Dan A. Penning

Some would argue that a place is just a place but the people make it special. When it comes to the family cottage, it can be argued “the place” is special, sometimes almost magical, and can transform those who spend time in that place from stressed out, overworked adults back to their carefree days as a child; skipping rocks on the water, swimming off the dock, nursing a sunburn and eating s’mores by the campfire. For most, the family cottage creates a place for memories and traditions to be formed and a safe haven to retreat to for rest, reflection and reminiscing later in life. The family cottage is a constant in an ever-changing world. It’s where experiences can be shared and passed on to the next generation in their purest form.

It’s those intense emotions that fuel the desire to keep the family cottage in the family to preserve “the place” for future generations of “people” to experience and enjoy. Keeping the family cottage requires careful planning, cooperation among family members and a common purpose.

The focus of this writing is to identify the types of ownership forms that exist and can facilitate preservation of the family cottage, including the positive and negative aspects of each form of ownership.

Outright / Direct Transfers of Ownership

A direct transfer of ownership interest from one generation of owners, (i.e. parents) to the next (i.e. children) can be in the form of joint tenants with rights of survivorship, tenants in common or a life estate for the older generation with the younger generation receiving a “remainder” ownership interest in the family cottage. In summary, these forms of ownership involve transfers by deed of some or all of the current owners’ outright ownership to other individuals such as children, grandchildren or others.

The benefits of direct transfers of ownership by one generation to the next are as follows:

• The transfer can easily and economically occur by simply drafting and recording a deed reciting the form of ownership interest transferred.
• Fractional interest or “part interest” can be transferred to assist the transferors with estate tax planning objectives. Establishing fractional interests for the family cottage can provide discounts to lower ownership values in the transferors’ estate.
• Transfers whereby the transferors (parents) retain a partial ownership interest can, in most instances, provide a right for the parents’ continued use and enjoyment of the family cottage during their lifetime.
• Direct transfers can, in certain circumstances, be useful as part of a larger overall long-term care or Medicaid planning process to help parents protect the family cottage from having to be sold to raise proceeds to pay for long-term medical or supportive care expenses.

Direct transfers of ownership can also provide negative consequences. They are as follows:

• If the transfers are done without an overall analysis of estate, gift and income and property taxes, the parents can find themselves with unintended tax consequences.
• Direct transfers of ownership interest can create unintended consequences of exposing the family cottage to the claims of their children’s creditors.
• Direct transfers of ownership can expose the family cottage to claims by the spouse of a child in the event of a divorce.
• Direct transfers cannot guarantee that one or more family members will get along in the future. Disputes can arise without accompanying safeguards to transfer ownership that could result in the whole family being in court and a judge ordering the family cottage sold. In addition, an unexpected economic hardship may arise among one or more of the children owning the family cottage and their wanting to sell their interest in the cottage which can also cause complications for the non-selling individual owners and can ultimately lead to an impasse regarding any resolution of the situation ultimately requiring a sale of the family cottage altogether in its entirety to a third party.

Ownership of the Family Cottage in a Trust

Ownership of a family cottage can also be in a lifetime trust. There are two common trusts for this purpose. In both instances, the transfer of ownership is simple in that it is accomplished by the execution and recording of a deed.

The first type of trust is a revocable living trust. The benefits of this type of ownership are as follows:

• Ownership of the family cottage in a revocable trust maintains the parents’ control of the property during their lifetime. The parents can be the current trustees of the trust during their lifetime, thus retaining full authority to make all decisions on the use, management and even disposition of ownership to a third party in the event of an unexpected need or occurrence.
• The revocable trust is a grantor trust for income tax purposes so any transactions for the family cottage such as payment of expenses and property taxes is reported and deductible by the parents/grantors in the same way as if they owned the family cottage in their individual names.
• If a parent/grantor is disabled, usually a successor trustee is appointed in the trust, who then continues to manage the family cottage without interruption or court involvement.
• In the event of either the grantor parents’ disability of death, the family cottage is not subject to probate administration and that the terms of the trust govern the disposition of the family cottage and asset of the trust.

However, placing a family cottage in ownership of a revocable trust can have certain detriments. These are as follows:

• The full fair market value of the family vacation home will be included in the parents/grantors’ taxable estate if the family cottage is titled in the parents’ revocable trust.
• If the transfer of the family cottage was simply made to the trust and there were no provisions for a “succession plan” the family cottage then remains in the grantors’ revocable trust with no specific direction as to its disposition at the parents’ death. Also, any contributions of funds that may be necessary to pay for expenses of the family cottage may prevent gift tax issues if the title of the family cottage remains in the parents’ revocable living trust
• A revocable living trust is generally not a good option in situations where multiple parties are required to make capital contributions for improvements or sharing expenses for maintenance. If a parent/grantor becomes disabled and a successor trustee is appointed, the successor trustee may not have the discretion to keep the family cottage “alive and well”. If the grantor needs funds for other reasons (for example, health, support, medical treatment and so on), the successor trustee may be forced to sell the family cottage to raise funds for those purposes.
• Creditor protection is limited with a revocable living trust based on the fact that it is a “self-settled trust” whereby the grantors/parents simply transfer by deed ownership to the trust and maintains total control during the trust during his/her or their lifetime. In most states, creditors can pierce through the trust ownership of the family cottage and attach it for judgment liens or other liabilities.

