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George F. Bearup, J.D. Senior Legal Trust Advisor

14-Apr-21

SLATs and Vacation Homes

Take-Away: A second home, or vacation home, is an excellent asset to transfer to a spousal lifetime access trust (SLAT). A vacation home normally consumes income rather than generates income. In addition, often the vacation home is an heirloom type of family asset with plenty of memories held by children and grandchildren, which makes it less likely the children will sell the vacation home, since as a lifetime gift to the SLAT, the vacation home will receive a carryover income tax basis.

Background: A SLAT is considered to be an effective device to use an individual’s available large federal gift tax exemption while it exists. The SLAT is funded with appreciating assets that are removed from the donor’s taxable estate. The donor’s federal applicable exemption amount shelters the transfer from federal gift taxation. The donor’s spouse, and perhaps other family members, are the SLAT beneficiaries. If income producing assets are transferred to the SLAT, that income generated by the SLAT’s assets indirectly remains available to the donor, through the donor’s spouse who is the SLAT beneficiary. Consequently, valuable assets, and the subsequent appreciation of those assets, are fully removed from the transferor’s taxable estate, yet the income derived from those transferred assets is indirectly accessible by the transferor-grantor. While SLATs are frequently used to hold income producing assets, some non-income producing assets like a vacation home or second home, while not income producing, can also be effectively held in a SLAT.

Planning Options: If a SLAT holds a vacation home or second home of the grantor, like any other assets transferred to the SLAT, any future appreciation of the residence is removed from the grantor, and the grantor’s spouse’s taxable estates for federal estate taxes. Often the SLAT functions as a dynasty trust that holds title to the vacation home for several generations, thus avoiding estate taxes on the residence each time a SLAT beneficiary dies.

  • Grantor Trust: A SLAT is normally a grantor trust for federal income tax purposes when the donor’s spouse is the trust beneficiary. This means that the donor pays the income taxes on the SLAT’s income, which enables more assets to accumulate in the SLAT in a tax-free environment (tax-free only because the grantor continues to pay the income taxes.)
  • Rental: If the donor wishes to use the vacation home after it is transferred to the SLAT, it is advisable that the donor pay the SLAT fair rental value for the home. This rental payment will avoid claims by the IRS that the donor spouse retained the use and enjoyment of the transferred residence, which would otherwise bring the present value of the residence into the grantor’s taxable estate. [IRC 2036(a)(1).] In addition, by paying the SLAT fair rental value for the use of the residence, the rent paid is also removed from the donor’s taxable estate. As with QPRTs, the donor’s rental agreement with the SLAT’s trustee is not considered a retained interest under IRC 2036(a)(1).
  • Sale: There is some concern, however, with the recent Tax Court decision, Estate of Nancy Powell Tax Court No. 18 (2017), that expanded the scope of retained rights under IRC 2036(a)(2) with regard to implied retained legal control by the donor. One way to avoid the problem of implied control posed by Powell, is to rely on the bona fide sale exception under IRC 2036. If the donor sells the vacation home to the SLAT for its fair market value, then Powell should not pose a problem. Note that because the SLAT is normally classified as a grantor trust, the sale of the residence to the SLAT will still have carryover basis, but no gain will be recognized by the transferor spouse. Since the SLAT is a grantor trust, the trust’s existence is disregarded for income tax purposes and the transferor will be viewed as still owning the residence for income tax purposes. However, a sale of the vacation home to the SLAT will probably not qualify for the IRC 121 $250,000 exclusion from gain, first because it is not the transferor’s principal residence, and second, as noted, the sale is to a grantor trust where gain is not recognized, resulting in a carryover income tax basis in the residence held in the SLAT.
  • Spouse as SLAT Beneficiary: There might be some concern of the appearance of a retained right by the donor if the donor’s spouse is given the use and enjoyment of the vacation home that is transferred to the SLAT. However, in Estate of Allen D. Gutchess, No. 4926-63, 1966-08-9, a family residence was transferred by a husband to his wife 11 years before his death. The value of the residence was not included in the husband’s taxable estate under IRC 2036, even though the husband continued to occupy the home with his wife until his death. There was no written or oral express retention of the right of occupancy by the husband and no agreement for his right of occupancy. The Tax Court refused to find an implied agreement of occupancy merely from the fact that the husband lived in the residence with his wife until his death.

