Reduce estate taxes and head off family feuds when you pass on your vacation house. September 30, 2007 By Kathryn A. Walson When Gary and Chriss Otto bought a vacation retreat in the Southern California desert about six years ago, they knew they wanted to eventually leave it to their three adult children. So the Ottos, who live near Los Angeles, put their vacation property into a trust, along with money to cover its costs for 20 to 30 years after they die.The trust bars the couple's daughter and two sons from selling their shares, unless two of three siblings agree to it. Gary, 60, says his children like the plan because they want to one day share the seven-acre haven with their own children. "The objective was to keep the estate in the family long after we're gone," says Gary, who runs a construction business. Like the Ottos, you may own a vacation home that brings your family together for fun times and relaxation. But passing it on to your heirs requires planning. If you don't work out details now, the source of memorable gatherings could drive your children apart after you die. Your heirs could also end up paying substantial estate taxes. The first step is to find out whether your children even want the home. No matter how much they cherish the family retreat, they may believe that the drawbacks of owning it outweigh the benefits. Perhaps they live far from the property, making it a hassle to get there. Consider broaching the topic this summer, while you're spending time together at your beach cottage or lakeside cabin. "You may feel like you're leaving a nice bequest when in fact you're leaving them with a burden or headache," says Bernard Krooks, an estate-planning lawyer with Littman Krooks, in New York City. "The kids may have great memories, too, but they may not want to vacation there every year." Advertisement If your children say they want the house, ask how they plan to use it. Will they all want to visit the property in August? Sharing a second home can create discord among your children and their spouses. Krooks recalls one instance where the spouse of one sibling changed the locks on a house during a dispute so other family members couldn't use it. When children don't get along, the simple solution is to have the house sold after you die, with your children sharing the proceeds. Robert Sullivan, a financial planner at Sullivan & Serwitz, in Los Altos, Cal., suggests that you ask yourself: "Would they naturally come together and buy this house?" But if you're determined to keep the property in the family, realize that not all your children may be able to afford to pay for its maintenance and taxes. Consider doing what the Ottos did: Leave your heirs enough money to cover the costs. If only one child wants the house, you could leave it to that child and set aside the equivalent amount of money to the other heirs. The home will have to be appraised following your death to ensure that your children receive accurate amounts. Regardless of who will get your second home, you can leave it through a will or a revocable living trust. Neither has an effect on estate taxes. But if the property goes into your will, the house will go through costly and time-consuming probate. If the vacation home is in a different state from your main residence, your heirs will have to go through probate in two states. A living trust doesn't have to go through probate and gives you more control. Note that estate laws are different in each state. Advertisement If you plan to pass your vacation home to multiple heirs, you can establish rules in your trust. You could also set guidelines in an operating agreement or joint venture agreement, which are contracts with your heirs. Make sure to share your plans for the trust with your family, and ask for ideas. "The more parents pave the way with guidelines, the less likely there will be family discord in the future," says Colleen Barney, an estate-planning lawyer with Albrecht and Barney, in Irvine, Cal. For example, you can bar your children or grandchildren from selling their shares to an outsider without majority consent, as the Ottos did. Or it might be wise to outline what will happen if one child fails to fulfill his or her responsibilities. If you want to ensure the property isn't lost in a divorce, name your children and grandchildren as sole beneficiaries. You can even choose who gets the house on which holidays and whether to allow pets. Another option is naming an heir who will be in charge of writing the checks for taxes and repairs, or you can divvy up duties among family members. Shelter Your House From Taxes To save on estate and gift taxes, consider an irrevocable qualified personal residence trust, or QPRT. You would transfer the house to a trust and retain the right to live there rent-free for a specified amount of time, perhaps 10 or 15 years. If you're still alive when the trust term ends, your heirs receive the property free of estate taxes, no matter how much the property has appreciated. The amount of gift taxes owed, if any, is based on a formula that takes into account the owners' ages, the term of the trust and the property's value. However, if you die before the term ends, the house will be returned to the estate and the children will pay estate taxes on the fair market value. If you go with a QPRT, be sure to choose a realistic term for the trust. "At 70 or 75, you've got a pretty good feel if you're going to make it to 80 or 85 -- better than if you're 40," Barney says. Advertisement You could reduce the potential estate-tax bill by giving the property to your kids while you're alive. Doing so would keep any future appreciation out of your estate. But the picture changes if your children ever sell the house. They could end up paying a lot in capital-gains taxes because the bill would be based on the price you paid for the house. If, instead, your children inherit the house, they would get a "stepped up" tax basis, which would be the value of the home when you die. All appreciation during your lifetime would then become tax-free. Whether you give the house to your children now or later depends in part on how much the place has appreciated since you bought it and how long your kids are likely to keep the house after your death. If your kids don't plan on selling, the value of avoiding estate taxes after your death would be enhanced. This year, the top federal estate-tax rate is 45%; the top rate for capital gains is 15%. Hiring a financial planner to crunch all the numbers for you could be a wise investment. This article was originally published in the August 2007 issue of Kiplinger's Retirement Report.