Any happy memories you have of childhood summers spent on Lake Swimmersitch are far exceeded by regret that your parents weren't using your college fund to buy every inch of shoreline that came on the market back then. In the last few decades, easy money, a shrinking supply of properties and boomers looking to spend their golden years on Golden Pond have caused prices of second homes in some vacation areas to grow at twice the annual rate of primary residencies.
This meteoric rise has left many families with some unexpected concerns. For one thing, it's no longer just the family retreat. It's often a vacant expensive-to-maintain property that has become so valuable that hefty estate taxes will have to be paid some day.
Thankfully, by using insurance and trusts, you can help your clients retain their recreation homes for generations without burdening their children with a tax bill. Used separately, the strategies are effective. But together, the advantages are extraordinary.
The Best Policy
Whenever “death” and “taxes” occur in the words of a client's question, “life insurance” is certain to be part of the answer. This goes double for families looking to pass a second home to their children. But the process is a little more complicated than just paying premiums.
First of all, someone other than the parents should own the insurance policy. The advantage of this is that when the policy is paid off the proceeds will not be part of the parent's taxable estate. The adult children are obvious choices.
Another consideration is the type of life insurance to buy. The kind your clients will choose will depend on the family's specific needs, but it's likely they will want to get the highest death benefit they can for the lowest possible cost. If covering potential estate taxes is the primary goal, then a second-to-die policy would be the best solution.
When calculating the death benefit, you'll need to consider more than just Uncle Sam's take. Be sure to provide enough money to compensate the children who would rather have the cash instead of a share of the cabin. And add another amount worth at least six figures to cover future property taxes, maintenance costs and management expenses.
A Matter of Trusts
Although a decent life insurance policy will generate the cash needed to bequeath a vacation home to descendants, some clients might balk at the price of the premiums. Or the insurance company may say, “Thanks, but no thanks” once the applicants' medical evaluations are submitted.
In that case you should redirect your clients to a qualified personal residence trust, also known as a QPRT. It's an irrevocable trust with your clients' heirs as the beneficiaries. It will cost your clients a few thousand dollars in attorney fees to set up and may trigger a gift tax now, but the time and money spent today could save a lot more of the same in the future.
The most important feature of the QPRT is that it expires on a predetermined date chosen by your clients, so when the term of the trust ends the beneficiaries become owners of the property — free from all gift and estate taxes.
About that gift tax liability — yes, the donors may incur a decent-sized bill from the IRS for their generosity. But that can be reduced or eliminated, thanks to two factors.
First, clients are free to use their lifetime gift tax exemption of up to $1 million. But even more useful is how the property's value is determined. Instead of using the market value, it is calculated based on an IRS formula that incorporates the age of the donor(s), the “applicable federal rate” at the time of the transfer and the predetermined life of the QPRT. Higher numbers in any of these three categories will reduce the size of the gift for tax purposes — usually to a fraction of what the place would sell for on the open market.
There are some other features of the trust that need to be considered. Since the trust is irrevocable, there's no “do-over” if your clients change their minds. Also, because the value of the property in a QPRT is based on what it was worth when it was placed in the trust, if the children decide to sell the property in the future, they could be hit by capital gains taxes.
Belt and Suspenders
Buying life insurance while establishing a QPRT is an especially shrewd move for benevolent owners of second homes. Since the trust will theoretically eliminate estate taxes on the property, the clients can get by with a smaller death benefit — and lower premiums. And if the parents don't outlive the trust the life insurance proceeds can still be used to pay any estate taxes.
Now is the time to act. After all, the odds of parents expiring before the QPRT does, the cost of insuring their lives and the prices of vacation homes are all likely to go in one direction — up.
Writer's BIO: Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com