which the property could be sold upon agreement of the LLC members.
An LLC structure can also provide a format for lifetime gifting. If you transfer your interest in the property to an LLC, you can gift LLC interests to family members at a favorable valuation for gift tax purposes because the gift tax value of the LLC interests can be discounted for lack of control and marketability.
In the event that a sale of the property is contemplated in the future, it should be noted that with any lifetime gift of property, your tax cost basis will carry over to the donee, and a significant capital gain may be realized upon the sale of the property. In contrast, under current law, if you died holding the property in your individual name, the tax cost basis of the property would be stepped up to the fair market value as of your date of death, which could greatly reduce capital gains tax liability on a future sale.
Another Alternative: QPRTs
Another ownership structure worth exploring is a Qualified Personal Residence Trust (QPRT). With this structure, you make a gift of residential real property (your primary or vacation home, or an undivided fractional interest in your primary or vacation home1) to a trust and retain the right to use the property for a term of years. If you survive the term, the property is removed from your estate for estate tax purposes. If you die during the term of the retained interest, then the gift fails, and the property is included in your estate for estate tax purposes. Spouses who own property jointly may wish to consider creating two separate QPRTs with different terms, which would reduce the mortality risk during the term of retained interest. Note that a grantor cannot have term interests in more than two QPRTs.For gift tax purposes, the value of the gift is the present value of the remainder interest—in other words, the fair market value reduced by the value of your retained interest. The present value of the remainder interest is determined based on a number of factors including your age and the rate of interest proscribed monthly by the Internal Revenue Service (the “7520 rate” or the “hurdle rate”). The higher the hurdle rate and the longer the term of your retained interest, the steeper the discount on the gift tax valuation. The hurdle rate for July 2023 is 4.6%, which is relatively high compared to rates over the last few years. If you have not used all of your lifetime exemption from federal gift tax, the exemption can be employed to prevent or reduce the payment of gift tax on the transfer.
Assume a 65-year-old donor creates a QPRT with a 15-year term, and funds it with a residence worth $5,000,000. In this case, assuming the 4.6% hurdle rate, the taxable gift (the present value of the remainder interest reduced by the value of the donor’s right to use the house for 15 years) is only $1,726,100. The donor could use $1,726,100 of the lifetime exemption from federal gift tax (currently $12.9 million in 2023) and pay no federal gift tax on the transfer.2 If the property’s value increased at an annual rate of 4%, the value of the property would be approximately $9,000,000 after 15 years, and the potential estate tax savings for the donor’s estate could be approximately $3,639,309.
It should be noted that generation-skipping transfer (GST) tax exemption cannot be applied to a QPRT during the period of your retained interest. This restriction means that the trust beneficiaries should be only one generation below you (i.e., children rather than grandchildren). (There are ways to structure the trust so that the trust assets can be protected from GST tax upon the death of your children, or to have the GST exemption applied after the end of the retained-use period.)
During the retained-use period, you can continue to use the property as you had before the transfer, and you may serve as trustee of the trust during this time. If you wish to continue to use the property after the period of retained interest has ended, then you must pay fair market rate rent to the trust. While at first this may seem undesirable, the rental payments to the trust can provide a stream of income to be used for maintenance and other property expenses.
At the end of the period of retained use, the property can continue to be held in trust for the benefit of the trust beneficiaries. The trust document can provide governance structure and procedures for management of the property. The beneficiaries can serve as co-trustees, as long as their powers are limited to preserve certain tax and non-tax benefits of the trust.
Just as with an LLC structure, the QPRT structure does not provide for a step-up in basis since the trust property will be outside of your estate for estate tax purposes. This may not be a primary concern if the intention is to retain the property for generations, but it is important to note that if a step-up in basis is desired, then the property must be included in your estate for estate tax purposes.
With any transfer of real property, whether through an LLC, a trust or otherwise, state and local real estate transfer tax liability can arise, so it is important to consult with a real estate lawyer in the jurisdiction where the property is located to understand all implications of such a transfer.
Strengthening Your Planning Foundation
Your family’s vacation home can continue to be the tie that binds your children, grandchildren and future generations together as long as you give them guardrails to guide the management and use of the property. By putting an appropriate, thoughtful structure in place for future generations, you can give your family a path to friction-free vacations full of opportunities for strengthening family relationships and creating shared memories.
1 Funding a QPRT with an undivided fractional interest in the property may provide additional discounts.
2 There may be a potential state gift tax liability in Connecticut, currently the only state that imposes a gift tax.
This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Investment decisions and the appropriateness of this material should be made based on an investor’s individual objectives and circumstances and in consultation with his or her advisors. This material is not intended as a formal research report and should not be relied upon as a basis for making an investment decision. The firm, its employees and advisory clients may hold positions within sectors discussed, including any companies specifically identified. Specific securities identified and described do not represent all of the securities purchased, sold or recommended for advisory clients. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. Neuberger Berman, as well as its employees, does not provide tax or legal advice. You should consult your accountant, tax adviser and/or attorney for advice concerning your particular circumstances. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. The use of tools cannot guarantee performance. Diversification does not guarantee profit or protect against loss in declining markets. As with any investment, there is the possibility of profit as well as the risk of loss. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Unless otherwise indicated, returns reflect reinvestment of dividends and distributions. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
Tax planning and trust and estate administration services are offered by Neuberger Berman Trust Company. “Neuberger Berman Trust Company” is a trade name used by Neuberger Berman Trust Company N.A. and Neuberger Berman Trust Company of Delaware N.A., which are affiliates of Neuberger Berman Group LLC.
Hypothetical growth examples are for informational and educational purposes only.
Neuberger Berman Investment Advisers LLC is a registered investment adviser. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.