Estate Planning for the Passage of Family Vacation Homes Using Conservation Easements, QPRTs, Family LLCs, Dynasty Trusts and Other Strategies
by Nancy G. Henderson

• I. TAX CONSIDERATIONS IN PLANNING FOR VACATION HOMES
• II. THE IMPORTANCE OF A FEASIBILITY STUDY
• III. GIFT AND ESTATE TAX PLANNING STRATEGIES FOR TRANSFERRING VACATION HOMES
• IV. PLANNING WITH QUALIFIED CONSERVATION CONTRIBUTIONS
• V. DISPUTE AVOIDANCE AND RESOLUTION

Introduction

Recent statistics have suggested that as many as 13% of all homes purchased in recent years are second homes acquired primarily for personal use, such as weekend and holiday retreats or family vacations. In many cases, the owner of such a vacation property hopes to pass that property on to children or other family members as part of his or her estate plan.

Whether a vacation home is a beach front condominium in San Diego, a ranch in Montana, a cabin on Lake Tahoe, or an historic Victorian home in San Francisco, a client's desire to preserve that property as a family asset can present significant challenges to the estate planner.  This Outline addresses some of the key issues to consider in planning for family succession for vacation homes. The first part of the Outline provides an overview of the primary tax considerations in planning for succession to a cherished family property.  The second part of the Outline highlights the importance of conducting a feasibility study before proceeding with any planning for the preservation of a vacation property and the issues that need to be addressed in a feasibility study.  The third part of the Outline provides an overview of a number of estate, gift and GST tax planning techniques that should be considered in the context of planning for family vacation properties.  The fourth part of the Outline offers a detailed discussion of qualified conservation contributions as an important tool in the context of estate planning for certain types of vacation properties.  The Outline concludes with a discussion of how to anticipate and avoid common disputes that arise in the context of the co-ownership of family vacation properties and means for resolving disputes if and when they do arise.

I. TAX CONSIDERATIONS IN PLANNING FOR VACATION HOMES

Estate planning for the succession to vacation property requires careful consideration of a number of complicated, and sometimes conflicting, tax laws.  The primary tax considerations in estate planning for a vacation homes are discussed below.

A. Federal Estate Tax.  For most clients, the primary impediment to a successful transfer of a valuable family property to children and grandchildren is the federal estate tax.  The federal estate tax is imposed upon the cumulative fair market value of all of a decedent’s assets held at death (or otherwise included in the decedent’s taxable estate), net of enforceable debts against the decedent, certain expenses, and allowable deductions and exclusions.[1]  Important in the context of planning for vacation homes is that, included in the decedent’s taxable estate are not only assets legally owned by the decedent at the time of death, but also assets which the decedent may have given away from a state property law perspective, but over which the decedent held impermissible “strings attached” for federal estate tax purposes.  Such “impermissible strings” include for example, the right to retained use or enjoyment of transferred property without adequate consideration to the donee, the right to receive the income generated from transferred property, or the right to control the donees’ beneficial interests in transferred property (or the income therefrom) in a manner that is not limited to a reasonably definite standard.[2]  The decedent’s taxable estate will also include assets transferred by others, in trust or otherwise, over which the decedent held a general power of appointment exercisable during life or upon death.[3]  Such a power would include any power to appoint the property to the decedent, the decedent’s estate, the decedent’s creditors, or the creditors of the decedent’s estate unless such power is limited to an ascertainable standard related to the decedent’s health, maintenance, support or education or is exercisable only with the consent of an adverse party or the creator of the power.[4]

No estate tax is imposed upon transfers at death to qualified charities or to U.S. citizen spouses (outright or in a qualifying trust for such spouse) due to the availability of the unlimited estate tax charitable deduction[5] and unlimited estate tax marital deduction,[6] respectively.  Estate tax can also be deferred upon transfers at death to the decedent’s non-U.S. citizen spouse so long as the transfer is made to a “qualified domestic trust” or “QDOT.”[7] 

Where real property is included in a decedent’s estate, there are other exclusions and valuation rules that may reduce the estate taxes that will be imposed upon that property.  One exclusion of potential importance in the context of vacation property arises from the Special Use Valuation rules, which permit an estate to reduce the estate tax value of certain real property used in agricultural (or in a trade or business) by up to $940,000.[8]  If the value of the property at its current use is less than its value at its highest and best use.[9] In addition, as discussed in detail later in Part IV of this Outline, an estate tax exclusion of up to $500,000 is available for certain property that is subject to a qualified conservation easement at the time of the decedent’s death, or becomes subject to such an easement during the period of post-mortem administration and if a timely election is made to apply the exclusion.[10]  An estate tax deduction is also available for the value of certain post-mortem grants of qualified conservation easements.[11]  This deduction is also discussed in detail in Part IV of this Outline.

In addition to the foregoing exclusions and deductions, a decedent’s estate is entitled to an estate tax applicable exclusion.  Presently, in most cases, the estate tax applicable exclusion serves to shelter the first $2,000,000 of net taxable value of a decedent’s estate from federal estate tax.[12]  This exclusion is reduced, however, dollar for dollar, by lifetime gifts made by the decedent using the decedent’s $1,000,000 gift tax applicable exclusion.  The tax imposed upon the otherwise taxable value of the decedent’s estate in excess of the applicable exclusion is presently 45%. As a result of the EGTRRA 2001, the estate tax applicable exclusion is scheduled to increase to $3,500,000 for decedent’s dying in 2009. The estate tax will be entirely repealed under EGTRRA for a one-year period in 2010, after which there will be a $1,000,000 estate tax applicable exclusion and graduated estate tax rates that will be as high as 55%.

B. State Inheritance Tax.  Until EGTRRA 2001, decedents’ estates were entitled to a federal estate tax credit for state inheritance taxes or other state “death” taxes up to certain maximum thresholds.  As a result, most states enacted inheritance tax laws that simply absorbed the maximum amount of the state death tax credit (a “pickup tax”).  However, EGTRRA 2001 eliminated the state death tax credit and replaced the credit with a deduction for state death taxes.  As a result, many, if not most states have since enacted inheritance tax laws that impose a state inheritance tax in addition to the federal estate tax.  Importantly in the context of planning for vacation homes, if real property is located in a state that imposes a separate inheritance tax, the property will likely be subject to such tax even if the decedent resided at the time of death in a different state.  Further, many states that impose inheritance taxes have “decoupled” their inheritance tax system from the federal estate tax system, meaning that state inheritance taxes might be imposed upon an estate that has no federal estate tax liability (such as because the state inheritance tax exclusion is less than the federal estate tax applicable exclusion).  It is therefore of utmost importance for the estate planner advising clients with vacation homes in other states to research the state inheritance tax rules that will apply and to consider strategies to avoid or minimize the imposition of the state inheritance tax, such as by placing the property in a limited liability company or gifting the property during life (assuming the state in which the property is located does not have gift tax, as discussed below).

C. Gift Tax.  The second most important tax imposed in connection with succession planning for family vacation homes is the federal gift tax.  Under current federal tax law, lifetime transfers of real property made out of detached and disinterested generosity (other than a transfer for full and adequate consideration in money or money’s worth) will give rise to a federal gift tax unless a transfer qualifies for certain statutory exclusions or deductions.[13]  Among the available deductions are the unlimited gift tax marital deduction for transfers to U.S. citizen spouses (or certain qualifying trusts for the benefit of U.S. citizen spouses)[14] and the unlimited gift tax charitable deduction for transfers to qualified charitable organizations.[15]  Also excluded from gift taxation are gifts of present interests in property, provided that the cumulative amount of all such gifts from one donor to one donee in any one calendar year does not exceed the amount of the gift tax annual exclusion, which is presently $12,000.[16] Once a donor’s cumulative gifts to a donee in any given year exceed the gift tax annual exclusion, or if the gift is not a gift of a present interest, and if no other exclusion from gift tax applies, the donor must begin to consume his or her lifetime applicable exclusion from gift tax, which presently shelters from gift taxation the first $1,000,000 of such otherwise taxable gifts (computed cumulatively for all donees over the donor’s lifetime).[17]  To keep the Internal Revenue Service (the “Service”) apprised of the use of the donor’s gift tax applicable exclusion, a gift tax return is required to be filed for any calendar year in which the donor makes gifts to which the applicable exclusion will apply.

In the case of gifts of real property or real property interests, the federal gift tax is imposed upon (or the amount of the exclusion that is utilized is determined based upon) the value of the transferred property or property interest on the first date that the transfer is deemed complete for gift tax purposes.[18]  In most circumstances, the gift will be complete on the date legal title has been transferred under applicable state law, such as the date that a deed to real property is signed and delivered to the donee (unless recording is also required to complete the transfer under applicable state law), or the date that an interest in a partnership or LLC holding real property is legally assigned to, and accepted by, the donee.  However, there are circumstances in which a gift will not be “complete” for federal gift tax purposes on the date of legal transfer of title to the gifted property or property interest.  For example, a gift will be “incomplete” for federal gift tax purposes if the donor has retained the power to change the beneficial interests of the donees.  In such case, the transfer will not be complete for gift tax purposes, and the gift tax value of the transferred property or property interest will not be finally determined, until the donor relinquishes such power over the gifted interest.[19]

The amount of the gift tax imposed upon a taxable property transfer depends upon the amount of the cumulative taxable gifts that have been made by the donor.  In most cases, the gift tax that will be imposed upon the first dollar of taxable gifts in excess of the $1,000,000 gift tax applicable exclusion will be 41%.  The gift tax then increases gradually as the cumulative amount of the donor’s taxable gifts increases, ultimate reaching the current highest marginal gift tax rate of 45% on cumulative gifts in excess of $2,000,000.[20]

In most cases, a transfer of real property will not give rise to a state gift tax.  The author of this outline is aware of only four states that currently impose a gift tax:  Connecticut, Tennessee, North Carolina and Louisiana.  Therefore, with regard to vacation homes situated in such states, attorneys not normally practicing in those states should consult competent legal and tax counsel to seek appropriate methods to minimize or avoid state gift tax on the lifetime transfer of the property.

