Planning makes all the difference. Leaving the vacation property to each of your children in equal shares, without addressing all of the complexities of co-ownership, maintenance costs and the potential for serious disputes among the owners is not a plan.
Somebody recently asked me what was one of my fondest childhood memories. I immediately thought back to my childhood summers at my family’s cottage on Narragansett Bay in Rhode Island. Many families have vacation homes — the cabin in the North Carolina mountains or the beach house on Anna Maria Island. Whether you inherited it, bought it or built it with your own hands, your vacation home provides a great escape and builds lasting memories.
Most people who own a vacation home have high hopes that it will be an asset that future generations will continue to enjoy. Parents see their children grow up enjoying the vacation home and building lifetime memories. It is only natural for them to assume that their children will eventually take over and keep the home in the family for the grandchildren and later generations. Often, owners of a vacation home do not give it much thought other than to arrange their affairs such that each child will inherit an equal share in the vacation property. But as the original owners age, problems often arise. Adult children move away and find that they cannot use the home as much as they’d like to. The financial burden of maintenance and real estate taxes may be too much for some children, even if the home itself is owned free and clear. After the original owners pass away, one child may favor selling the vacation home while another may want to keep it. One child may want to rent it, while the others may want to keep it exclusive to the family.
Despite these obstacles, with advance planning and free and open discussions between the generations, it is possible to keep the vacation home in the family for future generations to enjoy for years to come.
The original owners of the vacation home (which I will refer to as the parents) should create a limited liability company (LLC) and transfer the vacation property to the LLC. Initially, the LLC will be owned by the parents. Over time, the parents can make gifts of LLC interests to their children or they can arrange for the LLC interests to transfer upon their death. Either way, the LLC operating agreement is the key to a successful vacation home transfer plan.
The LLC operating agreement must contain provisions dealing with the following:
Management of the property
Maintenance and financial contributions
Fair use by the owners
An exit strategy
The parents, with the help of an attorney, should discuss these issues with their adult children and include them in the drafting of the LLC operating agreement. The operating agreement will serve as the co-ownership agreement, imposing a fair structure on future generations with the goal of keeping the vacation home in the family for generations to come.
LLCs can be manager-managed or member-managed. A manager-managed LLC vests all authority to manage the LLCs property in a single manager or a board of managers. A member-managed LLC is more democratic, with each member having an equal say in management decisions.
The parents should discuss these options with their adult children and determine whether family dynamics would favor electing a single manager from among the siblings or diffusing management responsibilities among all of them. If the parents choose a manager-managed LLC, the agreement should specify how that manager is to be chosen and for how long the manager will serve. It may also be advisable to impose some restrictions on the manager, requiring him or her to get the approval of a supermajority of the members (or unanimous approval) for certain actions, such as significant capital improvements, selling the property, or renting the property.
The ownership restrictions in the LLC agreement should include a prohibition on any family member selling or transferring his or her interest to anyone other than a sibling or a lineal descendant. Third parties should be excluded. Such limitations will protect all of the owners from third party claims against an owner’s interest. Potential claims may arise out of an owner’s divorce or financial difficulties. These restrictions also protect an owner from being required to liquidate his or her interest to “spend down” the owner’s share at the time of disability or old age, prior to receiving governmental benefits, like Medicaid.
The agreement should contain provisions dealing with an owner who wishes to sell his or her interest. In that case, the other owners should have the right (or perhaps the obligation) to buy the interest, pro-rata. The agreement should provide a method for determining the purchase price and a built-in discount, because no sales commission is paid and because the seller is getting paid for something he or she did not have to buy and for something that otherwise would probably not be sold for decades to come. In the event of an owner’s death, the agreement would allow the LLC interest to be passed down to the owner’s children or to a trust for their benefit, if the children are minors.
Another issue that should be addressed in the operating agreement is the question of foreclosure. If one of the owners is not able to meet his or her financial obligations, should the LLC have the right to lower that owner’s interest over time, while allowing him or her to continue to use the property? Or should the LLC have the right to foreclose on a defaulting member and expel him or her from ownership? This is a difficult issue that is best discussed while the parents are still alive and with due consideration of each adult child’s relative ability to fund his or her maintenance obligations. Whether or not the parents are able to establish a maintenance fund will play into this discussion as well.
If the parents are able, they should consider establishing a maintenance fund and contribute to it regularly while they are still alive. Alternatively, the proceeds from life insurance could fund the maintenance fund when the parents die. The LLC operating agreement should address the preparation of an annual budget and fair assessments to be paid by each owner.
Ordinary maintenance costs can be paid by the owners on an annual basis, and a portion of each year’s assessment should go into the maintenance fund. Regular maintenance should be within the responsibility of the LLC manager, but major maintenance or capital improvements should require the approval of a majority, or perhaps a supermajority, of the owners. If the parents were not able to establish a maintenance fund or if the owners struggle with building reserves, then renting the property is a good way to generate the necessary funds. The operating agreement should address what approval is required to rent the property.
The agreement should also contain a dispute resolution mechanism, such as mediation and binding arbitration.
How and when the owners use the property should also be addressed in the operating agreement. Certain days — perhaps Memorial Day, 4th of July, and Labor Day — might be designated “open days” on which anyone and everyone can enjoy the home together. Otherwise, the calendar can be allocated fairly among the owners, with the possibility of certain weeks dedicated to rentals. The LLC manager can maintain the calendar or one of the other owners can be appointed the “scheduler,” with the final schedule subject to a majority vote of the owners.
Finally, it is important that the operating agreement provide an exit strategy. At some point, the owners may agree that it is time to sell the property. In other cases, some owners who do not use the vacation property as much as they’d like may wish to sell their interests to other owners who would like to use it more. As discussed above, owners should be restricted to transferring their interests only to other owners or to lineal descendants. The operating agreement should specify when the agreement itself should terminate. This date can be at the agreement of all the owners, or after as little as 5 to 10 years or as long as 30 to 50 years, depending on the number of owners involved, the expense of maintaining the property, the existence of a maintenance fund set up by the parents, and other issues.
As with most things in life, a plan makes all the difference. Leaving the vacation property to each of the children in equal shares, without addressing all of the complexities of co-ownership, maintenance costs and the potential for serious disputes among the owners is not a plan. Open discussion between the generations and the negotiation of a comprehensive LLC operating agreement can assure the vacation home stays in the family and is available for the enjoyment of future generations.
To plan your operating agreement, call business and corporate attorney Matthew Lapointe at 941.748.0100.