Vacation Home or Passive Income?

Problem: After decades of use and enjoyment, the high net worth family of an entrepreneur who had done very well in manufacturing, and then e-commerce, decided it was time to part ways with a beloved vacation property in Sonoma, California. The three children who had used it were now starting careers of their own and scattered across the country. The property had appreciated considerably in twenty years and the entrepreneur and her husband were faced with the challenge of realizing the benefit of that appreciation without paying a huge tax bill and, ideally, transferring some of that value to their children.

Solution: The Farella Braun + Martel High Net Worth practice group, in partnership with our Real Estate and Tax practices, developed a four-phase strategy that would allow the family to dispose of the original property, while deferring taxes, and create a long-term passive income stream for their children.

Step One was transferring ownership interests in the entity that owned the property from the parents to their children. The couple had originally purchased the property through an LLC as a liability shield and to protect their privacy. This structure allowed them to transfer indirect ownership interests in the property to their three children without triggering transfer tax or reassessment. The transfers used up some of the couple’s lifetime gift exemption, but they were able to minimize that impact since the non-controlling, minority membership interests were appraised at a discounted value, compared to if the couple had transferred 100% of the LLC to any particular child.

Step Two was renting out the property. To qualify for a 1031 like-kind exchange (which is discussed more in Step Four below) a property must be an investment property or used in a trade or business. In this case, they found a family friend who was interested in renting the property long-term and entered a lease at a fair rental rate. Other owners in similar situations have converted properties to vacation rentals, which can be more lucrative, but also requires more work and management.

Step Three was to sell the property. Since the property was rented and generating income, the family was not under pressure to sell and was able to time the local market. The family ultimately sold the property to the renter without using a broker, which saved having to pay a six percent brokers’ commission. 

Finally, Step Four was purchasing a replacement property utilizing what’s called a 1031 like-kind exchange, named after the section of the Internal Revenue Code that permits it. Under a 1031 exchange, the newly-acquired property simply replaced the appreciated original property, with no immediate tax liability. The new property was selected to provide a passive income stream for the children. The children would be personally liable for the tax on this income, of course, but the largest tax liability, on the appreciation of the original property, was deferred so long as the family owned the replacement property.

Problem solved.