D. Generation-Skipping Transfer Tax.   The generation-skipping transfer (GST) tax is a tax imposed upon transfers of wealth to or for the benefit of individuals who are, or are deemed to be, two or more generations younger than the transferor (“skip-persons”).[21]  The GST tax is imposed separate and apart from, and sometimes in addition to, the federal gift or estate tax. The purpose of the tax is relatively straight-forward; that is, with certain exceptions, to insure that the transfer of wealth is taxed at least once at each generation, whether or not interim generations have the actual possession or use of that wealth. 

The GST tax rate is imposed at the highest marginal estate tax rate,[22] which is presently 45%.  Therefore, for transfers that are subject to both the highest estate or gift tax rate, as well as the GST tax, the effective combined tax rate is 70%.  The GST tax is imposed on transfers made directly to skip-persons and to trusts as to which only skip persons are permissible beneficiaries (“direct skips”).[23] The GST tax is also imposed upon certain trust distributions to skip persons (“taxable distributions”)[24] as well as upon the entire value on a non-GST exempt trust at such time as there are no longer any “non-skip-persons” who are permissible beneficiaries (“taxable terminations”).[25] 

An exemption is available from the imposition of GST tax.  This exemption shelters from the GST tax the first $2,000,000 of generation-skipping transfers taking place either during the donor’s lifetime or, to the extent not applied to lifetime transfers, occurring by reason of the donor’s death.[26]  In addition, there is a GST tax annual exclusion which excludes from the GST tax direct skips that also qualify for the gift tax annual exclusion, discussed above.[27] However, the availability of the GST tax annual exclusion for gifts in trust is substantially more limited than is the gift tax annual exclusion.  Specifically, in order for a gift in trust to qualify for the GST tax annual exclusion, (i) the transfer must qualify for the gift tax annual exclusion; (ii) there must be only one current beneficiary of the trust and that beneficiary must be a “skip person”; (iii) during the current beneficiary’s lifetime, no part of the trust principal or income may be distributed to or for the benefit of any person other than the current beneficiary; and (iv) if the current beneficiary dies before the trust terminates or is otherwise fully distributed to the current beneficiary, the remaining assets of the trust must be includible in the deceased current beneficiary’s taxable estate.[28]  Consequently, gifts made in trust which qualify for the gift tax annual exclusion because, for example, one or more beneficiaries hold Crummey withdrawal powers over the trust, will not qualify for the GST tax annual exclusion unless the trust is administered as individual separate shares for each of the beneficiaries holding a withdrawal right who are skip-persons and the other requirements of the GST tax annual exclusion, just described, are satisfied with regard to each such share.  Thus, the GST tax annual exclusion is a substantially more limited tool in the context of planning for the succession to real property through the use of trusts than is the gift tax annual exclusion.

E.  Income and Capital Gains Tax.  Transfers or real property present challenging income and capital gains tax considerations as well. While a lengthy discussion of these taxes is outside of the scope of this Outline, there are certain income and capital gains tax issues that bear particular mention. 

First, family properties are often held for a long period of time and may therefore be highly appreciated.  As a result, any strategy that contemplates intervivos gifts must balance the estate tax savings of the strategy against the loss of the basis step-up that would have been achieved had the property been held until the death of the owner.[29]  Further, any strategy that contemplates a sale of the property, other than to a sale to a defective grantor trust[30] or a sale taking place during post-mortem administration (when the property has secured as new tax basis), will generate capital gains taxes and possibly the recapture of certain income tax deductions taken by the seller if the property was at any time held for the production of rental income. 

Occasionally, estate planning may involve a residence being used by the donor as the donor’s principal residence. In such circumstances, the estate planner should carefully consider the impact of any transfer of that residence upon the availability of the $250,000 capital gains tax exclusion for the sale of a principal residence.[31]

Encumbered property also presents income tax considerations.  First, a transfer of encumbered property to a trust, to a partnership, or to a limited liability company could impact the ability of the donor to deduct payments of mortgage interest as the property may no longer be treated as the donor’s personal residence.  In addition, if the debt is assumed (or deemed to be assumed) by the donee, the transfer could generate capital gains tax to the donor.

A final income tax consideration when planning for a vacation home is whether the property will be maintained after the transfer as an investment property or a personal use property for purposes of claiming income tax deductions for all or a portion of such ongoing expenses as repairs, maintenance, advertising, cleaning fees, utilities, and depreciation.  Although a detailed discussion of the rules concerning these deductions is outside of the scope of this Outline, the planner is encouraged to understand how the donor has treated the property for income tax purposes in the past and to contemplate the implications of the recommended strategy for succession to the property on the future deductibility of the expenses of owning and maintaining the property.[32]

F. Property Tax.  In many states, property tax value is neither favorably nor negatively impacted by normal estate planning for real property. However, some states provide exclusions or reductions in property tax value for certain owners (such as senior citizens or disabled individuals) that may be sacrificed if the property is transferred to children, to trusts, or to a family-owned entity, such as a family partnership or LLC.  This issue is particularly sensitive with regard to real estate in the state of California, where Proposition 13 constitutionally limits the ability of county tax assessors to revalue property unless and until there is a “change of ownership” in the property or some other event permitting reassessment (such construction of certain types of improvements to the property).[33]  As a result, so long as there is no change of ownership in the property giving rise to reassessment, the property tax value of California real property can be dramatically lower than its actual fair market value.  Further, in certain circumstances, it is possible to preserve the favorable property tax basis of California real property, in whole or part, when transfers are made between parents and children.[34]  Therefore, whenever engaging in succession planning for California real property, it is critical to consider the impact of the plan upon the property tax imposed and to consider options that could preserve a favorable property tax basis for the next generation.

II. THE IMPORTANCE OF A FEASIBILITY STUDY

Estate planning for succession to a valued family property should be approached with careful and detailed consideration of all of the relevant facts.  Family homes are unique assets in estate planning.  They are associated not only with potentially significant monetary value, but they often represent sentimental value to the donor and the donor’s family as well.  Family homes, unfortunately, also carry burdens in the form of management and ongoing expenses of ownership and maintenance. Further, the very use of the property by family members can become burdensome if it creates disputes among family members concerning the use of the property, involves expensive travel to reach the property, or will require working family members to consume limited personal vacation time to make use of the property.  Finally, family members may have conflicting feelings about the property.  If these issues are not understood and considered in the planning process, even the best tax plan for the property can ultimately be a wasted effort.  It is therefore important to conduct a feasibility study to first determine whether it is at all reasonable or practical to plan to preserve a particular property, and, if so, what issues must be addressed in order to accomplish the successful transition of the property to the next generation. 

While the scope of a feasibility study will certainly be driven by the size of the property and its importance in the context of the client’s overall estate plan, in nearly every case the study will help identify planning issues that would otherwise have been overlooked and could be much more difficult to address after the donor’s death.  Further, as it’s name implies, both the client and the advisor should approach the feasibility study with the understanding that a conclusion could be reached that the preservation of the property for the next generation is not, in fact, a practical objective in light of all the relevant facts and circumstances.

 A.  First Step: Understand the Significance of the Property as an Estate Asset 

The first step in the feasibility study is to determine the relative significance of the property in the overall estate plan. This will require an examination of all of the assets owned by the donor and a determination of the relative economic value of the property as compared to the value of the entire estate. Even if the economic value of the property is not significant, however, the sentimental value of the property needs to be considered in this regard.  There may be some members of the next generation who have a deeper connection to the property than others.  If that is the case, rather than craft a plan to leave the property to all of the donor’s children, a better plan might be to leave the property to those children who have expressed an interest in retaining the property.  Such planning, however, can create resentment, either because certain family members feel they are being unfairly excluded from ownership of the property, or because the family members to whom the property is being allocated may feel that other family members are receiving more valuable assets (such as income producing property).  All of these issues need to be discussed with the client and addressed in the feasibility study. 

 B. Second Step: Identify and Understand the Nature of the Property

The second step in the feasibility study is to understand the nature of the property itself and to determine whether there are any legal impediments to a succession plan. The following summarizes a number of property types or characteristics and certain legal or practical issues that can arise in each case.  Importantly, a particular vacation property could possess several of the following characteristics.

 

(1) Single Family Residences and Condominiums.  The most common form of vacation property is the single-family residence. Important in planning for such a property is whether the property is part of a homeowners’ association or is subject to a zoning ordinance restricting the use of the property as a vacation home.  For example, CC&Rs may require the property be owner-occupied, that use cannot be “transient,” or that the property may not be rented.

 (2) Long-Term Leaseholds.  Occasionally, a vacation home will be constructed on land that is not owned by the client, but is on land subject to a long-term leasehold (typically 99 years or more).  In planning for any such property, it is important to secure a copy of the underlying lease agreement to determine the remaining term of the leasehold as well as the rights and responsibilities of the lessor and the lessee at the end of the lease.  Commonly, the lease provides the lessee an option to renew the lease, either for the historic rental amount or some adjusted amount.  It could, however, provide a reversion to the lessor, with or without compensation to the lessee for the value of the improvements that were constructed and maintained by the lessee.

 (3) Cooperatives.  A vacation home could be represented by stock in a cooperative rather than a deed to real property. Planning for co-ops requires a review of the Articles of Incorporation, the Bylaws, the CC&Rs, and other corporate documents to determine whether there are restrictions on ownership and use that could affect the plan for the property.