A second type of trust that is sometimes used for ownership of family cottages is a qualified personal residence trust (“QPRT”).

The QPRT is a trust where the grantors/parents make a gift of the family cottage to the trust while essentially retaining an interest similar to a life estate for the term of years of the QPRT. As a result, the parents maintain the use and enjoyment of the family cottage during the QPRT’s term of years. A gift of the interest in the family cottage using a QPRT is less than if the gift were made outright by the parents to their children. The QPRT allows for gifts of fractional interest, thereby reducing the gift tax clause. The QPRT is also a grantor trust for income tax purposes so all deductible costs (i.e., real estate taxes) continue to be deductible by the grantor parents for income tax purposes during the term of the trust. The QPRT can also be a useful tool in minimizing the grantors/parents estate tax liability. Basically, a complete gift of the family cottage from the parents to the QPRT, based on the parents’ retaining the use and enjoyment of the family cottage during the term of the QPRT, allows for a reduction of the amount actually counted as a gift for gift tax purposes. As a result, a complete gift of the family cottage can be made for much less than the fair market value of the cottage and all future appreciation of the cottage can be excluded from the parents’ estate.

The detriments of transferring a family cottage to a QPRT is if a grantor/parent dies during the QPRT term, the fair market value of the family cottage is then accountable in the grantor/parent’s estate for estate tax purposes. That could result in a waste of the gift tax credit. In addition, at the end of a QPRT term, if a grantor/parent survives and continues to occupy the family cottage, the grantor/parent must rent the family vacation home from the QPRT continuation trust or the QPRT individual beneficiaries (i.e., children) at fair rental value. This can also be a benefit in that parents seeking to transfer wealth from their estates to their children can do so by the amount of the rental payments over time. If the family cottage is sold during the QPRT term, the net proceeds of the sale must be reinvested in a qualifying replacement home or an arrangement must be converted to a grantor retained annuity trust whereby the income of the principal of the trust would be paid to the grantors/parents. In addition, similar to a grantor trust, there is little, if any, creditor protection in most states with respect to the family cottage being owned by a QPRT.

Ownership of Family Cottage in an “Entity”

The ownership of the family cottage can also be transferred in an entity such as a general partnership, limited partnership or limited liability company. For purposes of ease of explanation, all references to an entity in this writing will be to a Limited Liability Company (“LLC”). Most of the concepts discussed herein are equally applicable to other types of entities, such as Family Limited Partnerships (“FLP”) or General Partnerships. One caveat is there may be some additional requirements in different nuances relating to ownership of the family cottage in a different entity, but for purposes of this article, reference to an entity as an LLC should suffice for the concepts to be explained below.

In transferring a family cottage to an LLC, there are a number of non-tax and tax reasons usually motivating such a transfer. One consideration in placing a family cottage in an entity is whether or not the formation of the entity was limited in its purpose to establish ownership of a single “personal” asset such as the family cottage fulfills the “business purpose” requirements under some states LLC laws. In addition, another consideration is whether because the nature of the LLC is a personal use of a family cottage is a problem with respect to the inclusion of the family cottage in the grantors/parents estate under IRS Code Section 2036. In the event that transfer of a family cottage to an entity is being done for tax planning purposes, individuals should consult with an attorney to draft the LLC operating agreement in such a way to try and maximize the tax benefits of the transfer.

Another issue affecting the transfer of the family cottage to an entity, such as an LLC, is the management or control of the family cottage. Usually, where grantors/parents transfer the family cottage to an LLC during his/her or their lifetime, the parents maintain management positions of the LLC to make decisions regarding the maintenance, use and other matters affecting the family cottage. If gifts of ownership interest in the LLC are made by the parents to children, the appointment of the parents as managers of the LLC usually avoids a problem with respect to the use and maintenance of the LLC while the parents are living.

In addition, a significant benefit of an entity, such as an LLC, owning the family cottage is creditor protection. The only remedy, for instance, in the state of Michigan and many other states, is that outside creditors can only receive a charging order against the LLC owner’s interest in the LLC and, therefore, cannot become a member of the LLC or force any asset within the LLC to be sold to satisfy any liability of an individual member (owner). A charging order on behalf of a creditor of a member/owner does not give the creditor any management rights, voting rights or other participation rights with respect to the asset of the LLC.

