While many families enjoy owning vacation homes and using these properties for getaways and gatherings, a vacation home is a unique type of asset that requires careful planning regarding its ownership structure.
The type of ownership format chosen will affect a wide range of legal, financial, and procedural factors including asset and creditor protection, property management and usage, income tracking and expense disbursing, transfer of ownership within and outside of family (during lifetime and at death), and estate and gift tax planning.
Accordingly, it makes sense to thoroughly analyze and then decide on the most appropriate and advantageous course of action.
Why is the Vacation Home LLC the Preferred Choice for Intelligent Families?
Although a family vacation property may be held in a trust or corporation, or titled as tenants in common or joint tenancy with the right of survivorship, the limited liability company (LLC) form of ownership seems to be the most popular among intelligent family patriarchs and matriarchs.
The LLC provides the tax planning and ownership flexibility of a partnership along with the liability protection of a corporation, and in most states LLCs can be formed for non-business purposes, including owning a vacation home.
The Operating Agreement, the document “rulebook” for an LLC and its owners (known as members), spells out in detail the management authority, rights, and responsibilities of each LLC member (family member) with respect to the property, and can be binding on heirs who are future owners of the home.
5 Important Reasons to Hold Your Vacation Home in an LLC
The LLC is used to manage the outcomes of several extremely important situations which are sure to arise during vacation home ownership.
Asset and Creditor Protection
An LLC can significantly limit liability exposure of its owners, the LLC members. 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, judgments filed against LLC owners for lawsuits totally unrelated to the LLC (personal judgments), and claims arising regarding the adequacy of goods and services provided to the property by trade creditors. Please note that it is crucial to carry adequate general liability insurance to supplement the asset protection afforded by the LLC structure.
For example, suppose a visitor suffers a serious back injury when falling down the front steps of a family’s vacation home and receives a large jury settlement as a result. In most states, if the home is held in an LLC, the family exposure to the settlement would be limited to its investment in the LLC — or in other words, the vacation home itself. Family members’ primary residences and other assets, including investment assets and business interests, would be shielded from exposure.
Another example would be if a family member has a serious car accident and is subsequently sued by the other driver, who then wins a judgment in excess of available insurance coverage. A properly structured LLC prevents the judgment creditor from seizing that family member’s LLC “shares” (member’s interest), thereby protecting their equity in the LLC. The creditor is very likely to settle quickly due to this “charging order protection” technique widely used by savvy LLC owners and their attorneys. If the home is owned in an LLC, the creditor cannot force the partition of the home to pay for the settlement. This protection is not available with other forms of ownership, including corporate ownership and joint-individual ownership.
Also, if the LLC has a dispute with a trade vendor and is then sued by this vendor to collect, the LLC owners are shielded from personal liability for business debts incurred under the LLC umbrella.
Property Management and Usage
A properly drafted LLC operating agreement prevents 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.
Income Tracking and Expense Disbursing
An LLC is a separate legal entity, which means it has its own bank account with cash to operate the property. Accordingly, the expenses incurred to own and operate the home — such as the mortgage, property taxes, property improvements and repairs, and 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 family members. Similarly, income earned from renting the home can also be allocated among family members based upon specifically chosen criteria.
Transfer of Ownership Within and Outside of Family During Lifetime and at Death —Buy-Sell Provisions
LLCs have an eternal lifetime known as “perpetual existence”. This enables 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 also stipulate such things as: a) who can become an owner (other than family members); b) in what circumstances ex-spouses of members and ex-spouses of their divorced children can be prevented from becoming owners; and c) the requirement of a professional appraisal whenever the price of the property needs to be determined (for possible sale or for gifting/estate tax purposes), and for the final sales price when the home is placed on the market.
At the same time, there’s flexibility in intra-family ownership transfers. LLC membership interests represent the personal property of the LLC members. Therefore, transfers of these interests do not involve conveyance of real property owned by the LLC. As a result, intra-family transfers can be made without triggering any anti-transfer provisions that may be imposed by lenders. These transfers also won’t result in any real property transfer fees or taxes, nor will they affect title insurance policies and rights.
Other ownership transfer issues that can be addressed by the operating agreement include the following:
- Will ownership be limited to blood family members and their descendants or also extended to their spouses?
- How will transfers of interests be handled? Will family members have a right of first refusal to buy ownership interests of other family members who want to sell due to divorce, bankruptcy, or other reasons?
Estate and Gift Tax Planning
For starters, probate may be avoided when the vacation home property is in another state (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 may be required to go through a lengthy and expensive probate proceeding. LLC vacation home ownership avoids this hardship.
Also, upon death of an LLC owner, heirs will receive a “step-up” in cost basis of the home to its fair market value, thereby significantly reducing the capital gains tax due when the home is eventually sold.
And, LLC interests are both restricted and fractionalized (minority and marketability discounts) resulting in a lower appraised value and thus lower estate and gift taxes.
Your Vacation Home Belongs in Its Own Separate Vacation Home LLC
As can be seen from the aforementioned discussion, there is no better way to hold a vacation home than in its own separate LLC. Unlike corporations, 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 enjoyed by its members. The only caveat is to ensure that a very experienced and technically competent financial and legal team is retained to do this work. Every state and family has its own specific requirements for vacation home LLCs. Here’s to your success using this strategy!