 (4) Multi-Parcel Properties.  A vacation property may consist of a residence located on one of several adjoining (or otherwise related) parcels, some of which are undeveloped.  Such multi-parcel properties present unique challenges and opportunities.

 

(a) Can Parcels Be Sold to Pay Expenses and Taxes?  An important question multi-parcel properties present is whether one or more of the parcels could be sold to pay estate taxes or expenses without negatively impacting the desired use of the remaining property by the next generation. 

(b) Can Different Parcels Be Allocated to Different Children?   In some cases, the land represented by a vacation property has far greater value to the family than the residence that is located on the property.  In that case, it might be feasible to gift or otherwise allocate different parcels to different children so that they will each own a parcel independently of the other.  Consideration needs to be given, of course, to the relative financial and ascetic value of each of the parcels and also what costs a child would necessarily incur in order to construct a cabin or other home on a parcel if that would be necessary for its use and enjoyment.  Further, the family as a group may wish to agree upon restrictions on development of the parcels in a way that could negatively impact the use and enjoyment of the other parcels.  Finally, consideration should be given to providing the family a right of first refusal to buy back a particular child’s parcel before it can be sold to a third party.

(c) Securing Easements.  Any plan to break up adjoining parcels should contemplate whether access to certain parcels will be required by the owners of other parcels, such as to reach a public road or secure connections to public utilities.  If so, it is maybe advisable to survey and record easements that will preserve the economic viability of each parcel before there is a change of ownership.

(d) Avoiding the Merger of Previously Subdivided Parcels.  In some parts of the country, adjoining parcels of land can lose the benefit of subdivision if they have identical ownership; essentially, upon achieving unity of ownership between two or more adjoining parcels, the parcels become “merged” into a single parcel.  This can have a dramatic impact upon the value of parcels, which will most likely be considerably more valuable as smaller subdivided parcels than as a large single parcel. Further, once a merger has occurred, changes in land use law since the original subdivision of the property may preclude approval of a new subdivision. Planning for parcels that are at risk of merger therefore requires careful consideration of what constitutes identical ownership under the applicable law (which is often law developed at the municipal or county level rather than at the state level) and the design of an ownership structure for each of the parcels that is sufficiently different from the others to avoid an unintended merger.

(5) Ranches and Other Agricultural Properties.  A vacation property could be subject to ranching or other agricultural use during the donor’s lifetime. In these circumstances, planning for succession to the property can be very similar to planning for succession to any business.  Some of the complex issues presented by such properties are outlined below.

 

 (a) Continued Use for Agriculture.  An important consideration in the context of property used for ranching or agriculture is whether the expectation is for such use to continue after the donor’s death.  If that is the expectation, how will the ranch or farm be managed after the donor’s death?  Will any of the donor’s children be occupied in that endeavor?  Will the children engaged in the agricultural or ranching business reside on the property and will that result in the effective exclusion of the rest of the family from use of the residence?  How will those children be compensated for their services?  Will the agricultural income produce a net cash flow to the property owners that can help defray the expenses of ownership or could it actually be a net loss?

If the property generates significant business income from ranching or farming, it will be important in estimating the estate tax value of the property to also consider the estate tax value of the ranching or farming operation, as such value will be separate from, and in addition to, the underlying value of the land and improvements.

(b)  Plan for Equipment and Livestock.  When designing a plan for the succession to real property used in ranching or farming, it is important to include in the plan the passage of title to tangible personal property that is essential to continued operations; specifically livestock and equipment.  The value of these tangible assets needs to be factored in to any estate or gift tax projections for the preservation of the property, as well as any plan for equalizing estate value among the children if less than all of them will receive an interest in the farm or ranch.

 (c) Property Tax and Other Benefits.  Frequently land that used in ranching or farming enjoys a reduced property tax value that is contingent upon its continued agricultural use.  Properties used in agriculture might also qualify for reduced water rates, or a higher allotment of water in areas where water is scarce.  When planning for these properties, consideration must be paid to preserving these important benefits if at all possible.  If agricultural use will cease at some point, it is important to consider the impact upon the property if these benefits will be sacrificed.

(d) Preserving the Availability of I.R.C. Sections 2032A and 6166.  Family properties that are used in ranching or farming could qualify for special use estate tax valuation under I.R.C. Section 2032A as well as the deferral of the payment of estate taxes under I.R.C. Section 6166.  The plan for the succession of the property should consider whether these benefits could be available under the circumstances and, if so, whether the plan can be structured to protect these important tax benefits while still accomplishing the donor’s non-tax estate planning objectives.

(6) Properties with Significant Natural Habitat.  Vacation properties are often located in areas that have significant natural habitat.  These properties could be subject to federal or local use restrictions that must be considered in a succession plan.  Even if a property is not so restricted, it is important to consider whether the client values the property for its natural habitat and would like to see it preserved.  It has been this author’s experience that children and grandchildren will not necessarily share in the older generation’s conservation goals.  Rather, after they have secured ownership of and control over the property, some (or all) of the donor’s children and grandchildren would prefer to maximize the economic value of the property through subdivision and development, by mining, or by harvesting timber.  Therefore, if an important goal for the property is to preserve its natural beauty for the enjoyment of future generations, the planner should discuss with the client the possible benefits of imposing perpetual restrictions upon the use and development of the property before it is transferred to the next generation, such as by granting a conservation easement to a qualified charitable organization.  (See the discussion of conservation easements and other qualified conservation contributions at Part IV of this Outline).

(7) Historic Properties.  A host of special planning issues and opportunities are presented when a donor’s property is listed in the National Registry of Historic Places, is located in, or in proximity to, a recognized historic district, or is otherwise identified as a place of historic significance.  Of primary importance in succession planning for such properties is  whether the value of the property can be reduced for estate and gift tax purposes by granting an historical society or other qualified charitable organization an historic preservation easement, as discussed in Part IV of this Outline below.

(8) Family Compounds.  Some families have assembled groups of adjoining properties or parcels into a single family compound consisting of multiple residences and appurtenant facilities and structures that are shared and enjoyed by many different family members, often across multiple generations and even different family groups. Planning for these properties may require the joint effort of attorneys and other advisors representing the different family groups who share an interest in the property. Careful consideration needs to be given to whether the concept of the family compound will continue to be successful among members of the next generation, who may be more distantly related to one another, or whether dividing the property into separate independent properties for each family group (or selling the property) would be more practical.

 (9) Property Susceptible to Natural Disaster.  Some cherished family properties are located in regions that are at risk of a significant natural disaster that could destroy the property or damage it substantially.  Examples of such properties are properties located in western forests that are susceptible to firestorms, coastal or island properties that are subject to hurricanes, or properties in river valleys that are subject to flooding.  In recent years, some of the author’s clients with properties in coastal areas are considering the potential effect of rising sea levels upon the long-term value of those properties.  Insurance for properties of this nature can be very expensive to secure and the deductibles can be as high as 10% of the value of the property or more.  Careful consideration should be paid to whether it is reasonable to establish a plan that contemplates the retention of such properties for decades to come, or whether the property should be sold in order to pass the cost of insuring the property and the risk of catastrophic loss to a new owner.

 (10) Encumbered Property. Property that is subject to debt presents significant challenges in the context of succession planning.  First, any transfer of the property to children, to a trust, or to a partnership or LLC, whether during the donor’s lifetime or upon the donor’s death, could trigger the due on transfer clause in the underlying loan documents, potentially causing the debt to be immediately due and payable.  To avoid this consequence, it is important to secure the lender’s consent to any such transfer before it occurs.  Further, a gift of encumbered property to a child or to a trust for a child’s benefit could be treated as a bargain sale of the property rather a gift, potentially triggering capital gains taxes on the transfer.  Finally, if the debt is to remain on the property after the transfer, consideration needs to be given to who will be responsible for the loan payments, whether making those payments will be treated as a gifts to the other owners, and also whether the form of ownership will negatively impact the payor’s ability to deduct the interest payments on the loan.

 (11)  Co-Owned Property.  Individuals will sometimes purchase vacation homes with friends or others as partners or tenants-in-common.  Important in planning for these properties is whether it is reasonable for these unrelated owners to co-own the property with the children of a deceased owner.  It is also important to know whether there is an understanding or expectation between the owners that the surviving owner will have the right, or even the obligation, to buy out the interest of a deceased owner and, if so, how the value of the deceased owner’s interest will be determined, whether fractional interest or other discounts will apply to determine the purchase price, and whether the purchase price will be paid in full or over time in installments, with or without interest.  Even if the original co-owners have been able to operate on rather informal terms, it is generally wise to formalize the relationship with a Tenancy-in-Common Agreement or Partnership Agreement to address these issues before bringing in the next generation

(12) Yachts and Houseboats.  Although not often considered in the context of planning for vacation homes, for many families a yacht or houseboat has the same personal attachment and sentiment as a land-based family vacation home.  Yachts and houseboats, of course, present their own unique issues.  The first issue relates to where the yacht or houseboat will be kept, as in many parts of the country slip and mooring availability, particularly for large vessels, can be a significant problem, with waiting lists extending two or three years or longer.  Therefore, in planning for the succession of ownership for a yacht or houseboat, consideration must be given to whether the current slip or mooring is transferable to the children, to trusts for their benefit, or to a partnership or LLC.  Another important consideration in planning is whether all of the children have the skills necessary to sail a yacht safely, how far the children should be permitted to take the yacht from its home port, and for how long a period of time.  Of course, the character of the children must be taken into consideration as one child’s use of the vessel for an illegal purpose could result in the forfeiture of the vessel under federal narcotics laws.

