Fractional Ownership – Answers To Frequently Asked Questions
What is Fractional Ownership?
The phrase “fractional ownership” is typically used to describe shared ownership of a vacation or resort property in an arrangement that allocates usage rights based on time. In other words, only one owner will be allowed to use a particular home at a particular time. Fractional ownership arrangements can be applied to a single home or apartment (typically referred to as a “one-off fractional”) or to a multi-unit building or resort development. In multi-unit developments, each co-owner may have ownership rights to all the units, some of the units, or only one unit, and his/her usage rights, and cost obligations, may or may not correspond to his/her ownership rights. Groups can be assembled by groups of friends or family members, one or more of the prospective buyers/users, an individual seller, developer, builder or real estate agent, a web-based fractional ownership marketing and support company or platform, or a real estate development or hotel company.
The terms private residence club (or “PRC”), timeshare, shared ownership, vacation home partnership and fractional co-ownership are also used to describe these arrangements, and there are no consistent distinctions in the use of these descriptions. Since property usage is allocated based on time, this type of co-ownership falls within most legal definitions of a “timeshare”, which means it can be subject to restrictions and requirements applicable to the creation and sale of timeshare property. Nevertheless, there are significant practical distinctions between most arrangements commonly called fractional ownership and more traditional timeshares, and these are discussed more fully below. Fractional ownership arrangements should not be confused with “destination clubs” (in which participants purchase a temporary right to use without ownership), or a “condohotel” or “condotel” (in which each participant has whole ownership of a particular hotel room or suite). For more about factional ownership terminology and the differences between different type of fractional ownership, visit Fractional Ownership Terminology and Fractional Ownership Types.
Why Would a Vacation Home Buyer Consider Shared Ownership?
Although many people dream of owning vacation property, most either can’t afford the type of property they want, or reason that they would not use the vacation home often enough to justify the expense. Fractional ownership provides a solution to these problems by allowing each co-owner to pay only a fraction of the costs and ongoing expenses of vacation home ownership, and share the risks of unforeseen maintenance problems and value depreciation with others. Of course, in exchange for spreading the costs and risks, the owner gives up some of the usage rights and freedoms of whole ownership. But job and school commitments prevent most people from using a vacation home more than a few weeks or months each year, and some loss of freedom and control is often an acceptable sacrifice for the huge cost savings. For more on why factional ownership makes sense, visit Why Fractional Ownership Beats Owning Your Own Vacation Home.
How Does Fractional Ownership Differ From Time Share?
The definition the term “timeshare” found in most laws and regulations encompasses any arrangement under which a group of people share use of a property based on time, regardless of whether they own the property directly (on title or indirectly or through an LLC, trust, HOA, or some other entity form) and regardless of whether a management company or developer is involved in organizing or operating the property. But marketing customs and consumer perception reflect significant differences in the use and understanding of the terms timeshare and fractional ownership, including a number of incorrect stereotypes.
For example, contrary to the widely-held belief, it is not uniformly true that timeshare owners have a right to use the shared property but do not own it, and it is not uniformly true that fractional owners are always on title to the shared property. Many “timeshare properties” involve direct titled ownership, and many “fractional properties” do not. Misconceptions about the difference between fractional ownership and timesharing often lead to two significant problems: (i) an assumption that timeshare restrictions and regulations do not apply to fractional ownership arrangements, and (ii) buyer failure to focus on the key elements of an offering rather than on how it’s characterized by the person or farm marketing it.
Although there are no “bright lines” differentiating time shares from fractional ownership, there are some discernible patterns in how these terms are currently applied for marketing purposes. Most significantly, the term fractional ownership is generally used to describe arrangements involving a much smaller owner group, a single shared home (as opposed to a multi-unit property or resort), and a higher degree of owner group autonomy and control.
For more about the differences between fractional ownership and timeshare, visit Differences Between Fractional Ownership and Timeshare and Five Key Differences Between Co-Ownership and Timeshares.
What is a Private Residence Club? Is a Residence Club a Timeshare? Is a Residence Club a Kind of Fractional Ownership?
As with the terms timeshare and fractional ownership, application of the term private residence club or PRC is inconsistent among developers and salespeople and this inconsistency makes it difficult to generalize about the characteristics of the offerings marketed as residence clubs. But it would be fair to say that most residence clubs have the following characteristics: (i) they involve multi-unit properties or resorts, but the properties generally have fewer units compared with developments characterized as timeshares; (ii) the ratio of owners to units is generally 6-8 owners per unit; (iii) each owner is either on title to a particular home or a member of a single purpose entity that holds title to only one home; (iv) although ownership is individuated (in the sense that each owner holds ownership of a particular home), usage is non-individuated (meaning that, during any particular stay, the owner will not necessarily be using the unit he/she owns); (iv) the level of owner autonomy and control is relatively low; (v) the level of amenities and services is high; and (vi) the acquisition cost and annual dues are high.
