From the November 2007 issue of Wealth Manager Web • Subscribe!

House Proud

Jack Johnson thought he had it all figured out: 17 years ago, he placed his summer house in an irrevocable trust that enabled him to transfer it to his two daughters as a gift, rather than an inheritance. Not only did that put the property outside of his estate--saving on estate taxes--but the property transferred to them at about a quarter of its value--greatly reducing the amount of gift tax he had to pay. At the time of transfer--17 years ago--the property appraised at $700,000. But under a complicated formula that takes into account items such as net present value and interest rates, the house was then valued at only $170,000. Unfortunately, the plan hit a snag: His daughters were unable to pay the property taxes and upkeep on the property, so he was forced to buy it back--for $5 million. And the house is now back in his estate.

"I bought it back at the current market value so that [my daughters] wouldn't have to pay the upkeep," says Johnson (who asked his name be changed to protect his privacy).

Apparently, say the experts, this is a pretty common problem for the wealthy, and their children--though it usually happens after the parents die. Mom and dad own a beautiful vacation home, but their children simply can't afford to inherit it.

"The issue comes up a lot," says Eric Wasserman, a partner with Wasserman & Walkup, a multi-family office in Los Angeles and Wilmington, Del. "Oftentimes, when I'm in planning sessions with clients, and we begin to talk about the transition plans involving property, they come to the conclusion that it's beyond the ability of the next generation to maintain it."

Wasserman's firm serves the ultra-wealthy, whose properties often involve maintenance issues that go well beyond property taxes. While the clients usually leave their children cash along with the property, the money is sometimes split among so many heirs that it still isn't enough to maintain the property on a long-term basis. "In a large family, no one in that next generation has the level of wealth that would provide for the lifestyle the patriarch and matriarch had," Wasserman says.

However, there are ways of addressing this problem. One possibility is for the first generation to form a trust specifically devoted to the upkeep of the property. Parents might put aside, say $4 million which, at 5 percent, would generate $200,000 a year--enough to cover the property taxes, annual costs and maintenance of the property. Another possibility is to purchase an insurance policy whose payments can be used for property maintenance.

Sean Sebold, president of Sebold Capital Management in Naperville, Ill., is currently working with a family that owns a very large, $3.5 million to $4 million vacation home that the patriarch--now deceased--had hoped would remain in the family for centuries. But the family matriarch can no longer afford to hold onto it and wants to sell. "If someone doesn't have the financial wherewithal, they don't have a decision," Sebold says.

The family discussed the issue for six months, and the three children finally concluded that the house would have been more of an albatross than an asset. Moreover, they would always have felt compelled to vacation there. "It was a large piece of property with a lot of value, but there wasn't a whole lot of excess cash flow, and it didn't generate any income," Sebold explains.

The burden on children would be smaller if parents better prepared for it, for instance, by taking out an insurance policy whose sole purpose would be to cover the estate and property tax burdens. But many parents simply don't want to do that.

Matthew Chope, a CFP in Southfield, Mich., says one of his clients pays $30,000 a year in life insurance premiums so that his children will have $3 million with which to pay the estate taxes. Still, he hates writing that check every year.

The truth is, most children don't even want their parents' vacation homes, advisors say. They view any kind of fixed asset or real estate as a burden. And the parents--if they are still alive--are usually surprised by this notion. "People who own a second home often think it's the Taj Mahal. They think it's so beautiful, why wouldn't someone want it?" says CFP Robert Mecca of Mt. Prospect, Ill.

Of course, the children can simply sell the house. Problems develop when one child wants to sell, and the other does not. Mecca has one client whose son wanted to move out of his rental unit to buy a house--but his parents' second home was in Florida where he did not want to move. The parents solved the problem by rewriting their will: Instead of splitting the Florida house between the son and his sister, they gave him half the value of the house in cash at today's rates, and gave his sister the house in its entirety.

When issues like this come up after the parents have died, an estate attorney has to help determine precisely what the will says. If two children hold ownership, the property would then be valued, and the child wanting to retain it would have to buy out the child who wants to sell it. In general, when it comes to vacation property in an estate, advisors say the key to a smooth transition is for the family to communicate about these issues early and often. "As long as the family is discussing the plan, you can find an answer. The problems arise when no one wants to talk about it," says Scott Horn, chief wealth management officer at INLIGN Wealth Management in Phoenix.

Horn actually had one family create a quasi time-share arrangement: The parents had five properties sprinkled around the country; their five children were scattered in a similar pattern. The two living on the West Coast saw little value in having a condo in the East or a home on a lake in the Midwest, while the three living farther east didn't think they would get much use out of the condo or mountain house in the West. Furthermore, everyone wanted to keep the beach house on the East Coast, but those on the West Coast said they were unlikely to get there much because of the long plane ride. Eventually, the parents threw everything into a trust, in which everyone is a beneficiary but no one holds title to any one property. In theory, each child only gets so much time at each property. The parents plan to purchase an additional property on the West Coast just to keep things even: two properties in the West, two in the East, and two smack in the middle.

If the family is dysfunctional, however, advisors may not even be able to get everyone to sit down at a table to discuss the issues that may arise after parents die. "There's a desire not to talk about the money," says Horn. "Sure, it has to be the right time. It's not always good for an eight year old to know he's worth $10 million. But someone going through college needs to understand what they have and what their responsibilities will be."

A couple of times a year, Horn sits down with his clients--and, hopefully, their children--to discuss which assets should be considered "legacy" assets, those the family plans to keep in perpetuity. And when it comes to property, the objective is to transfer those assets to the children as quickly as possible.