C. Third Step: Create Detailed Expense Projections and Calculate the Required “Endowment” 

Once it has been determined that it is otherwise reasonable, practical and legally possible to pass a vacation property to the next generation, the next step in the feasibility analysis is to determine what financial resources will be required to own, maintain and use the property once it has been transferred.  The expenses that must be considered include, but are not necessarily limited to, property taxes, homeowner’s fees, utilities, landscape and other regular maintenance, security, housekeeping, and repairs.  Further, if the property is in a location that will require significant travel by family members to use it, such expenses should be projected and taken into consideration as an important element in accomplishing the client’s goals for the property. 

In the ideal succession plan for a vacation home, the vehicle that is established to own the property should be self-supporting; that is, the owner or owners should have an identifiable and reliable source of revenue to pay all of the expenses of the property over the desired time horizon. This might be accomplished by establishing an endowment that is funded with other assets from the client’s estate or from life insurance on the client’s life (or the life or lives of others with an interest in the property).  As noted above with regard to multi-parcel properties, an endowment to fund the expenses of ownership, maintenance and use of the property could be established by selling one or more of the parcels (or even by selling a conservation easement over one or more of the parcels, as discussed in Part IV of this Outline below).  Alternatively, expenses could be funded in whole or part by generating rental income from the property, whether from third parties or from family members who use the property, or by requiring the family members who own an interest in the property to make regular financial contributions to the property. 

Before a plan can be crafted to establish a source for the payment of expenses, it is important to identify and quantify those expenses.  The author recommends the creation of an Excel or other spreadsheet that identifies both recurring expenses, such as taxes, utilities, homeowner’s fees, insurance, and regular maintenance as well as occasional large expenses for which a reserve should be established.  The spreadsheet should also consider the cost to replace furniture and furnishings as they wear out.  Finally, the budget might contemplate the costs to the client’s family of using the property, such as airfare, particularly if requiring travel costs to be born by children or other intended beneficiaries would impede the accomplishment of the donor’s goals for the use of the property.

D.  Fourth Step: Detailed Tax Projections

 The estate tax impact of the preservation of a vacation home is not necessarily intuitive either to the donor or the advisor.  It is therefore essential to perform detailed estate tax projections demonstrating not only the amount of estate tax that would be imposed upon the property but the practical effect of the plan upon the disposition of the entire estate. The projections should not simply be Excel or other spreadsheets, although they are enormously useful in this context.  Rather, they should also involve box diagrams or flow charts that can visually demonstrate to the client how the preservation of the property will affect the assets available for distribution in the context of the overall estate plan.  The projections and charts should show the impact of the plan not only on the basis of current asset values, but also projected future values determined by applying assumptions for appreciation in the estate’s assets over a given time horizon, as well as the possible consumption of the donor’s financial assets for the donor’s support and health or in connection with other gifting strategies. These projections might well suggest that the plan for the preservation of the property will require the liquidation of more of the balance of the estate than the donor might have intended or anticipated. If so, the donor might need to consider lifetime gifting strategies to reduce the transfer taxes that will be imposed, or possibly secure life insurance to provide a source of cash to pay estate taxes and to establish an endowment to fund the continuing expenses of owning and using the property after the donor’s death.

E.  Crucial Last Step:  Hold a Family Meeting or Conduct Family Interviews 

Once all other indications suggest that preserving the property for future generations is economically and legally possible, the last step in the feasibility study is to hold a family meeting or to conduct interviews with individual family members.  Such meetings and interviews can provide valuable insight into each child’s perspective with regard to the preservation of the property.  Often parents will assume that their children share the same sentimentality with regard to the property and will be anxious to preserve the property and the many memories that it represents.  The children, on the other hand, may have an entirely different point of view, yet they may feel uncomfortable sharing these sentiments with their parents.  For example, although the children may share fond memories of family vacations on the property when they were young, they may now as working adults resent the fact that scarce vacation time must always be spent on the family property and look forward vacationing elsewhere in the future.  The children may recall pleasant holiday gatherings at the property, but they may nevertheless prefer to see the property sold after their parents’ deaths in order to enjoy some financial freedom.  Individual interviews could also identify rarely discussed family tensions, such as the in-law that nobody wants to be around or the child that has always been a source of discontent, allowing the planner to take these facts into consideration when designing structures for the future use and ownership of the property.  In fact, while the first four steps in the feasibility study could suggest that a plan for preserving the property is economically and legally achievable, the information gathered in family meetings and individual interviews could lead to the opposite conclusion, either because most of the members of the next generation do not really want to keep the property or because their perspectives and personalities differ so greatly that co-ownership of the property will inevitably lead to conflicts and disputes.

III. GIFT AND ESTATE TAX PLANNING STRATEGIES FOR TRANSFERRING VACATION HOMES

This Section of the Outline provides an overview of a number of estate and gift tax strategies to be considered in the context of transferring vacation properties to children and grandchildren.

A. Outright Gifting of Property Interests.  From the donor’s perspective, the simplest alternative for transferring a vacation home to children and grandchildren is to make outright gifts of real property interests. 

(1) Outright Gifting with the Annual Exclusion.  With the possible exceptions of certain vacation timeshares and campground memberships, it is unlikely that there are many vacation properties that could be entirely transferred to children in a single round of gifts using the gift tax annual exclusion.  However, gifts of fractional interests in real property are, in most cases, gifts of present interests in property that qualify for the gift tax annual exclusion.[35]  Further, such fractional interest transfers should be discounted for gift tax valuation purposes by some reasonable factor that takes into account the lack of marketability and lack of control inherent to co-ownership of real property as tenants-in-common.[36]

The annual exclusion, which, as discussed earlier in this Outline, is indexed for the effects of inflation, presently allows a donor to give up to $12,000 in cash or property to any individual donee during any calendar year free of gift tax.[37]  The annual exclusion can be effectively doubled if the donor’s spouse participates in the gifting program, either because the donor’s spouse is a co-owner of the property or because the donor’s spouse agrees to gift splitting.[38] It is therefore possible to make incremental annual gifts of interests in a vacation property to children, grandchildren or others which, over time, can result in the complete transfer of the property without gift tax. 

The disadvantages of this strategy, however, are many.  First, annual gifting of interests in real property generally requires a reappraisal of the property before each round of gifts to maximize the benefits of the exclusion without exceeding it.  Such appraisals can be expensive, particularly if they involve the determination of the appropriate fractional interest discount, which typically must be done by a business interest appraiser or an expert in the valuation of tenancy-in-common interests.  Another disadvantage of gifting direct real property interests in small annual increments is that, over time, title to the property can become complicated, and it may be difficult after several years of fractional interest transfers to calculate the interests acquired by each donee as compared to the donor’s remaining interest in the property. A third potential disadvantage is that annual exclusion gifts typically are not reported on a gift tax return and, therefore, the statute of limitations will not run and the IRS will have the ability to question the values used for the annual transfers, in most cases, at any time until an estate tax return is filed the donor’s estate.  Perhaps most importantly, once a direct interest in the property has been titled in the name of a child or grandchild, the property becomes potentially subject to the claims of the child or grandchild’s creditors.  As a result, liens can be placed on the property that will make selling or borrowing against the property difficult for everyone, and the debtor’s interest in the property can be foreclosed upon by his or her creditors.  Further, absent a Tenancy-in-Common Agreement (discussed below) restricting transfers of interests in the property, any child or grandchild could freely sell his or her interest in the property.  As a result, the family could find itself co-owners of the property with strangers or even hostile persons.  Finally, all co-owners will need to agree with regard to the sale or lease of the property, potentially diminishing its value to all of the owners. 

(2) Outright Gifting with the Applicable Exclusion or by Paying Gift Tax.  To address some of the disadvantages of gifting real property in small, incremental amounts, gifts or more significant interests in the property, or possibly the entire property, can be made using the $1,000,000 gift tax applicable exclusion for the donor and, with respect to jointly owned property or separate property if a gift-splitting election is made, the donor’s spouse.  Such gifts will require the filing of a federal gift tax return and, in states that have a state gift tax, a state gift tax return as well.  If the cumulative value of the property transfers exceeds the donor’s remaining gift tax applicable exclusion, a gift tax will be paid.  Note that, in large taxable estates that are almost certain to be subject to significant estate tax (unless the advisor believes that the client will die in the year 2010 or Congress will permanently repeal the estate tax), there can be substantial transfer tax savings achieved by paying gift tax on the lifetime transfer of a vacation home as compared to paying estate tax on the value of the donor’s remaining interest in the home.  This is because the gift tax is “tax exclusive” meaning the gift tax is a liability of the donor that is not treated as an additional taxable transfer, so long as the donor survives for a period of three years following the transfer.[39]

(3) The Importance of a Tenancy-in-Common Agreement.  Co-ownership of real property, particularly real property that is held for the personal use of the owners, is fraught with peril.  The subject of addressing issues of co-ownership and the resolution of disagreements or disputes between co-owners is discussed in some detail in the companion Outline to this paper entitled “Practical Considerations for Achieving Success in the Ownership and Administration of Cherished Family Properties, including Dispute Avoidance and Resolution.”  However, in the context of gifts of direct interests in real property, it is worth at least some discussion at this juncture of the importance of a Tenancy-in-Common Agreement and the issues that should be addressed in such an agreement.

