Owning a second home can provide both personal enjoyment and
financial benefits, but ownership also requires careful planning to ensure
long-term success. Whether the goal is to enjoy the property for years to
come, maximize rental income, or successfully pass the property to future
generations, making informed decisions is essential. Three key aspects
of planning with a second home include selecting the right ownership
structure, understanding the implications of owning the property in an LLC,
and developing a strategy for transferring ownership.
Each of these factors plays a critical role in preserving the property’s
value, minimizing tax burdens, and avoiding legal complications. This
paper explores these considerations, providing insights into how second
homeowners can effectively manage their properties for both present
enjoyment and future legacy.
HOW TO TITLE OWNERSHIP IN A SECOND HOME
Titling real estate properly is a key part of estate planning to ensure a smooth transfer of
assets, minimize taxes, and avoid probate. Choosing the right titling method depends on
individual circumstances, including relationship status, estate planning goals, and creditor
considerations. Many second homes have co-ownership titling with a spouse or other co-tenant, or are titled in the name of an entity such as a revocable trust or an LLC. Let’s compare
these common types of ownership and explore why you might use one over the other.
CO-OWNERSHIP
Among the most common forms of co-ownership are Joint Tenancy with Rights of
Survivorship (JTWROS) and Tenancy by the Entirety (TBE). JTWROS is a form of property
co-ownership in which two or more individuals hold equal shares in a property. TBE is
a special form of co-ownership available only to married couples and only in certain
states (e.g., Tennessee, Florida, North Carolina). While both ownership structures
provide for survivorship benefits and avoid probate, they differ in creditor protections
and transferability.
Creditor Protection: If a property is owned as JTWROS, a creditor can place a lien
on an individual tenant’s interest. Although the non-debtor tenant’s interest remains
protected, this could potentially force a sale of the property. If a property is owned as
TBE, creditors of one tenant cannot place liens on the property unless both tenants are
liable for the debt.
Transferability: A joint tenant can transfer their interest without the consent of the other
tenant. If a property is titled TBE, where available, neither spouse can unilaterally transfer
their interest; both must consent to any sale or mortgage.
Both JTWROS and TBE offer distinct advantages for property owners. JTWROS is ideal for
co-owners who seek equal ownership and an automatic transfer of property upon death,
though it lacks strong creditor protections. In contrast, TBE provides robust asset protection
and ensures both spouses maintain equal, indivisible ownership, making it a preferred
choice for married couples in states where it is available.
ENTITY OWNERSHIP
If creditor protection is not a concern, a revocable trust (also known as a living trust) can
be an effective way to own real estate. The primary benefits of this type of ownership are
as follows:
Probate Avoidance: Property in a revocable trust does not go through probate when the
grantor passes away, allowing for a smoother transition to beneficiaries.
Privacy: Unlike a will, which becomes public record, a trust keeps property ownership and
distribution private.
Planning for Incapacity: If the grantor becomes incapacitated, the successor trustee can
manage the real estate without the need for court intervention.
TRANSFERRING A SECOND HOME TO AN LLC
If creditor protection is important, a limited liability company (LLC) may be a good option.
LLCs have become an increasingly popular method for individuals to hold and manage real
estate assets, particularly if those properties are rentals. The structure of an LLC provides
numerous benefits:
Limited Personal Liability: An LLC creates a legal separation between the owner and the
property. This ensures that the members’ personal assets are not at risk if the LLC is sued,
provided that the LLC is properly maintained and corporate formalities are followed. This
is particularly important in the case of rental properties where claims related to property
liabilities, such as tenant injuries or contractual disputes, could arise.
Privacy and Anonymity: Some states allow LLCs to be registered with anonymity,
protecting property owners from public disclosure of their real estate holdings. This can
be advantageous for those concerned about privacy.
Before transferring a second home to an LLC to avoid probate or to make it available for
rent, carefully consider several important factors to ensure a smooth transition and avoid
potential pitfalls.
LEGAL FORMATION
When transferring property to an LLC, careful attention should be paid to the formation of
the LLC and the execution of any transfer documents to ensure the proper function of the
LLC. Items to monitor include:
• Ensure deeds transferring the property the LLC are properly executed and recorded
• Open a checking account in the name of the LLC to pay expenses and/or receive
rental income
• Draft and execute an operating agreement
Failure to adhere to the necessary legal procedures and documentation requirements could
potentially result in the LLC’s owners being held personally liable for the company’s debts
and obligations, effectively “piercing the corporate veil” that normally protects them.
MORTGAGE DEFAULT ON TRANSFER
Transferring a mortgaged property to an LLC can potentially trigger a default on the
mortgage, as many loan agreements contain a “due on sale” clause. This clause stipulates
that the full mortgage balance can be called due immediately upon transfer of ownership,
even if payments are current. Lenders include this clause to protect themselves against
the property being transferred to a borrower with a higher risk profile. Triggering this
clause could create the need to refinance, which could prove detrimental to borrowers
with favorable interest rates, or in the worst-case scenario, the lender could foreclose on
the property. To avoid defaulting, it may be prudent to obtain the lender’s consent before
transferring a mortgaged property into an LLC, which may require the LLC members to
personally guarantee the mortgage. Alternatively, the property could be transferred to the
LLC subject to the mortgage, with the original borrowers remaining on the loan.