Another consideration in owning a family cottage in an entity, such as an LLC, is protection of ownership with respect to divorced spouses. If gifts of ownership interest of the LLC are made by parents to children, a child can usually keep ownership of the LLC interest separate and distinct from commingling any ownership of the asset with his or her spouse. This fact, together with the fact the LLC operating agreement can make special provisions regarding what happens when a divorced spouse, through court order, attains certain rights against, in the form of a lien, a spouse’s family LLC interest. The LLC operating agreement can be helpful in creating an organized formula with respect to how the interest will be paid for to a divorcing spouse and ultimately extinguish the divorced spouse from the entity.

An extremely important non-tax issue surrounding the transfer of the family cottage to an entity and, ultimately, a succession plan for distribution of ownership interest to succeeding generations, is the operation and maintenance of the family cottage, for instance, who pays, who works, and who does what. Although, regardless of the care taken by an individual to draft a carefully thought-out operating agreement to govern these types of issues for future generations, ultimately cooperation between the individuals will either make such an agreement tenable or, in the event of un-cooperating owners, it becomes more difficult to enforce.

The operation and maintenance of the family cottage usually consists of addressing the following areas:

• Duties, responsibilities and payment for routine, regular maintenance.
• Duties, responsibilities and payment for extraordinary maintenance, such as more capital intensive things such as structural, mechanical or other significant expense.
• Responsibility for payment of regular operating expenses.
• Schedule or personal and rental use of the family cottage.
• Sale of the family cottage and division of tangible personal property.

One significant benefit to using an entity to hold ownership of a family cottage is imposing certain “buy sell provisions” in an operating agreement to govern how, and to whom, individuals sell their ownership interest in the family cottage. These types of buy sell agreements are essentially the same types of buy sell agreements governing the buying and selling of ownership interest in corporations that have been employed by applicable owners of closely held businesses for years. The benefit of buy sell provisions is that various provisions can be inserted into the operating agreement to provide a methodical and fair system in which individuals can offer, and ultimately obtain, the sale of their ownership interest to other LLC owners or, in some instances depending on the terms of the operating agreement, to third parties.

Conclusion

Planning for cottage ownership and succession should not be taken lightly. Without adequate planning various taxes and family disagreements can destroy the future enjoyment of the family cottage. Unfortunately, there is no “cookie cutter” to planning. A family’s goals and personal relationship will influence the ultimate decisions to be made; however, consulting with an expert in cottage law and engaging in careful consideration and a planning process will keep generations of family’s memories intact, and protect the family’s most important asset, the family cottage.

Circumstances need to be evaluated for each family and cottage property. There are a few special cases where keeping your cottage under direct real estate ownership is the simple solution to a complex situation. Two cottage planning solutions which should be examined, and discussed with your cottage law attorney, are Life Estates and the Ownership Agreement.

Dan Penning examines each aspect of your estate and cottage property including strategies to employ to avoid uncapping cottage property taxes. The advantage you gain using a cottage law expert is knowing you will have created a flexible legal entity to fulfill your hopes and dreams of protecting, preserving and saving your family cottage for use by all future generations.

There are two ways to hold title to real estate:

• directly, or
• indirectly

Direct Ownership
Real Estate Law governs the rights and duties of “direct owners”. The granting of these rights and how real estate laws impose duties on direct owners often surprise cottage owners. It’s real estate law surprises which put the family cottage at risk. Real estate laws of direct ownership do not promote keeping the cottage in the family for multiple generations, and the threat of partition and turmoil always exist.

Indirect Ownership
Entity Law, which are Laws of Trusts, Partnerships, Corporations, and Limited Liability Companies, govern the rights and duties of “indirect owners”. Entity Law is extremely flexible and accommodates the complex realities of commerce.

A Cottage Succession Plan relies on indirect ownership and addresses inherent cottage sharing problems and allows you to manage your cottage like a business. A flexible Operating Agreement will determine everything about your cottage.

A Limited Liability Company (LLC) will change the way your family owns an interest in the family cottage. Instead of a “direct ownership” in the cottage property real estate, each family member becomes an “indirect owner” of membership units in your LLC.

First, ask your child, or children, if they want a share of the cottage. They may not want a share of the family cottage and there could be a variety of reasons. Each should be explored for passing on to them an alternative value of their share of the family cottage.

The best way to protect your family cottage is to move it away from the hazards of “direct ownership” being governed by real estate laws. We recommend moving the family cottage from direct ownership to “indirect ownership” and for a Limited Liability Company which is governed by Entity Laws rather than Real Estate Laws.