(a) Waiver of Rights of Partition.  Under the law of most, if not all states, tenants-in-common have a right of “partition.”  A right of partition provides a co-owner, among other rights, the right to cause the property to be sold.  Because it is almost always the intent of the donor that the property be retained, it is generally advisable for a Tenancy-in-Common Agreement to contain a provision waiving the owners’ state law rights of partition. A waiver of state law rights of partition should also decrease the value of the tenancy-in-common interests for gift, estate and GST tax purposes, as the official position of the IRS has been that the discount applicable to tenancy-in-common interests should be limited to the costs of a partition of the property.[40]

(b) Restrictions on Transferability.  A Tenancy-in-Common Agreement should address the further transfer of interests in the property.  It is not advisable to prohibit transfers of property interests, as such a provision could be attacked as an unreasonable restraint on alienation, a forfeiture, or a violation of the rule against perpetuities. It is, however, reasonable to provide the family a right of first refusal should an owner seek to transfer a property interest outside of the family (or should an involuntary transfer occur, such as upon the divorce or bankruptcy of an owner).  Such a provision can allow the family to either match the price and terms of a given offer or have the property interest appraised and purchase the interest for favorable terms, such as on an interest-only note with a balloon payment at maturity.  Further, the agreement can require that discounts be applied to the valuation of a fractional property interest, to reflect its lack of marketability, and lack of control, as well as the costs of the transaction (such as attorneys fees and recording costs), and even the estimated future costs of selling the property, as those costs will be born by the remaining purchasers.

(c) Expenses and Capital Contributions.  The Tenancy-in-Common Agreement should address the relative responsibilities of the co-owners for the expenses of owning and maintaining the property.  The agreement should address not only the relative contribution percentages, but also how much will be spent each year in connection with ownership and maintenance of the property.  Because expenses will change over time, the agreement must be flexible. One option is to establish an agreed annual budget, to allow adjustments to the budget for the effects of inflation, and then to require a certain number of owners (such a majority in interest) to approve any change to that budget. Another option is to appoint one of the owners to manage the property (or to serve as the primary interface with a professional property manager) and to provide that owner the authority to incur expenses up to a certain threshold.  Even if such procedures are established, however, the agreement should also provide some enforcement mechanism should an owner fail to honor his or her expense contribution obligation.  For example, the agreement might provide that, should any owner fail to make a required contribution, the contributing owners will be deemed to have made a loan to the non-contributing owner.  The deemed loan might be repaid, with interest, out of the eventual proceeds of the sale of the property.  If, however, it is not likely that the property will be sold in any reasonable time frame, the agreement can provide that the deemed loan will be converted into an equity interest in the property when the loan reaches a certain amount or has been outstanding for a certain time period, or may permit the contributing owners to buy out the non-contributor for a favorable price and under favorable payment terms.

(d) Use of the Property by the Owners.  With regard to vacation homes, the Tenancy-in-Common Agreement should address the rights of, and restrictions imposed upon, the owners with regard to the use of the property.  If the property is not large enough to accommodate multiple occupants at the same time, the agreement should address how a calendar will be established for the use of the property and, in particular, how to insure that the owners equitably share the most desirable dates, such as holidays and school vacations.  The agreement might also address such issues as who is allowed to be a guest at the property, whether pets are permitted and whether personal items can be stored at the property.  Finally, the agreement might account for damages to the property (or to furnishings or other tangible items) attributable to the use of the property by the owners or their guests.  To address this last issue, it might be advisable to require a damage deposit before anyone may use the property and to perform an inspection of the property (preferably by a third party) before and after each use.

(4) Continued Use of the Property by the Donor.  Often, donors will wish to retain some (if not the exclusive) use of a gifted vacation home after ownership has been legally transferred to children or others. In such circumstances, care needs to be exercised to avoid the reinclusion of the gifted property in the donor’s estate under Section 2036(a)(1) of the Code. The strategy to be utilized to avoid reinclusion will depend upon a number of factors, some of which are discussed below.

(a) Retained Use for Only Limited Periods.  If a donor transfers the property to children or grandchildren, and then retains the right to use the property for a specified period of time each month, and if that is in fact the amount of time that the donor spent in the property prior to death, the IRS has ruled that the entire value of the property is not included in the donor’s estate under Section 2036(a)(1).  Rather, only the portion of the value of the property that is related to the donor’s retained use of the property is so included. [41]  For example, where a donor gifted his vacation home to his children, retaining the right to use the property for the entire month of January each year, the IRS computed the reasonable rental value of the property for the month of January as compared to the reasonable rental value of the property for the rest of the year to arrive at the inclusion of 13.3% of the value of the home in the decedent's estate.[42].. On this basis, if a donor retains a partial interest in a gifted vacation home, and only retains the right to the use of the property that is reasonably attributable to such retained interest, the gifted interests should not be included in the decedent’s estate under Section 2036(a)(1).

 (b) Non-Exclusive Retained Use by Donor.  When a donor transfers property by gift but continues to use the property on a rent-free basis at such times as the donor wishes, the IRS can be expected to seek to include the property in the donor’s taxable estate under Section 2036(a)(1) of the Code on the basis an actual or implied agreement between the donor and the donees that donor would retain the use and enjoyment of the property.  The Tax Court, however, has taken the position that such an implied agreement has to be shown to exist on the basis of all of the facts and circumstances, particularly if the decedent has a retained ownership interest in the property.  For example, if the facts suggest that, while the decedent continued to use a gifted property, such use was not exclusive and the possession of the property was not at any time denied to the donees, an implied agreement will not exist and inclusion under Section 2036(a)(1) is not justified.[43]  If, on the other hand, the decedent transfers property and retains the rent-free use of the property to the exclusion of the new owners, an implied agreement may exist, in which case Section 2036(a)(1) will apply to include the property in the donor’s estate at death.[44]

(c) Payment of Rent for Use of the Property.  Where the donor either will not retain an interest in the property, or where the donor wishes to use the property disproportionately to his or her retained interest, estate tax inclusion may nevertheless be avoided so long as the donor pays fair market rent to use the property.  Specifically, in several private letter rulings in the context of terminated QPRTs,[45] the Service has ruled that the donor’s retained use of property formerly held in a QPRT will not result in estate tax inclusion of the property in the donor’s estate so long as the donor pays fair market rent for the continued use of the property.  Importantly, however, the donors agreement to continue to pay the expenses of ownership and maintenance of the property will not be deemed a substitute for paying fair market rent.[46]  Rather, to defeat estate tax inclusion under Section 2036(a)(1), donors should be strongly advised to pay rent to the new owners and to require the new owners, rather than the donor, to pay their respective shares of the expenses of owning and maintaining the property.  Further, a formal lease agreement should be entered into between the donor and the donees, and the donees should report the rental income received from the donor, net of any deductible expenses, as income from real property on their personal income tax returns.  

B. Family Limited Partnerships and LLCs.  An alternative to gifting direct interests in a vacation home to children or other family members is to transfer the property to a limited partnership or a limited liability company and to make gifts of interests in the partnership or LLC to children or other family members.  The potential benefits of this approach in the context of vacation homes are many.  First, because title to the property will be held at the entity level, transfers of interests in the partnership or LLC will not negatively impact upon the chain of title to the property.  Correspondingly, because no partner or member will have a direct interest in the property, the property will be protected from liens arising from the debts and liabilities of the various partners or members.  Further, the partnership agreement or operating agreement (“entity agreement”) can be drafted to address all of the issues of co-ownership discussed above in connection with Tenancy-in-Common-Agreements, including issues related to the use of the property by the partners and the members, the management of the property, and the sharing of the expenses related to ownership of the property.  Further, if a partner or member fails to contribute his or her agreed share of the expenses of owning and maintaining the property, the penalties imposed will be easier to implement. Specifically, upon the failure of a partner, or member to make a required contribution, the entity agreement can dilute such partner’s or member’s interest in the partnership or LLC in a manner that is essentially self-executing.  The entity agreement can also address the transferability of interests in the partnership or LLC to third parties, it can provide for rights of first refusal and other methods to restrict the transfer of entity interests to non-family members, and it can provide a means for the resolution of disputes between partners or members. 

A question that arises when using FLPs and FLLCs in the context of estate planning for vacation homes is whether discounts for lack of control and lack of marketability will apply for purposes of determining the gift or estate tax value of interests in such an entity.[47]  Generally, a limited partnership or LLC can be formed under state law to accomplish any business or investment purpose not otherwise prohibited from operating in that form.  Even though real property held by a limited partnership or LLC may be made available for the personal use of its partners or members, such property also has significant investment value.  The Tax Court has consistently held that, so long as a partnership or limited liability company is validly formed under state law, and if there is no reason to believe that a hypothetical willing buyer would disregard the partnership, then the partnership form should be respected for gift and estate tax valuation purposes.[48]  Therefore, an entity should possess a valid business or investment purpose even if the principal asset of that entity is a vacation home.

While a family limited partnership or LLC holding a vacation property should be respected as a valid legal entity so long as it is properly formed under state law, to secure long-term gift and estate tax benefits, it is important that the entity be properly administered.  This is particularly crucial if the donor either retains an ownership interest in the entity or if the donor will continue to use property owned by the entity.  Specifically, the IRS has had consistent success in including the assets of a family limited partnership in a deceased partner’s estate under Section 2036(a)(1) of the Code where the decedent was the primary source of funding for the partnership, the decedent retained the rent-free use of partnership real property, and the decedent otherwise failed to respect the distinction between the partnership’s income, assets and expenses from the decedent’s own income, assets and expenses.[49]

Some commentators have suggested that inclusion of partnership assets in a decedent’s estate under Section 2036(a)(1) can be avoided so long as the decedent gives away his or her entire interest in the partnership.  However, in Est. of Disbrow v. Comr., [50] a decedent fully divested herself of her entire interest in a general partnership owning a residence.  The residence was nevertheless included in her estate under Section 2036(a)(1) of the Code.  In that case, the decedent executed a lease agreement for her exclusive retained use of the property for her lifetime, but the rent paid was not its fair rental value.  Further, the decedent failed to pay the required rent on a regular basis, and the partnership, in turn, failed to take any action to enforce the lease or to evict the decedent.  Consequently, the partnership property was included in the decedent’s estate under Section 2036(a)(1) of the Code.[51]

C. Gifting of Property Interests in Trust 

(1) Trusts as Vehicles to Hold Vacation Homes. To address some of the disadvantages of gifting direct interests in vacation property without creating a limited partnership or LLC, the donor could establish a trust for the benefit of children or other family members and make gifts of interests in the property to such a trust during life and/or at death.  Like the Tenancy-in-Common Agreement and Entity Agreements discussed earlier in this Outline, the trust agreement could establish the rules for the use of the property by the trust beneficiaries as well as a plan for the succession to a beneficiary’s interest in the trust upon the beneficiary’s death.  A significant benefit of holding a vacation property in a trust is, so long as no beneficiary possesses the right to withdraw the trust property (or other similar powers that constitute a general power of appointment), and so long as the trust instrument includes a spendthrift clause prohibiting the transfer of a beneficiary’s interest in the trust or its property, the trust property should be protected from the claims of the beneficiary’s creditors.  Further, the terms of the trust could insure that, for as long as the trust is permitted to continue under applicable state law, the trust property will remain in the family. 

