Whether the “family real estate” is a real estate up north, cabin on a lake, vacation home in another state, or the family hunting land, chances are it has significant value, whether that value is economic value, sentimental value, or both, and for that reason is something that everyone in the family has an interest in protecting.
Protecting the family real estate requires careful planning, cooperation among family members and a common purpose. It’s those intense family emotions that fuel the desire to protect the family real estate to keep the family real estate in the family to preserve “the place” for future generations of “people” to experience and enjoy.
There are different types of ownership forms that exist and can facilitate preservation of the family real estate, including the positive and negative aspects of each form of ownership.
Ownership of the Family Real Estate in a Trust
Ownership of family real estate can be in a lifetime trust. There are two common trusts for this purpose, revocable trusts and irrevocable trusts. 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 real estate in a revocable trust maintains the parents’ (or original owner’s) 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 real estate 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 real estate 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 real estate without interruption or court involvement.
- In the event of either the grantor parents’ disability of death, the family real estate is not subject to probate administration and that the terms of the trust govern the disposition of the family real estate and asset of the trust.
- Following the parents death, the trust (or a sub-trust created under the living trust) can continue to own the property, and at this time it can have creditor protection for the benefit of the successor beneficiaries who inherited it from the parents. This can be done in the form of a “Cabin Trust” that is dedicated to hold the family real estate, or in separate trust shares for multiple beneficiaries. This allows for the land to be protected as to the liabilities that may be present, now or in the future, in the beneficiaries lives.
However, placing family real estate in ownership of a revocable trust may not be the best option in every circumstance. The following additional factors should be considered:
- The full fair market value of the family vacation home will be included in the parents/grantors’ taxable estate if the family real estate is titled in the parents’ revocable trust. This is only a real issue if the parents are likely to have an estate that is close to being taxable, in other words, $12.06 million or more in assets until 2025, and $5M (indexed for inflation), starting January 1, 2026.
- 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 real estate “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 real estate to raise funds for those purposes.
- Creditor protection during the parents’ lifetime 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. Creditors can pierce through the trust ownership of the family real estate and attach it for judgment liens or other liabilities.
Alternatively, the ownership of the family real estate could be transferred to an irrevocable trust. Irrevocable trusts can take many forms and serve many purposes, such as gifting the real estate now to the next generation, sheltering the real estate from long term care costs and Medicaid, or creating a succession plan for the ownership and use of the real estate for family members both current and future. The biggest difference between a revocable living trust and an irrevocable trust is that the letter cannot be modified, amended or changed y the parent/grantor, and that transfer of the real estate to such an irrevocable trust would constitute the parents “divesting” themselves of the property.
Some of the primary benefits of transferring the property to an irrevocable trust include:
- The property is transferred outside of the estate of the parents, and therefore is not included in their estate at death.
- Because the property is transferred outside of the parents’ estate, the real estate can be sheltered from the creditors of the parents during their lifetime. Depending on the type of irrevocable trust and purpose behind creating it, this could shelter it from long term care costs, health care costs in their later years, or potentially even liabilities such as bankruptcy or divorce.
- Long term family succession of the management and use of the trust can be structured now.
However, using irrevocable trusts to own the real estate is not without potential drawbacks, some of the most significant of which are:
- Loss of control. Because the trust is irrevocable and typically requires the parents to select a third party trustee (i.e. not themselves), they may lose significant control and management authority during lifetime.
- Loss of access to value of the real estate. Because the parents have divested the ownership to an irrevocable trust, they typically can never access or use the principal amount contributed, so if they need money later in life, they cannot get it through selling or mortgaging the property.
- Lack of flexibility. The trust is irrevocable, and as such cannot be easily modified based upon changed circumstances in the future. This concern can be mitigated through use of advanced trust planning features such as trust protectors, non-judicial settlement agreements, and trust decanting, but all are advanced strategies that require significant future work.
Using a trust to own and transfer the family real estate makes sense in many situations, however the pros and cons need to be weighed to determine if the use of a trust is appropriate, or whether the family should consider using an entity as discussed below.
Ownership of Family Real estate in an “Entity”
The ownership of the family real estate 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 real estate 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 family real estate to an LLC, there are a number of non-tax and tax reasons usually motivating such a transfer. One consideration in placing family real estate 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 real estate 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 family real estate is a problem with respect to the inclusion of the family real estate in the grantors/parents estate under IRS Code Section 2036. In the event that transfer of family real estate 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 real estate to an entity, such as an LLC, is the management or control of the family real estate. Usually, where grantors/parents transfer the family real estate 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 real estate. 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 real estate 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 family real estate 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 real estate to an entity and, ultimately, a succession plan for distribution of ownership interest to succeeding generations, is the operation and maintenance of the family real estate, 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 real estate 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 real estate.
- Sale of the family real estate and division of tangible personal property.
One significant benefit to using an entity to hold ownership of family real estate is imposing certain “buy sell provisions” in an operating agreement to govern how, and to whom, individuals sell their ownership interest in the family real estate. 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.
As with trusts, the use of the LLC to manage family real estate is very appropriate in some scenarios, but less than ideal in others. When considering whether to use a trust or LLC in planning for your families real estate, it is important to discuss all relevant factors with your attorney to ensure you are making the appropriate selection for you and your family.
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