Practical Considerations: If a vacation home is to be transferred to a SLAT, some provisions to consider including in the SLAT instrument are the following:

  • Personal Use Assets: A provision that permits the trustee to hold personal use (non-income producing) property; a professional trustee might have some concern in the absence of  such an  authorization;
  • Rent of Residence: A provision that permits the SLAT beneficiaries to use of the residence rent-free, although as noted earlier, it may be preferable for the donor-settlor to pay rent to avoid IRC 2036 issues and to shift (through rental payments) more assets out of the donor’s taxable estate;
  • Trust Director Responsible: If the SLAT uses a trust director, f/k/a a trust protector, who controls investments, is wise to identify if the SLAT’s personal use property is viewed as an investment decision or a distribution decision, so that it is clear which trustee (investment vs distribution) controls the holding and use of the residence by the SLAT beneficiaries;
  • Rules and Regulations Regarding Use: Whichever trustee controls the use of the residence, that trustee should be authorized to create and enforce the rules and regulations for the use of the real property. These regulations might address religious preferences of some beneficiaries, e.g. the kitchen adhere to a particular faith religious dietary restrictions; or a restrictions on pets or prohibition of smoking or alcoholic beverages on the premises if some SLAT beneficiaries have allergies;
  • LLC as Titleholder: If the vacation home might be used by third parties who are not SLAT beneficiaries, e.g. a bed and breakfast, then authority should be given to the trustee to hold the residence in the name of a single member LLC for liability protection purposes. The Operating Agreement of that LLC could contain the rules and regulations about the use of the real property, or when it is used, or who is responsible for repairs, etc. The use of the LLC may also be helpful if the residence is located in another state, as the LLC effectively transmutes  real property (controlled by the laws where the real estate is located) to an intangible asset that the SLAT trustee can hold, regardless of where the real estate is located. In short,  the use of the LLC to hold title to the residence will provide: (i) control and management of the residence; (ii) succession of management; (iii) permits the SLAT to hold real estate, wherever the real estate is located; and (iv) supplies an additional layer of asset protection with regard to other assets that may be held in the SLAT.
  • Property Taxes: If title to the residence is held in the SLAT, there is a good chance that the residence will not qualify for the homestead exemption. That is clearly the case if title to the residence is held in a single member LLC which, in turn, is owned by the SLAT. The Michigan Tax Commission has expressly held that an LLC that owns a residence will not qualify as for the homestead property tax exemption because the LLC is a ‘business entity.’ This position is a bit contrary to the Uniform Limited Liability Company Act which provides that an LLC “may have any lawful purpose, regardless of whether for profit.” [Uniform Act, section 108(b).] Thus, under the Uniform Act, an LLC need not have a business purpose to satisfy that Act. If a second home, or a vacation home, is transferred to a SLAT, probably the grantor’s home is used to claimed as their homestead.
  • Insurance:  Questions often arise when a trust holds an LLC which in turn holds title to real estate. Liability insurance companies each have their own rules with regard to coverage. Both the trust as well as the LLC should be listed as the insured, and an additional insured to the liability policy,  to assure coverage not only with regard to the real estate, but also its contents.

Conclusion: SLATs are getting a lot of attention these days as individuals seek to use their large federal gift tax exemption while it exists. Often income producing assets are the subject of the transfer to the SLAT to assure the donor indirect access to the income the SLAT assets generate (at least while the donor’s spouse is alive and remains a beneficiary of the SLAT.) A vacation home, while not necessarily an income producing asset, might also be a good choice to transfer to a SLAT. Often they are appreciating assets, and a vacation home is also the type of legacy asset that the children and grandchildren are not apt to sell, which means that the carryover income tax basis that comes with the lifetime gift of the vacation home to the SLAT will not cause much of a problem if the intent is to hold the title to the vacation home for many generations to come.