Tax Planning For Your Vacation Home

Many people with second homes do not give much thought to the estate taxes that could be due when they die; often the possible estate taxes are not even on their radar. The second home is supposed to be a place of respite, a happy place, so why interrupt that solitude with death and taxes.

However, if your vacation home is located outside your state of residence, your heirs could owe an estate tax to that state (in addition to taxes due to the federal government and your state of residence). Here is what you need to know:

• Remember, the estate tax is a completely separate tax from the income tax. An estate tax is typically due nine months after someone dies if the value of their assets exceeds exemption amounts.
• The federal estate tax exemption amount is $12,920,000 per person in 2023, and will be dropping to approximately $6 million in 2026. (These amounts can be doubled for a married couple.)
• In addition to the federal estate tax, 17 states and the District of Columbia impose an estate (or inheritance) tax—Hawaii, Connecticut, Illinois, Iowa, Kentucky, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, Oregon, Pennsylvania, Rhode Island, Vermont, Washington and the District of Columbia.
• All states have an exemption amount which is designed to allow people with more modest means to transfer their assets at death with little to no tax imposed.
• The exemption amounts range from $1 million (Oregon) to $12,920,000 (Connecticut).
• Even if your vacation home is valued below the state’s exemption amount, you should not assume that no taxes will be due. This is because in many states, the tax due for a non-resident is proportionally based on the value of the assets in that state compared to the person’s worldwide assets. For example, if you are unmarried and living in Florida, with a $2 million cape house in Massachusetts and total worldwide assets of $10 million, a tax is due to Massachusetts, even though the Massachusetts exemption amount is $2 million. Your estate will owe an estate tax of approximately $193,600. However, if you have a condo on Cape Cod worth $800,000 and worldwide assets of $2 million, there will be no tax due to Massachusetts. Bottom line, in many states your total assets (not just your vacation home) have to be below the exemption amount to avoid an estate tax.

If you do have a tax due, you have some planning opportunities. One option is to create an irrevocable trust and gift the vacation home to the trust. This is particularly attractive if the home will be a legacy property where the family will gather for years to come. Be advised that if you do gift the house to an irrevocable trust, you will need to lease the property back in order to use it. Some people are opposed to this because they do not like the idea of paying their children rent. However, it is actually another way to move money to the next generation, since the rent payments can be used to defray operating costs that the children would otherwise need to pay.

Another option involves transferring the vacation home to a limited liability company (an LLC) to avoid the estate tax. By doing so, you would convert the real estate to an intangible asset (the interest in the LLC), which many states do not tax if you live out of state. This works best when the LLC will have a legitimate business purposes; for instance, if you will rent the property out to tenants for most of the year. If you do transfer the home to an LLC without a business purpose, there may be risks associated with the transfer, so be sure to speak with your attorney about them.

Finally, make sure your estate planning attorney knows about all your assets including your out of state real estate and any foreign assets. Your estate plan may need to be updated to account for them.