While there are many issues to consider in drafting a trust as an alternative to making outright gifts of fractional real property interests or creating a family partnership or LLC, certain issues bear particular mention in the context of vacation homes.  The first of these issues relates to the practical consideration of who will serve as trustee of the trust and how much power that trustee will hold over the use of the property by the trust beneficiaries.  It is inadvisable for the donor to hold such power as it will risk the inclusion of the property in the donor’s estate at death.[52]  The donor’s children or other trust beneficiaries may also be poor choices for the role of trustee as it will place the trustee/beneficiary in a conflict of interest with the other trust beneficiaries.  On the other hand, corporate trustees may not be willing to serve as trustee under circumstances where the only trust asset is real property held for the personal use of the trust beneficiaries.  Where they are willing to serve, the corporate trustee’s fees may be prohibitive, particularly if the property does not produce income.

Another consideration in the context of trusts as donees of interests in vacation property is how the trust will acquire the resources to pay its proportionate share of the regular expenses of property ownership and maintenance.  There are three options to consider in this regard.  The first option is for the donor to make annual gifts to the trust using the gift tax annual exclusion as to each of the trust beneficiaries.  Such gifts will, of course, serve to reduce the availability of the gift tax annual exclusion for additional transfers of property interests to the trust.  Another alternative is to endow the trust with an upfront gift of cash using the gift tax applicable exclusion, to draw upon that cash as needed to pay the trust’s proportionate share of expenses and then to replenish the trust at the donor’s death (or the deaths of the donor’s children or other beneficiaries) through bequests from the donor’s estate or from life insurance proceeds.  A third option is to generate income to the trust by charging the beneficiaries, third parties or, in appropriate circumstances, the donor rent for the use of the property. 

(2) Dynasty Trusts.  In many cases, it is the intent of the donor that the property will remain in trust for the use and enjoyment not only of the donor’s children, but for future generations of the donor’s descendants. A trust can be an excellent vehicle to accomplish this objective so long as careful consideration is provided to the effect of the generation-skipping transfer tax upon the donor, the trust and the trust beneficiaries.

When transferring a vacation home to a trust, unless the donor’s GST tax exemption is applied to the transfer, or the transfer qualifies for the GST tax annual exclusion discussed earlier in this Outline,[53] the GST tax will be imposed upon the initial transfer only if that transfer is a “direct skip.”  The transfer of a residence to a trust will be a “direct skip” only if the trust is a “skip person” for GST tax purposes.  A trust that will hold a residence for the collective benefit of the donor’s children and grandchildren will not be a “skip-person” and, therefore, the GST tax will not be imposed upon the initial transfer of the residence to the trust.  On the other hand, unless the donor’s GST tax exemption is applied to each transfer that is made to the trust (or a late allocation of the exemption is properly made), and unless the portion of the donor’s GST exemption so applied was sufficient to render the “inclusion ratio” of the trust zero (0) for GST tax purposes,[54] a GST tax will be imposed upon each distribution from the trust to a “skip-person” (a “taxable distribution”).  Further, a GST tax will be imposed upon the entire trust upon the first date that the only remaining beneficiaries of the trust are skip-persons (a “taxable termination”).  In either case, the amount of the GST tax imposed will depend upon the inclusion ratio of the trust.  If the trust has an inclusion ratio one (1), meaning no portion of the donor’s GST tax exemption was applied to the trust, then the GST tax will be imposed at the maximum estate tax rate, which is presently 45%.  If, however, the inclusion ratio of the trust is, for example, .4 meaning the donor’s GST tax exemption was only sufficient to exempt 60% of the value of the trust from the imposition of GST tax (a “mixed inclusion ratio), the GST tax will be imposed at 40% of the highest marginal estate tax rate, which, under current tax rates would be 18% (40% of 45%).

In an ideal planning environment for a vacation home, a “dynasty trust” will have an inclusion ratio of zero.  If that is not possible, however, then careful consideration must be given to structuring the trust to postpone the imposition of the GST tax for as long as possible.

(a) Creating GST Exempt and Non-Exempt Trust Shares.  If the donor’s GST tax exemption is insufficient to fully exempt the trust from the imposition of the GST tax, rather than create a trust with a mixed inclusion ratio, the trust should be divided into GST exempt and non-exempt shares.  The beneficiaries of the non-exempt share should be limited, for as long as possible, to the donor’s children and other non-skip persons.  On the other hand, the beneficiaries of the exempt share can include grandchildren and more remote descendants.  Importantly, if the trust is funded with a cash endowment to fund the expenses of owning the vacation home, that cash endowment should be allocated proportionately between the exempt share and non-exempt share to match their respective interests in the property.  Otherwise, the use of funds from the non-exempt share to pay expenses for the exempt share could be deemed a constructive addition to the exempt share, causing the exempt share to lose its zero inclusion ratio. Conversely, the use of funds from the exempt share to pay expenses for the non-exempt share would waste the exempt share.

(b) Postponing a “Taxable Termination” on Non-Exempt Trust Assets.  If a trust holding a vacation home has been divided into exempt and non-exempt shares, or if the trust has a mixed inclusion ratio, then the planner should consider strategies for postponing a taxable termination of the non-exempt trust for as long as possible.  For example, the class of beneficiaries who are permissible users of property held in the non-exempt trust and who are discretionary beneficiaries of trust income, could be expanded to include the donor’s nieces and nephews, or the spouses of the donor’s children, thereby postponing a taxable termination until the death of the last to die of this class of beneficiaries (as well as the donors children).  It has also been suggested that a taxable termination can be postponed indefinitely if charitable organizations, which are by definition non-skip persons, are permissible income beneficiaries of a non-GST exempt trust or are entitled to an annuity payment from the trust.[55] 

Even if a taxable termination of a non-exempt trust holding a vacation property is postponed indefinitely, this begs the question of whether the rent-free use of trust property by a skip-person will constitute a deemed taxable distribution that will give rise to the imposition of the GST tax and, if so, the amount of the GST tax that will be imposed upon any such deemed distribution. There is, unfortunately, little or no direct authority concerning the GST tax consequences of the rent-free use of real property by skip-persons, whether the subject property is held in trust or owned by the deemed transferor.  On the other hand, the gift tax consequences of the rent-free use of real property was discussed in dicta by the U.S. Supreme Court in Dickman v. Comr.[56]  The issue before the Court in Dickman was not the gift taxation of the use of real property; rather, the question before the Court was the gift taxation of interest-free loans between family members prior to the enactment of the imputed interest rules under Section 7872 of the Code.  In concluding that the interest-free use of a donor’s capital was a deemed gift to the donee of the donor’s foregone interest, the Court in Dickman acknowledged that the same rational could be used to tax the rent-free use of real property.  However, the Court stated that, until the IRS actually sought to treat the rent-free use of real property as a taxable transfer, the Court would not address the issue.[57] 

While there is no direct authority for the imposition of the GST tax upon the rent-free use by a skip-person of real property held in a non-GST exempt trust, the rational applied by the U.S. Supreme Court in Dickman would suggest that such use is a taxable distribution.  It is therefore advisable, when drafting a non-GST exempt trust to hold vacation property, to contemplate a means for skip-persons to use the property in a manner that is arguably something other than a taxable distribution.  One option is to charge skip persons rent for the use of the property in some amount that is reasonable.  The amount of rent charged might take into consideration, for example, whether the grandchild’s use is of the property is non-exclusive or otherwise limited in scope, and be reduced appropriately.  Another option might be to provide the Trustee the discretion to permit only non-skip persons to use the property rent-free, but, under the terms of the trust agreement, to permit such non-skip persons the ability to assign such rights to other family members, including skip-persons.[58]  Arguably, if the non-skip person had the right to use the property, but assigned that right to a member of the next generation, the non-skip person/beneficiary should become the transferor for GST tax purposes.  The deemed transfer between the non-skip person beneficiary and the skip-person would be a gift.  If, however, the right to use the property is a gift of a present interest, the gift tax annual exclusion could apply to shelter this transfer from gift taxation.  Otherwise, immediate taxation can be avoided by the application of the deemed transferor’s gift tax applicable exclusion.