HOMEOWNERS INSURANCE
Transferring the home to an LLC may require changes to existing insurance policies or the
purchase of new coverage to ensure the property remains adequately protected. Obtaining
homeowners insurance for property held in an LLC can present some additional challenges
and costs compared to insuring a property owned by an individual. Insurance companies
often view LLCs as higher-risk policyholders, due to concerns over occupancy, maintenance,
and liability issues that may arise with rental properties or properties not occupied by
the owner. As a result, insurance carriers may charge higher premiums for LLC-owned
properties, or have more stringent underwriting requirements such as requiring a higher
deductible, additional documentation, or even a commercial rather than residential policy.
Working with an insurance broker experienced in insuring LLC-held properties can help
navigate these challenges and find appropriate coverage at more affordable rates. LLC
members should carefully consider the insurance implications when deciding how to title
and structure ownership of real estate assets.
INCOME TAX CONSEQUENCES
Income tax consequences should also be thoroughly analyzed, as transferring property to
an LLC could have significant tax implications that need to be accounted for. If the property
served as the taxpayer’s primary residence for at least two of the five years preceding
the transfer, the owners might be eligible to exclude a portion of the gain from taxation.
However, if property is sold after being transferred to an LLC taxed as a partnership, then the
capital gain exclusion would not be available.
When a property serves the dual purpose of being used as both a rental and a second home,
it is important to accurately pro-rate the expenses associated with the property if it is rented
for more than 14 days in a calendar year. This involves carefully tracking and allocating costs
based on the amount of time the property is used for each purpose. Expenses that may need
to be pro-rated include mortgage interest, property taxes, utilities, insurance, repairs, and
depreciation. The percentage of expenses allocated to the rental use of the property may be
deductible as a rental expense while the portion of expenses attributed to personal use of
the property is not deductible. Maintaining detailed records and documentation is essential
to support the pro-rating calculations and ensure compliance with tax laws.
PASSING THE PROPERTY TO THE NEXT GENERATION
Passing a second home to the next generation is a complex but rewarding undertaking that
requires careful planning and communication to ensure that the property remains a family
asset and does not become a family liability. With financial investments and cherished
memories at stake, families must consider several key aspects—terms of use, funding
for expenses, and dealing with potential exit strategies for family members in a way that
safeguards the emotional and financial value of the property.
TERMS OF USE OF THE PROPERTY
Establishing clear terms of use for a second home is essential to avoid potential conflicts
among family members. These terms should outline items such as the scheduling of visits,
maintenance responsibilities, and usage limitations. For example, a shared calendar
may help allocate specific times for each family member, ensuring that everyone gets an
opportunity to enjoy the property without overstaying.
Moreover, family meetings can foster open discussions about the property’s use and
maintenance, allowing family members to express their preferences and concerns. It is
advisable to document all rules and guidelines to create an official record that can be
referred to in the future.
Additionally, incorporating a rental policy can be beneficial if family members are interested
in renting the property when not in use. This policy should cover pricing, how earnings will be
allocated, and upkeep responsibilities to ensure that the property remains in good condition.
FUNDING EXPENSES, REPAIRS, AND IMPROVEMENTS
As every homeowner knows, owning a house entails ongoing expenses such as property
taxes, utilities, and maintenance costs. To manage these financial obligations, families
should establish a shared fund, either funded by a senior generation by all interested
parties. One option could be to set an annual contribution amount based on usage or equal
shares, ensuring that each family member has a stake in the property’s upkeep.
The family could also designate a financial manager, perhaps someone with experience
in budgeting or real estate, to oversee the fund and ensure that all expenses are tracked
meticulously. This manager can administer a transparent reporting process, providing
regular updates about the fund’s status and any upcoming financial needs.
For major repairs or improvements, families might want to discuss establishing a special
assessment to cover unexpected costs. Planning for these dimensions requires detailed
discussions and agreement among family members, and fostering a culture of financial
accountability can help sustain the property’s heritage.
EXITING OR SELLING AN INTEREST
While the hope is often for a second home to be passed down through generations,
circumstances may arise where a family member wishes to exit the arrangement or sell their
interest. This requires a compassionate yet structured approach.
It is prudent to establish a buy-sell agreement that outlines the rights and responsibilities
of family members in the event one party wishes to sell their interest. This agreement can
specify how a fair market value will be determined and give existing family members the first
right to purchase the departing member’s share before outside buyers are considered.
On the flip side, if a family member feels they no longer have an interest in the property
or cannot afford the ongoing expenses, open and honest dialogue is paramount. This
conversation should address their feelings and circumstances while ensuring that the rest of
the family understands and respects their choice.
CONCLUSION
With careful and attentive planning at the outset of owning a second home, families can
focus on the purpose the second home is meant to serve – an escape from the hustle and
bustle of everyday life and a place to build family memories.