The real estate industry indicates that cottage ownership in Michigan is at an all-time high. Cottage owners enjoy many benefits of ownership. Cottages often appreciate at a faster rate than primary homes. The owners also receive the enjoyment of a getaway where they can relax, unwind, and, perhaps most importantly, where they create a natural social gathering spot for children, grandchildren, extended family and friends.
Cottage legacy planning ensures that the cottage remains in the family for future generations. Proper planning for the cottage can help avoid negative tax consequences for the parents and their adult children and provide for the orderly transition of the cottage to the children.
A baseline tool of cottage legacy planning is that the parents need to convey the cottage to one of their trusts during their lifetime. This will keep the cottage out of probate and will allow for an orderly plan for the transition of the cottage to the children.
The key challenges in cottage legacy planning are:
- Avoiding an increase in the property taxes when the cottage passes from the parents’ generation to the children.
- Avoiding capital gains tax upon the appreciation that occurred during the parents’ ownership of the cottage.
- Simply and effectively providing for the payment of the annual expenses and taxes incurred through cottage ownership.
- Having a system in place that distributes use of the cottage among family members.
- Avoiding the threat to ownership that would result from a divorce, death, or disability of a child, tax lien, or judgment against a child.
Alternative Structures for Maintaining the Cottage in the Family
There are two primary alternatives for maintaining the cottage as a legacy during the life of the parents and following the parents’ passing. They are: 1) a trust; or 2) a limited liability company. The principal factors involved in selecting which of these alternatives should hold the cottage for the duration of the parents’ lives and following the parents’ passing include:
- Parents are able to impart their wishes for how the property is to be handled after death.
- Flexibility in changing the use of the cottage and other terms of the trust following the parents’ passing.
- Avoiding an increase in the property tax on the cottage due to events during the parents’ lives and following the parents’ deaths. This increase in property tax is often referred to as uncapping.
- Limiting the liability of the parents, the children, and the entity selected to own the cottage.
- The ultimate capital gain tax on the sale of the cottage.
Use of a trust can be employed to continue the ownership of the cottage within the family, manage the expenses, and dictate use of the cottage.
The transfer by the parents of the cottage to one of their trusts during their lives would not result in an increase in property taxes. This is permitted under new legislation in Michigan which came into effect on January 1, 2015.
The cottage would remain in one of the parents’ trusts following their passing. Upon the death of one of the children following the parents’ deaths, however, property taxes could increase.
The trust would provide for the contribution by the children of a pro rata share of the expenses, including maintenance and improvements, property taxes, insurance and utilities. If a child did not share in the burden of the expenses, after a period of non-contribution, that child’s interest in the trust would forfeit. This is intended to be a strong incentive to encourage contribution as opposed to causing forfeiture. Another alternative would be for the parents to leave a portion of their assets to provide for the payment of the annual expenses of the cottage.
A use agreement is necessary, either within the trust or as a separate document.
The trust would also maintain a policy of life insurance to buy out a deceased child’s interest in the cottage.
There are certain disadvantages to using a trust in legacy planning for a cottage. The primary disadvantage is that trusts offer little capacity for flexibility following the death of the parents. The children would be unable to alter the terms of the trust following the parents’ deaths, although this may be desirable in certain situations. A limited liability company would provide for greater flexibility in this regard. Another disadvantage is that a trust offers no shield against liability.
Limited Liability Company
Use of a limited liability company is the other alternative to continue the ownership of the cottage within the family and manage expenses and use. The mechanics of this include the creation of a “springing” limited liability company during the parents’ lives. The limited liability company would spring to life upon the death of the second parent –. At that time, the cottage would be conveyed to the limited liability company out of whichever of the parents’ trusts owns the cottage. It is believed that this will not result in an increase in the property taxes.
The children would enter into an agreement that provides for the remaining children to purchase the interest of the Cottage upon the death, divorce, bankruptcy, etc. of one of the children.
The agreement would provide that the limited liability company would maintain a policy of life insurance to buy out a deceased child’s interest in the cottage.
The agreement would also provide for the contribution by the children of a pro rata share of the annual expenses, including maintenance and improvements, property taxes, insurance, and utilities. If a child did not share in the burden of the expenses, that child’s interest would forfeit. Again, this is intended to encourage contribution as opposed to causing forfeiture.
The death of a child following the deaths of the parents can result in an increase in the property taxes. Michigan’s rules provide that when more than 50% of the ownership in limited liability company changes, the property taxes will “uncap”.
If you are a cottage owner or the child of a cottage owner, it makes sense to explore the alternatives available for passing the cottage to the next generation. Planning now is critical to avoid undesirable tax consequences and to provide for the orderly ownership, payment of expenses, and use of the cottage in the future.