(c) Including Non-Exempt Trust Property in the Taxable Estate of a Non-Skip Person.  Another option for avoiding a taxable termination of a non GST-exempt trust is to provide one or more of the trust beneficiaries who are non-skip persons a testamentary general power of appointment over a portion of the non-exempt share of the trust (such as the power to appoint trust property to the beneficiary’s estate with the consent of a non-adverse party).[59]  There are several possible benefits to this approach to avoiding GST tax.  First, if the deceased beneficiary’s estate is relatively modest, it is possible that his or her estate tax applicable exclusion will be sufficient to fully shelter the trust assets subject to the general power of appointment from estate taxation.  Second, if the deceased beneficiary’s estate plan does not otherwise employ the use of his or her GST tax exemption, that exemption can be applied to the assets subject to his or her general power of appointment, to be recirculated as GST exempt assets under the terms of the dynasty trust.[60]  Finally, if there will be an estate tax imposed upon the assets subject to the general power of appointment, it is possible to plan for the payment of that estate tax by acquiring life insurance on the life of the beneficiary holding the power.  In an ideal setting, that insurance would be owned by the GST-exempt share of the original dynasty trust (if any), which could use those insurance proceeds to purchase the property (or a portion of the property) from the non-exempt trust.[61]

(3) Qualified Personal Residence Trusts (QPRTs).   Qualified personal residence trusts (“QPRTs”), described under Section 2702 of the Code, can be extremely powerful transfer tax planning devices in the context of family vacation homes.  While a detailed discussion of QPRTs is beyond the scope of this particular Outline, a few of the most important aspects of QPRTs in the context of planning for vacation homes are set forth below.[62]

(a) The QPRT Basics.  A QPRT is an irrevocable intervivos trust funded with real property that is a personal residence of the grantor.  Under the terms of the trust agreement, the grantor retains the exclusive right to the use of the residence transferred to the QPRT for a stated term of years.[63]  At the end of that term, (the “QPRT Term”), the remainder beneficiaries (typically the grantor’s children or a continuing trust for their benefit) secures ownership of the trust property. 

The principal benefit of using a QPRT is that the gift tax value of the property transferred to the trust is the actuarial value of the remainder beneficiary’s interest in that property.  Such gift tax value is fixed on date of a contribution to the QPRT, and no further gift or estate tax is imposed upon the trust assets so long as the grantor survives to the end of QPRT Term.  Further, the value of the remainder interest is determined using the “subtraction method” of valuation; that is, by subtracting from the value of the property on the date of contribution to the trust the value of certain of the donor’s retained interests in the trust property.  Specifically, the gift tax value of the remainder interest is determined by subtracting from the value of any property contributed to the trust the actuarial value of the donor’s right the exclusive use of that property for QPRT Term.  Such value is determined by applying the actuarial principles supplied under Section 7520 of the Code and the applicable Treasury Regulations.  The gift tax value of the remainder interest can be further reduced if the trust agreement provides that, should the grantor die during the QPRT Term, the trust property will revert to the grantor’s estate.  In such event, the actuarially determined value of the donor’s reversionary interest in the trust, also determined under the principles set forth in Section 7520, will further reduce the value of remainder interest.

Based upon the foregoing valuation principles, the older the grantor and the longer the QPRT Term, the lower the gift tax value of the remainder interest.  This would suggest that the QPRT Term should be as long a term as possible.  However, a  critically important aspect of planning with QPRTs is that, should the grantor die during the QPRT Term, the assets held in the QPRT are included in the grantor’s taxable estate.  Consequently, structuring a QPRT requires a careful balancing of the desire to drive the gift tax value of the remainder interest as low as possible while managing the risk of the grantor’s death during the QPRT Term.  Occasionally this balancing act can be struck by selecting a relatively long QPRT Term and purchasing term life insurance on the grantor’s life to cover the QPRT term.

(b) Selected QPRT Technical Requirements.  The following are some of the most notable technical requirements for QPRTs:

(i) A grantor may create QPRTs for no more than two personal residences and one such residence must be the grantor’s principal residence.

(ii) Multiple QPRTs may be created to transfer fractional interests in the same residence.[64]

(iii) Tangible personal property (such as household furnishings) cannot be held in a QPRT.

(iv) The QPRT property must be used by the grantor as a personal residence.

(v) Using the property in a trade or business will disqualify the QPRT unless the business use of the property is secondary to its use as a personal residence.

(vi) Renting the property to a third party will not necessarily disqualify QPRT so long as the property satisfies the residence test set forth in Section 280A(d) of the Code.[65]

(vii) With regard to properties that consist of multiple parcels or multiple structures, only the portion of the property and structures that is reasonably related to the use of the property as a residence may be transferred to the QPRT.

(viii) The grantor must have the exclusive use of the property for QPRT Term, although this requirement does not preclude the grantor from inviting others to use the property from time to time.

(ix) The grantor of the QPRT is responsible for the costs of ownership and maintenance of the property during the QPRT Term.  However, expenses associated with capital improvements to the property, and any repayment of principal on a mortgage that is an obligation of the QPRT, will constitute additional gifts to the QPRT that must be valued using the same principles as those applied to value the initial contribution to the trust.[66]

(x) Except in certain very limited circumstances, the trust is prohibited from holding more cash than is needed to fund six months of expenses for a QRPT property.

(xi) If the residence held by the QPRT is sold, and if the sales proceeds have not been reinvested in a replacement property within two years of the sale, the sales proceeds must either be distributed to the grantor or the QPRT must be converted to a grantor retained annuity trust (“GRAT”) within the meaning of Section 2702(b)(1) of the Code, as to the sales proceeds.

(xii) During the QPRT Term, and after the termination of the QPRT Term so long as the grantor continues to be treated as the owner of the trust income and corpus under Sections 671-677 of the Code (the “grantor trust” rules), the grantor must be prohibited under the terms of the trust instrument from purchasing the residence from the trust. 

(c) Use of QPRT Property by the Grantor after Termination of the QPRT.  Although a QPRT can be a very attractive tax planning device for the passage of a vacation home, clients may be reluctant to choose a QPRT over a testamentary transfer of the property out of concern of being evicted from the property by the new owners.  To address this issue, the trust instrument can provide that the trust will continue after the QPRT term ends and the Trustee will lease the property back to the grantor for fair market rent.  Although such an arrangement could arguably be viewed as an impermissible retained interest in the QPRT property under Section 2036(a)(1) of the Code or an impermissible right to control the beneficiaries’ use and enjoyment of the trust property under Sections 2036(a)(2) and 2038 of the Code, the IRS has ruled privately that such arrangements will not result in the inclusion of the QPRT property in the donor’s taxable estate under any of these provisions.[67]  Importantly, in the context of a vacation home, unless the grantor wishes to retain the right to exclude all other owners from the use of the property, the grantor should only be required to pay rent for the portion of the time that the grantor will actually use the property rather than the rental value of the entire property for the entire year.[68]

(d) QPRTs and the GST Tax.  As a general rule, QPRTs are inefficient for GST tax planning purposes.  This is because the grantor’s GST tax exemption cannot be applied to the QPRT until the end of the estate tax inclusion period, or “ETIP.” [69] The ETIP is the period during which trust property will be includible in the grantor’s estate in the event of the grantor’s death.  With regard to QPRTs, the ETIP is the QPRT Term.  Therefore, the grantor’s GST tax exemption cannot be applied until the end of the QPRT Term.  Further, it must be applied based upon the value of the trust property at the end of the QPRT term, which is no longer diminished by the grantor’s term or reversionary interests.

If there is a high degree of certainty that the value of the property in a QPRT at the end of the QPRT Term will not exceed the grantor’s remaining GST tax exemption, then it may be possible to confidently design the QPRT to pass the property to a Dynasty Trust (discussed above).  On the other hand, if the value of the trust property at the end of the QPRT Term exceeds the grantor’s remaining GST tax exemption, then passing the trust property to a Dynasty Trust will cause that Dynasty Trust to suffer a mixed inclusion ratio for GST tax purposes, a consequence that is to be avoided.

Another unfortunate aspect of QPRTs in the context of GST tax planning involves the application of the predeceased parent rule. [70]  Under the predeceased parent rule, if the child of a donor is deceased, the child’s descendants move up a generation for GST tax purposes.  However, the generational move-up applies only to transfers occurring after the child’s death.  Therefore, if all of the donor’s children are alive when a QPRT is created and funded, but a child dies during the QPRT Term, the deceased child’s descendants will not move up a generation with regard to the QPRT property.  Rather, they will continue to be “skip-persons” as to the QPRT.  Because the deceased child’s descendants will be skip-persons as to the QPRT, a GST tax will be incurred if those descendants succeed to the deceased child’s share of the QPRT property unless the grantor’s GST tax exemption is applied to the entire value of the trust at the end of the QPRT Term, including the portion of the trust property passing to the grantor’s surviving children.  To avoid this consequence, it is generally recommended that the remainder beneficiaries of a QPRT be limited to the grantor’s children living at the end of the Trust Term.  The grantor can then make up the difference to the deceased child’s descendants by providing them a disproportionate share of assets from the grantor’s estate at his or her death, or by making other gifts to those descendants during the grantor’s lifetime.  Because such bequests or gifts would occur after the child’s death, the children of the deceased child would “move up” a generation for purposes of such bequests or gifts.[71]

(e)  The IRS Model QPRT Form (Rev. Proc. 2003-42).  In Rev. Proc. 2003-42,[72] the IRS announced that it will no longer issue private letter rulings affirming the qualifications of a trust for a single term holder as a valid QPRT.  Rather, in Rev. Proc. 2003-42, the IRS provided a model QPRT form.  Any trust agreement that is substantially similar to the model form, is valid under state law, and is operated consistently with the trust instrument will be a valid QPRT.  A copy of Rev. Proc. 2003-42 and the model form are attached to this Outline. 

As a general rule, estate planning attorneys who are not well versed in the law affecting QPRTs are well advised to use the IRS model QPRT form.  However, in doing so, commentators have noted that are three potential deficiencies in the model form that the drafter might wish to address. 

