Thinking about your vacation property should conjure up thoughts of happy summers, running children, good food, and relaxation. And hopefully, it does. But there comes a time when we turn our thoughts to the future. What thoughts and memories will the next generation hold when they think about your cottage?
For too many, the passage of time brings problems. Increasing values will make the property taxes jump, sometimes catastrophically, when the property is transferred. One of your children may want to keep the property in the family, while another may expect that it’ll be sold upon your death. Whatever the problem, too often these assumptions are unspoken, and unaddressed until it’s too late. The result is a family dispute… exactly the opposite of what the vacation property is supposed to engender.
Although each property and each family is unique, there do tend to be common themes. One thing is clear though: whatever the specific issue, planning can often be the key. Here is a summary of some common issues, and a possible solution to each.
1. I’ve heard of “cottage planning,” but why not just leave the property to the kids, and they can deal with it as they see fit? In some cases, letting the next generation deal with its own problems is wise. In many cases though, the first generation can only meet its goals by planning. If property is left to the next generation with no plan, then some will see it as a family heirloom; a place to go to relive old memories and to create new ones. Others will see its dollar value, and want it sold. In other situations, siblings may have conflicting plans to buy each other out rather than sharing the property. The specifics will vary, but the stress, anger, and bickering seem to be altogether too common. Planning eliminates the uncertainty, minimizes the stress and anger, and accomplishes the first generation’s goals.
In addition, planning while the first generation is still living and in control of the property also shifts the timing of these types of discussions. The hard questions can be dealt with – either by discussion and negotiation or by simply informing the kids of the parents’ decision – in the first generation’s timing. Not planning means the next generation will have to deal with the same issues, but without guidance and during the stressful, sad weeks and months after the parent’s death.
2. The property has increased in value so much, that when the property is transferred, taxes will be unaffordable. Property taxes do not follow market value in Michigan because of a 1994 law called “Proposal A” which “caps” the taxes. For as long as one party owns the property, the actual value may have increased substantially, but property taxes have been “capped” at a modest increase per year (the consumer price index). Then, when the property is transferred, the artificially low taxable value jumps up to the market value, often drastically increasing the tax bill. When the seller and the buyer are able to structure the transfer in certain ways, they can sometimes avoid this increase, at least temporarily, because not all actual transfers count as transfers under the uncapping rules. In some specific instances, joint tenancies can be created, or other uncapping exceptions can be used to pass along property without uncapping the taxes. Putting the property in joint ownership or transferring directly to the next generation may work just fine for some families, and the tax savings can be substantial. However, the bigger the family, or the greater the need for planning, the less likely it is that this is a good idea on balance. Often, other considerations like liability issues; equality in ownership, use or inheritance; and other cottage planning issues are more important than saving on taxes.
3. The property needs to be gifted to the next generation to avoid inheritance taxes. A common part of estate planning for the taxable estate (estates worth $5,340,000 or more in 2014) includes giving assets to the next generation in annual gifts designed to go under the annual gift tax exclusion amount. In 2014 each donor can give $14,000 to each recipient. Vacation property may be a good thing to give if the older generation wants the property to go to the younger generation anyway. But giving the whole thing is likely to hit the annual gift ceiling, potentially causing tax problems in the long run. As just one example of how to avoid this problem, the property can be placed in a limited liability company. Then, interests in the company an be given annually in sufficiently small amounts to avoid gift tax issues. This plan dovetails well with a cottage plan, which also frequently uses an LLC.
4. The next generation’s expectations are unrealistic or unknown, and the family can’t seem to talk about it in a helpful way. Whenever there is a vacation property that is worth efforts to save, there are deep emotions and opinions. Dealing with these wisely seems to be the biggest problem and the most ignored by the professionals. Some people deal with this in a top-down fashion: the older generation simply makes a plan, implements it, and informs the others. This can work well for some families. Other families want to have consensus. In that case, consider a family meeting scheduled specifically for the issues you want to discuss. Most families don’t often have business meetings, so doing it intentionally can bridge the gap between serious issues and the casual atmosphere that generally prevails at an impromptu conversation around the table. Discuss how each family unit feels and what they think their goals are and will be as time goes on. Then brainstorm solutions. If that seems overwhelming or doomed to failure, consider hiring someone to facilitate the meeting. Consider a trained mediator, if cost isn’t a factor. He or she will listen to each group, convey the goals of each group to the others, and find common ground – a solution that everyone can be at peace with.
5. A system needs to be set up to allow fair use of the property, and to handle the costs and decisions involved in owning property. This is one of the main goals people have in hiring someone to help with a cottage law plan. With planning, rules and guidelines can be put in writing that make clear to everyone the expectations about many issues. Some of the most prevalent might be (i) who uses the property when, (ii) how improvements are like a new roof decided on and paid for, (iii) whether the property can be rented out, and (iv) what happens when someone wants to sell.
6. Some of the family wants in, some wants out. There are two extreme positions regarding family that wants out, depending on the first generation’s goals, and your position can be anywhere between the extremes. If the goal is to keep the property in the family at all costs, then some method of reducing or eliminating the value of the property is a good idea. For example, a member of the next generation that wants to sell may be limited by the cottage plan to selling to a sibling only, for a fixed -- and artificially low -- amount. This discourages treating the cottage as a financial asset and encourages thinking of it as a leisure time opportunity. On the other hand, if the family thinks of the vacation property in financial terms, then perhaps limits on when to sell and who to sell to are still wanted, but the price could be at market value.
7. I want the kids to have the property someday, but I want to keep it simple, and in my own control, for now. Many people recognize that a system of rules and procedures will alleviate stress and anger later, and will make the property more likely to stay in the family. But they prefer not to be limited or controlled those rules and systems now, because they are still the primary users of the property. In this situation, the cottage plan can be put together now, but change in focus, or only take effect, at some future time, such as the first generation’s death, or when the first generation moves out of the property, or at whatever time or event trigger is desired. Generally, this is done by creating a trust that remains revocable and completely in the owners’ control for now, but which later becomes irrevocable. The trust then either controls cottage use itself, or the trust forms a limited liability company to own the property (whether a trust or an LLC is best is a topic to be discussed with your lawyer). This way, the decisions and management are set, but the current generation of owners is still fully in control.