When you form a Limited Liability Company (LLC) for your family cottage you create a company which has owners, and they are often referred to as “members of the company”.

The “Operating Agreement is the core strength of a successful Cottage Succession Plan. It is designed to control the use and enjoyment for all of the family cottage. The Operating Agreement provides a structure of rules to manage the operation and future of the cottage and includes the rights and obligations for each “member of your cottage LLC”. There are similarities with each operating agreement, but like the diversity of families, each plan is unique to that family’s requirements.

The Voting Power of Membership Units

It is natural when you think of a “company” to think in terms of owning a “share” in the company. Even though it’s not required, some families issue “Membership Certificates” to the new members of the Cottage LLC. Having a solid certificate in hand clarifies the identify of the owner and how many “units” in the company are held by that owner. An LLC is the perfect legal entity to incorporate the principles of democracy – each member gets a vote on everything so “Units” are important when members are voting on cottage operating and shared use concerns.

Because a cottage succession plan is designed for future generations, when determining the number of “units” or shares in the cottage LLC, it is best to choose many versus fewer to avoid having to create “fractional” units.

When Will Your Cottage Plan Become Effective? Now or Later?

Part of the initial cottage succession planning will be deciding which type of Limited Liability Company (LLC) to form. This involves timing – when do you want the LLC to become effective. Now or Later?

• An “Immediate LLC” takes effect “immediately” when you finalize your operating agreement, file articles of organization, and sign the deed.
• A “Springing LLC” takes effect when the cottage owner dies and is set up through an estate plan.

Where Will You Form Your LLC?

You can establish and organize your LLC within any state, but most set the company up within the state where they have their permanent residence or within the state where the cottage is located.

Each state has similar Limited Liability Company Laws, but they are not identical. In some states LLC managers have complete control, whereas in other states more power is granted to members of the LLC.

Name Your Cottage Limited Liability Company

The name you choose for your LLC has to be unique. States will not accept nor register two LLCs with the same name. If you have decided on a name for your family cottage, and are establishing an “Immediate Cottage LLC” have your cottage law attorney reserve that name with the state where you are organizing your company. This will prevent another person from registering the name you have chosen for your LLC while you are finalizing your operating agreement.

Unfortunately you are not able to reserve a company name for a “Springing Cottage LLC” due to the time span between the drafting of an operating agreement and the owner’s death.

Your Cottage Property Could be At Risk
Each summer is a chance to create family memories of good times all over again. You’ve spent a lifetime of summers at the family cottage. Your family memories live there and it’s the only place where laughter replaces ringing phones, the sun is your only clock, and keeping sand out of your shoes and picnic basket is the challenge of the day.

It’s easy to go on thinking this is how you, your children, and grandchildren will always spend summers, at your family cottage by the lake.

Few know of the hazards of real estate laws and how they can wreak havoc on your future plans of a loving peace shared between your children and heirs at the family cottage. The reality of real estate laws and rhythms of life and death could alter your hopes and dreams of harmonious sharing of the family cottage by future generations.

Did you know that real estate law does not promote keeping the the family cottage in the family for multiple generations?

Your emotions and sentiments that are woven into the family cottage may not match how your children, and their spouses, view your family cottage. A child might not want any part of the cottage because they can’t afford it, they live in another state and aren’t able to use it, or they simply want want its cash value and plan to “cash out their inheritance”, or worse yet, your child might lose their share of the family cottage during a divorce. All are messy situations without equitable solutions for all your children without a plan.

If there are no specific, and enforceable, instructions about how the cottage co-ownership should be managed you potentially place your valuable family legacy asset in harm’s way.

There is a lot to consider when planning the family cottage’s future survival. Yes, you could draw up a simple will and leave the family cottage equally to your children, but real estate law surprises put the family cottage at risk.

The Right to Partition Could Force the Sale of Your Family Cottage

This is where things could potentially go very wrong.

The American legal system is based upon common law. Our real estate laws are based upon 600-year-old laws which have not changed much over the years.

Read Your Cottage Property Deed
What could happen next depends on the first paragraph of the deed for the family cottage property.

If you leave your cottage equally to your children in the standard way as “tenants in common”, which is the traditional form of real estate ownership, any “tenant in common” (your children become co-owners) could force the sale of the cottage. This is called The Right to Partition.

The principle behind The Right to Partition is based upon English common law that no person can be required to own property. If there is a legal conflict between your children, or the co-owners of the cottage property, a court will order the sale of the cottage property if it cannot be divided in a fair way – easy to do for land, but how do you equally divide a building or a boat or a wooden dock? You can’t. The cottage property will be sold and the proceeds from the sale will be equally divided between the co-owners.