First, the model QPRT form does not provide for a contingent reversionary interest in the grantor should the grantor die during the QPRT Term.  There are two potentially important reasons to include such a reversionary interest.  First, a reversionary interest reduces the gift tax value of the remainder interest in the QPRT.  In fact, for elderly grantors, the reversionary interest can, under certain circumstances, have a greater impact upon the value of the remainder interest than does the grantor’s term interest.  Second, if the grantor is married at his or her death during the QPRT Term, a reversionary interest will permit the grantor to make a testamentary transfer of the QPRT property to his or her spouse or to a QTIP trust for the spouses benefit, thereby deferring the payment of estate taxes on the property until the spouse’s subsequent death (or, in the case of an outright bequest to the spouse, affording the possibility that the surviving spouse can create a new QPRT). 

Second, the IRS model QPRT form requires an independent trustee to determine whether, in the event that the QPRT property should cease to be used as the grantor’s personal residence, that property will be distributed back to the grantor or the converted into a grantor retained annuity trust.  There is nothing in the Code or the regulations that suggests an independent trustee is required to make this decision.

Finally, many grantors wish for the QRPT property to remain in trust after the end of the QPRT Term, at least for the grantor’s lifetime (to insure that the grantor will not be “evicted” from the property, as discussed above) and possibly after the grantor’s death.  The IRS model form does not provide for any continuing trusts at the end of the QPRT Term, but rather contemplates outright distribution of the QPRT property to the remainder beneficiaries.

While the foregoing provisions are not included in the IRS model QPRT form, the IRS has privately ruled that a trust agreement created a valid QPRT when it provided the grantor a general power of appointment over the QPRT property in the event that the grantor predeceased the QPRT Term, provided the grantor the sole discretion to determine whether to distribute the QPRT property to himself or convert the QPRT to a GRAT if the residence ceased to be used as the grantor’s personal residence, and permitted the QPRT property to be distributed to another trust at the end of the QPRT Term.[73]

D. Intervivos QTIP Trusts

If spouses are of uneven wealth, it might be possible to shelter a vacation home from estate taxation by taking advantage of the estate tax applicable exclusion and the GST tax exemption of the less wealthy spouse.  One means for accomplishing this objective is through gift-splitting, discussed earlier in this Outline in the context of direct gifts of real property interests.  Another option is to transfer an interest in the property to an intervivos qualified terminable interest property (“QTIP”) trust for the benefit of the less wealthy spouse.  So long as the less wealthy spouse is a U.S. citizen, the transfer of an interest in the property to an intervivos QTIP trust would be sheltered from gift taxation by reason of the gift tax marital deduction.[74]  During the lifetime of the less wealthy spouse, the more wealthy spouse can be the trustee of the trust[75] and the continued use of property by the more wealthy should not be considered a retained interest in the property for purposes of Section 2036(a)(1), so long as the spouses remain married.[76]  If the less wealthy spouse predeceases the more wealthy spouse, the more wealthy spouse can be a successor beneficiary under the terms of QTIP  trust without risking the inclusion of the assets of the QTIP trust in the more wealthy spouse’s estate under Section 2036(a)(1).[77] Further, should the less wealthy spouse predecease the more wealthy spouse, and if the less wealthy spouse has a taxable estate, the estate tax on the intervivos QTIP can be deferred until the subsequent death of the more wealthy spouse provided he or she has a qualifying income interest in the trust for life.[78]  Of course, upon the death of the survivor of the spouses, the terms of the QTIP can pass the QTIP property to trusts for the children and more remote descendants of the more wealthy spouse.

The primary disadvantage of an intervivos QTIP is that the less wealthy spouse will continue to be a beneficiary of the trust even if the spouses divorce.  In the event of a divorce, however, the more wealthy spouse could have the right to buy the residence back from the QTIP trust for its fair market value.  While this will not divest the less wealthy (now former) spouse of the economic benefits of the QTIP, it will protect the family from a potentially hostile visitor in their cherished vacation home.

IV.  PLANNING WITH QUALIFIED CONSERVATION CONTRIBUTIONS

While there are a number of techniques to be considered in the context of planning for vacation homes, in appropriate circumstances the use of an intervivos or post-mortem qualified conservation contribution can provide tax savings sufficient to tip the balance from a forced sale of a cherished property at a client’s death to its preservation for the use and enjoyment of future generations. overview of the perceived abuses of QCCs and how recent negative attention from the IRS and Congress may affect the future of QCCs as a tax planning tool.

 A. Lifetime Gifts of QCCs

 Under general income tax principles, no income tax deduction is allowed for gifts to qualified charitable organizations of less than the donor’s entire interest in the gifted property.  QCCs, as described in I.R.C § 170(h) of the Internal Revenue Code (“I.R.C.”), are an exception to this general rule. 

To qualify as a tax deductible QCC, the gift must be of a “qualified real property interest,” it must be made to a “qualified organization,” it must be exclusively for “conservation purposes,” and the conservation purposes must be enforceable in perpetuity.  Each of these requirements is discussed in detail below.

(1) Qualified Real Property Interest.  The first requirement for a QCC is that the gifted real property interest must constitute a “qualified real property interest.”  A qualified real property interest must be either the donor’s entire interest other than a qualified mineral interest, a remainder interest, or a restriction (granted in perpetuity) upon the use that may be made of real property.

(a) Gift of the Donor’s Entire Property Interest Other than a Qualified Mineral Interest.  A gift of the donor’s entire interest in real property other than a “qualified mineral interest” is a gift of a qualified real property interest.[79]  A “qualified mineral interest” is the right to the sub-surface oil, gas and other minerals, including the right to access those mineral interests.[80]

In addition to minerals that are clearly “subsurface” in nature, a qualified mineral interest can also include the right to extract surface minerals, such as gravel.[81]  However, a gift of a donor’s interest in real property subject to a retained mineral interest will not qualify as a QCC unless the terms of the gift specifically prohibit surface mining.[82]  The gift will also fail if any other method of mineral extraction is permitted that would be inconsistent with the conservation purposes of the gift, unless such extraction is localized in nature and the destructive impact is limited, can be remedied, and would not have a significant adverse impact upon the conservation purposes of the gift.[83] 

The Treasury Regulations provide that a donor cannot, in anticipation of making a conservation gift of this type, separate interests in the subject property beyond those contemplated by the definition of a qualified mineral interest and then later take the position that a gift has been made of the donor’s entire interest in the property.[84]  A special rule applies to mineral interests that have been separated from the property other than in anticipation of the donation.  Specifically, if such interests were separated from the property after June 12, 1976 and remained separated up until the time of the gift, and if the owner or owners of such interests are neither the donor nor persons related to the donor within the meaning of I.R.C. § 267(b) or I.R.C. § 707(b), such separate interests should not disqualify the gift so long as surface mining on the property is completely prohibited.[85]  For separations that occurred on before June 12, 1976, surface mining need not be completely prohibited, but the likelihood of its occurrence must be so remote as to be negligible.[86]  The Regulations provide factors to take into consideration for this purpose, including, for example, the presence of data indicating the absence of mineral reserves on the property as well as the lack of commercial feasibility of a surface mining operation.[87]  In making this determination, the opinion of a qualified geologist can be very valuable.[88]

(b) Gift of a Remainder Interest in Real Property.  Another form of qualified real property interest is a gift of a remainder interest in real property for conservation purposes.[89]  The donor’s retained interest can be for life (or joint lives) or for a period of years. However, tenants for life or a term of years cannot be permitted to use the subject property in a manner that diminishes the conservation purposes of the gift.[90]

Where the subject of the remainder interest gift is a farm or personal residence, it will usually be more desirable for the donor to claim an income tax deduction under I.R.C. § 170(f)(3)(B)(i) rather than a deduction under I.R.C § 170(h).  First, to obtain a deduction under I.R.C. § 170(f)(3)(B)(i), the donee need not satisfy the substantially more restrictive tests for a “qualified organization” under I.R.C. § 170(h).  Further, the donation need not be exclusively for conservation purposes.[91]  Regardless of whether a deduction is secured under I.R.C. § 170(h) or I.R.C. § 170(f)(3)(B)(i), however, the value of the remainder interest will be computed in the manner described in I.R.C. § 170(f)(4), including the requirement that the value of the donee’s remainder interest in any structures or other depreciable property be computed separately from the remainder interest in the land.[92]

(c)  A Gift of a Perpetual Conservation Restriction.  The third form of qualified real property interest for purposes of I.R.C. § 170(h), and the primary focus of this article, is a restriction granted in perpetuity with regard to the use of the donor’s real property.[93]  These restrictions can take the form of equitable servitudes, restrictive covenants, easements, and other restrictions on the use of real property as provided under applicable state law.  For purposes of the balance of this article, all such restrictions are referred to collectively as “easements” or “QCEs.”

QCEs are particularly attractive to donors because, in many instances, the donor’s current use of the property can remain unchanged.  In some cases, the donor can even continue to develop the property.[94]   However, no deduction will be permitted if the use of the property retained by donor is either inconsistent with the conservation purposes of the gift or would have a detrimental effect upon other significant conservation interests.  For example, a gift of an easement restricting a property to agriculture use for flood control purposes will not be a QCC if such use will involve the application of pesticides that are harmful to a significant natural ecosystem.[95]  On the other hand, a QCC will not fail simply because the advancement of the intended conservation interests of the gift will by necessity have a detrimental impact upon other important conservation interests.  For example, the excavation of a historically important archaeological site in accordance with established archaeological practices could have a negative impact upon the scenic beauty of the property without disqualifying the gift as a QCC.[96]

(2) Qualified Organizations.  The second requirement for a QCC is that the donee organization must be a “qualified organization.”  Qualified organizations are a narrow subset of the organizations that otherwise benefit from tax deductible charitable contributions. Qualified organizations are limited to governmental units, publi