Originally published in Michigan Lawyers Weekly and republished with permission.
Family cottages are a fixture of life in Michigan, especially in the summer. Often, there is a strong desire by owners to keep a cottage in the family for generations to come. Yet, thinking about how to transfer the family cottage to the next generation can be overwhelming.
Many owners focus on the big picture, which child(ren) will have an ownership interest in the cottage, who will maintain the cottage, and what rules will govern the use and management of the cottage. These are all important decisions. However, the manner in which these decisions are implemented and the entity that will govern the use and management of the cottage is equally important. Moreover, various taxes – particularly real estate taxes, income taxes and estate taxes – may well play a role in determining the proper manner of cottage ownership.
In our October 2009 advisory entitled “Protecting Memories, Making New Ones” we discussed an overview of the planning related to transferring a family cottage to the next generation, including issues related to real estate taxes, estate taxes and the ownership and management of the family cottage. In this article we suggested the use of a limited liability company (LLC) or trust as the ownership vehicle for a family cottage. So how do you decide which entity is best suited for their family cottage? An LLC or a trust? The answer to this question will depend on each individual family’s circumstances and objectives. Below we have outlined some of the issues that should be considered though before a family chooses between a trust and an LLC.
Real Estate Taxes: An initial consideration is whether the property at issue is classified as a “principal residence,” which results in an exemption from a portion of the real estate taxes owed on the property. Depending on the value of the property, this exemption can result in a significant reduction in the real estate taxes owed.
Michigan law defines a principal residence as the place where a person has his or her true, fixed, and permanent home to which he or she intends to return whenever absent. In Michigan, it is often the case that the family cottage is occupied as a principal residence, typically by the original owner. If this is the case, the cottage should not be transferred to an LLC because doing so will result in the loss of the principal residence exemption. Although if the owner desires to have an LLC in place for future generations, he or she could create the LLC now but not transfer the cottage to the LLC until after death. In order for this to work, the owner would have to include a provision in his or her estate plan for the transfer of the cottage to the LLC at death. This is sometimes referred to as a “springing LLC.”
Income Taxes: Another consideration with regard to cottage ownership is whether the owner may want to sell his or her interest in the cottage in the future. If a cottage has been owned for a long period of time, the sale of an interest in a cottage could be subject to hefty capital gains taxes. However, if the cottage is the owner’s principal residence, the owner is not subject to capital gains tax on the first $250,000 of gain (or $500,000 for a married couple). In this case, an LLC should not be used to hold current legal title to the cottage as the principal residence exemption will be lost and, thus, the owner will not be entitled to the corresponding exemption from capital gains tax.
Estate Taxes: If a cottage owner faces estate tax concerns, he or she should consider options to minimize estate tax liability. One popular planning technique is to gift interests in a shared-use asset, such as a family cottage. A cottage owner may deed up to $13,000 annually (or $26,000 for a couple) of ownership interests in the cottage to children and/or grandchildren without incurring any federal transfer taxes. Not only does this reduce the owner’s taxable estate, but it also assists in transferring ownership of the family cottage to the next generation. Preparing and recording deeds each year though can be arduous. If an owner intends to deed ownership interests in the cottage annually to children and/or grandchildren, it would be wise to transfer the cottage to an LLC. The owner (and the next generation of owners) will then be able to give “membership” interests in the LLC each year by simply signing an unrecorded Assignment.
However, if the owner’s children have sufficient wealth for estate taxes to be a concern in their estates, the owner may want to consider the use of a trust which contains “dynasty” planning. Dynasty planning would provide for long-term trust ownership of the cottage and it would allow assets to avoid inclusion in the children’s (and grandchildren’s) estates.
Prior to choosing an LLC or a trust, an owner should also consider the amount of control he or she desires to have over the future use and management of the cottage. An LLC provides more flexibility and control for the future owners of the cottage. With an LLC, the future owners can amend the terms of the Operating Agreement, provided they have the consent of all of the members of the LLC. Conversely, a trust offers greater control for the current owner over the future use and management of the cottage. With a trust, the future owners will have less (or no) flexibility to change the terms of the agreement. Thus, if an owner desires to give his or her children and grandchildren ultimate control over the use and management of the cottage, an LLC is more advantageous. If an owner desires to dictate the rules of the cottage for future generations to come, a trust is more advantageous.
Cottage owners should also consider whether the cottage will be used by non-family members or renters. In this situation, an LLC is more advantageous as it offers the owners liability protection in the event a person is injured while staying at the cottage. An LLC will limit the owner’s liability to the value of the cottage, thereby, insulating the owner from further personal liability.
For most owners, an LLC is going to be the preferred method of ownership for their family cottage, in part because of the ease of transfer, and in part because of the flexibility an LLC provides. However, each family and each situation is unique, so the above considerations (as well as many others) should be discussed with owners prior to making a decision between an LLC and a trust.
Contact any one of our experienced Cottage Law attorneys for more information.