Some Family Cottage Strategies in Light of the Klooster Case

Nothing triggers emotions more than the family cottage. You may have raised children who spent all their vacations there. You may have grown up there yourself. All the best memories are often there. Yet this family "heirloom" often becomes the most difficult asset to pass to the next generation; and sometimes the most contentious.

As an owner-family, one of the first questions I have clients consider is whether they should even go down that proverbial road? There is simply no legal "GPS" for finding the right mix of ownership and management of multiply-owned family recreational property. Much has been written about this subject over the years, including "Saving the Family Cottage," by Stuart Hollander, a Northern Michigan Attorney who lived and practiced in Leelanau County; and "The Cottage Rules" by Nikki Koski. These books purport to help "solve" the problems arising in trying to pass a cottage from one generation to the next. Yet they admit that it is more of an art than a science. In the end, I usually counsel my clients that their own family "chemistry" will make or break the succession, no matter how good or clever our written documents and plans may be. And, a continuing problem is how, even after passing to the second generation, successive generations will be treated. This article is not really a piece addressing whether the family cottage should be passed. Nor is it really a road map illustrating how it should be done. Rather, it addresses some of the pros and cons of different ownership methods and when they might be considered, in light of the real property taxation.

In 2010, the Michigan Supreme Court decided Klooster v City of Charlevoix, defining under what circumstances a "transfer" resulting in "uncapping" for purposes of the Michigan ad valorem real property tax. "Capping" refers to a limitation placed on the ability of the taxing municipality to raise the "taxable value" of real property as its fair market value increases. The intent of the act was to keep current owners from being unfairly taxed in relation to increase and development of surrounding properties, during their tenure of ownership. It imposes a formulaic limit on tax increases. However, when the ownership is transferred, this "cap" comes off and the taxing authority is free to make a one-time (for each transfer) adjustment to reflect fair market value in the hands of the new owner. The Klooster decision put an interesting (and for some of us, unexpected) twist on the meaning of "transfer" of ownership for purposes of the act. See, Michigan Buys Supreme Court Buys Us Another Generation on Real Property Taxes.

Before addressing the pros and cons, it is appropriate to review ownership options for family cottage properties. Over the years, some different methods of ownership by the next generation have been prevalent.

Joint Ownership

Perhaps the most common (and the most fraught with problems) is joint ownership of property. Michigan law observes several different types of joint ownership. Among non-married owners, the most common and often presumed type is as tenants-in-common. In tenancy-in-common, each owner owns an "undivided" fractional interest in the property. The interest can be sold, or transferred freely. In the event a problem arises in co-ownership, a tenant-in-common may ultimately petition the Circuit Court for an action to partition. The court may, alternatively, order a sale or physical division of the property. A second type of concurrent ownership is as joint-tenants. This type of ownership presumes that on your death, your interest passes, automatically, to the surviving owner. But during lifetime, between non-married owners, the interests may be sold or transferred freely. Such a transfer converts the joint tenancy to tenancy-in-common. A third type of joint ownership is known as joint tenancy with full rights of survivorship (JTWROS). Here, the decedent's interest also automatically passes to the survivor(s). However, these interests may not be transferred or sold without the concurrence of all joint owners. The JTWROS tenancy may not be severed, even by a court.

You may note that I have prefaced each of these with "among non-married owners." In Michigan, when a husband and wife take title to real property, it is presumed that they do so as tenants-by-the-entireties (a special type of JTWROS ownership reserved for married couples). It should be easy to see that, depending upon the makeup of owners and their ability to (and perhaps live) together, each of these owner methods may have potential significant disadvantages.

It is permissible, and in my view, strongly recommended, that the parties have a separate, recordable and enforceable written agreement providing for use, management and succession issues.

A separate, written agreement providing for use, management and succession issues is strongly recommended

Trusts

Another ownership method is a Trust. Most often, a parent-owner will create a Trust for ownership during their lifetime which provides for "rules" and management of the property following their death. Trusts can create complexities and difficulties that may have been completely anticipated by the client and/or drafter. Someone or some entity must act as the Trustee, with the significant responsibilities impose by both the Trust Agreement and the Michigan Trust Code. Tax reporting at both the federal and state level is required. The allocation of the taxable (and deductible) attributes is not always simple. There are annual reporting and accounting requirements, sometimes to more "remote" individuals who may have no current involvement, but have a possible future interest. Trusts are generally a cumbersome method for continuing ownership and often will direct another form of ownership upon the death of the original owners/trustors and transfer to the next generation. The "uncapping" circumstances for trusts are quite complex.

Entity Ownership - Limited Liability Company / Partnership

For numerous reasons, the Limited Liability Company (LLC) has become the real estate owning entity of choice in Michigan. It is an outgrowth of the Partnership, which was perhaps the preferred method before the LLC. The partnership's "achilles heel" was the unlimited liability every partner had on all partner activities. The LLC effectively created a Partnership with the same limited liability that a corporation traditionally had. And, over time, the Michigan LLC Statute has evolved as the most flexible and creative business entity tool available for planning.

The LLC has become the Real Estate Owning Entity of Choice in Michigan – but it has "uncapping" Issues.

With an entity format, the owners can have an agreement for management and succession of ownership for multiple generations. A manager(s) can be designated and "branches" among the family can be defined, for purposes of voting. A "buy and sell" agreement can be put in place, providing for valuation methods and payment methods, as well as limitations on sales and transfers. Accounts can be established for payment of expenses. And, because the entity is the owner of the real property, as "members" come and go, the ownership stays within the company. Because of this structure, the LLC is, in my view, a better practical and legal planning alternative to the Joint Property Agreement.

There are negatives. There is a cost to set up the LLC, and a (generally nominal) cost of annual maintenance. Like the Trust, federal and state tax reporting is required. The LLC is a "public" entity, in that it is on file in Lansing, with a register address and agent. Perhaps the most significant negative is the "uncapping" issue mentioned above.

How Klooster Applies

The Michigan Tax Tribunal has ruled that transfers of real property interests to a LLC will automatically cause uncapping. While a reading of the statute does not, in my view, intuitively suggest that result, the rulings of the Tribunal have the force of law in Michigan until a court having proper jurisdiction says otherwise. To the best of my knowledge, at the time of this writing, no court has done so. Nor is the Klooster result, in my opinion, the intuitive result of a reading of the statute. But the Michigan Supreme Court is the highest legal authority in the state and they have spoken.

If "uncapping is an issue, consider Joint Ownership with a written agreement; If it is not, go the route of the LLC

In summary, if "uncapping" is not a significant issue, you should strongly consider the formation of a LLC. Conversely, if "uncapping" is a significant issue, you should consider joint-ownership with a Property Agreement. However, before spending too much time on the "uncapping" issue, it is probably worth looking at whether the "uncapping" issue is as significant at one might think. Currently, most vacation property values are at a long-time low here in Michigan. Thus, the "jump" from current taxable value and fair market value (loosely, SEV in Michigan) may not be as significant as it first appears. Even though the "value" looks like a substantial number, it is worth doing the math to see what the actual increase in taxes might be. It may be that "uncapping" in the current environment is a "window" that should be taken advantage of. Remember that once the "uncapping" occurs, the "cap" starts over again for the succeeding owners.

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