Alan Brachfeld, a CPA and financial advisor in New York, is currently dealing with a family in which two children want to sell the parents' second home in Pennsylvania, but the third child wants to keep it. The family could have avoided much of their ensuing arguments had the parents put in their will that upon their death, the executor will sell all vacation property for cash, Brachfeld says. "It costs about $60,000 a year to maintain this property. Not a lot of people have that kind of discretionary income, particularly for a house they'll only use three or four times a year."

Brachfeld believes the children should retain the properties only if they generate income. And if that's the case, one of the best things a parent can do is throw that property into a testamentary trust that distributes the property's revenues to specified individuals, he says. That way, the parents can be assured the revenue goes to their children and their children's children, and does not get hijacked before it reaches future generations.

Sometimes, parents find out in advance that their children won't be able to handle estate management responsibilities. Financial advisor Matthew Chope had a client who was the president and CEO of a small gear company in the automotive industry--a supervisory role he seemed to take with his family as well. For instance, his retirement plan included a family limited partnership into which he placed a lot of his property, in an attempt to reduce the estate tax burden on his children. But the partnership structure required so much maintenance that he spent a good part of his retirement managing his retirement plan. For one thing, because he was running the limited partnership, he was preparing the tax returns for all the children.

"It was too much of a headache for him," Chope says. "He felt like he was the CEO and chairman of the board of his retirement corporation. He was the secretary and go-to person for everything, and he really just wanted to step back and live a little."

Chope advised the client to dissolve the Family Limited Partnership and stop doing the taxes for the entire family. Next, he distributed about $1 million in cash and property to his children--who were in their 40s--to see how they would handle the windfall. He soon discovered that they were not capable. While all his children held masters degrees and were exceedingly intelligent, two appeared to have emotional issues that impeded their ability to manage money, Chope says.

One daughter, a teacher in Alaska, spent her entire inheritance within six months. A son, trying to prove he was as savvy as his father, bought some rental properties that--after two or three years--were worth less than when he bought them. He had to turn to his father for a loan just to make ends meet. The remaining two children fared well and are taking good care of their new properties.

The lesson helped the family redevelop their estate plan. Instead of giving all of the children everything at once, the plan is now structured so that the cash and assets will roll out over a lifetime.

"When they look back on it, they think it was the best thing they ever did, because of what they learned from it," Chope says. "They learned their kids couldn't handle a big windfall."

Second-Home Blues

Wealthy clients can often afford a second--even a third--home, and most spend in excess of $1 million for such a property. But even the rich need to keep tabs on their spending. A client living off a $10 million investment portfolio is still going to feel a hit of $1 million, says Scott Horn, chief wealth management officer at INLIGN Wealth Management in Phoenix.

"If they buy another property, either their costs are going to go up, or they're going to have less to live on," Horn says.

"A lot of second and third homes never should have been purchased," says Roy C. Ballentine, a CFP and president of Ballentine, Finn & Company, Inc. based in Wolfeboro, N.H. "The family would have been better off to rent a property."

Ballentine says vacation homes can cost more than $100,000 a year to maintain--and that's for a property without a mortgage. With costs like that, clients had better be holding the property for at least 10 years to make it worth their while.

Robert Mecca, a Mt. Prospect, Ill. CFP, has a client who said, "I want a second house. I also want to retire." After running through the analysis, Mecca told him, "The numbers aren't working. You can't have both." The client, age 43, didn't hesitate. "I want the house," he said. Although Mecca warned the client he'd have to work a lot longer if he bought a second home, the client didn't seem to care. In fact, Mecca has seen cases where people even skip funding their children's college education to purchase a second home. "There are some people who will say to their kids, 'You're on your own. My parents never helped me, so I won't help you,'" Mecca says.

Sean Sebold, president of Sebold Capital Management in Naperville, Ill., says he recently had a client tell him he was buying a property in Vail, Colo., because it was a good investment. The client paid cash for the property and planned to rent it out, but he failed to take into account the upkeep costs, the high property taxes, and the fact that he would have to furnish and manage it.

"Generally speaking, when someone buys a second or third home, it's a bad investment," Sebold says. "I'm making a rather gross generalization, but my point is, people generally don't consider the cost of the property when they're buying a second home."

Alan Brachfeld, a CPA and financial advisor for Total Asset Planning in New York, says the wealthy may not be limited in how much they can spend on a second home, but they're limited on how much mortgage interest they can deduct, and that can affect how much they should shell out. Individuals can only deduct up to $1 million in mortgage interest. That means if their first home already carries an $800,000 mortgage, they're only going to be able to deduct up to $200,000 in mortgage interest from their second home.

Brachfeld has friends in Quogue and the Hamptons on Long Island who recoup most of their annual maintenance costs by renting out their multi-million dollar homes for just one month a year. Still, you can't forget the expenses: "When you have a home in the Hamptons, you have expenses related to the pool, the tennis court, landscaping, security." Landscapers can cost $10,000, the pool about $5,000 to maintain, real estate taxes can be well in excess of $17,000, and if you're near the water, your insurance costs can be three-times higher than being inland.

Clients who do buy real estate with the hope of renting it out had better live nearby, or it can be very difficult to manage. "If you live 3,000 miles away, it can be very frustrating. You'll need to hire someone to take care of it. And it's very costly to visit your property," Brachfeld points out.

Caren Chesler has written for the New York Times, Investor's Business Daily and Investment Dealers' Digest.

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