Residence clubs fall within the legal definition of timeshares but, as the above summary shows, generally have different characteristics from projects marketed as timeshares (e.g. fewer owners per unit, more amenities and services, and higher costs). Residence club characteristics also differ from those of projects typically marketed as fractional ownership (e.g. multiple units, resort-like amenities and services, less owner autonomy and control, higher acquisition costs and annual dues).
For more about comparing different fractional ownership options, visit Comparing and Choosing Among Fractional Ownership Options.
Is Fractional Ownership Better than a Timeshare? How Should I Choose Between Fractional Ownership, Time Share, and Residence Club? Should I Just Create My Owner Fractional Ownership Group?
It is important that anyone considering vacation home sharing first decide what characteristics are important to him/her and to his/her family by asking these questions:
- How much independence and autonomy do I need and want to find the home, choose my partners, furnish and equip the house, operate the property, and sell?
- Do I have the time, desire and ability to do all or some of the work to organize and operate a shared vacation home? Or, would I prefer to pay someone else to do these things?
- How often do I plan to use the shared vacation property? How long are my stays likely to be? How much reservation flexibility and predictability do I need to accommodate the work/vacation schedule of myself and my family?
- Is it important for me to be able to generate rental income to help pay my share of the ongoing costs or to feel better when I am unable to travel to the property?
- Do I want or need resort-like amenities like daily housekeeping, swimming pool, gym, or restaurant? Or, am I really only interested in having a nice home in a nice place?
- Do I need to finance the purchase, or can I pay cash?
- How long do I want to hold on to the property? How likely is it that life changes will make use of the home less desirable in the future?
If you decide to go the “form your own fractional” route, there are two possible approaches. One option is to first locate the property, then either buy it yourself or try to tie it up through purchase contract or option, then create the fractional ownership structure (i.e. how many family shares, how will usage work, etc.), and then assemble a group and/or market the fractional ownership interests either yourself or through a real estate agent. The other option is to first try to assemble a like-minded group of family and/or friends, identify and purchase the property, then organize the fractional ownership structure. In my 35 years experience is assisting fractional ownership groups, I have found that the first of these options is much more likely to succeed.
If you instead decide to seek out a fractional ownership opportunity in the marketplace, it is important to look beyond the marketing characterization (i.e. timeshare versus fractional ownership versus residence club, etc.) and focus on the actual characteristics of the offering. Here are the key questions to ask about a fractional ownership arrangement:
- How many owners will be sharing the home, and how much usage will that leave for me? Will the usage system allow me to get the usage I want and need from a duration, timing, and seasonality perspective?
- Can I let family and guests use the property when I’m not there? Can I generate rental income and, if yes, what sorts of restrictions and costs are imposed on rentals?
- Can the usage system be changed and, if so, to what extent am I protected from changes that will diminish the usefulness of the property for me? Is the usage system fair, can its fairness be verified and confirmed, and in what ways might an unscrupulous owner or manager manipulate the system?
- Is the acquisition cost reasonable in light of the organizational infrastructure, amenities and management services offered?
- Is financing available and do I need or want it? If financing is available, to what extent am I exposed to risk if another owner defaults on his/her payments?
- What will the ongoing costs of ownership be, and can I afford them? Has adequate homework been done so that I can accurately evaluate the ongoing costs of ownership, including periodic repair and replacement of the house and its contents?
- Who will be managing and maintaining the property, and how with that person or firm be paid? How is decision-making power and authority allocated between the manager and the owners? Can the owners replace the manager?
- What is the per-night cost when one adds up all of the annual costs (including management fees and dues) and divides them by the number of days of use each year? How likely is it that per-night costs will increase faster than the costs of alternative lodging? To what extent will per-night costs be influenced by the need to provide services that some co-owners may not want or use, or by the need for a large developer or resort operator to make a profit?
- What are the potential consequences for me and the rest of the owner group if an owner does not pay his/her share of costs? Is there a company or other third party that will step in and make payments during the process of foreclosing on the non-paying owner?
- Can I exchange my usage and vacation somewhere else, and how easy will it be to get my desired location and dates?
- How likely is there to be a resale market if and when I want to sell my share? Will any sort of resale assistance or program be offered by a manager or related entity? What restrictions apply to re-sale, gifting and inheritance? Is there an alternative exit strategy if it is impossible for me to find a buyer for my share?
For more about comparing different fractional ownership options, visit Comparing and Choosing Among Fractional Ownership Options.
Why Would the Owners of a Vacation Home or Resort Property Consider Selling a Fractional Interest?
Shared ownership is increasingly popular among those who already own a vacation home (or even a primary residence in a resort community) but feel burdened by the expense, upkeep and management of a property they use infrequently or are regularly absent from during certain seasons. Rather than sell a home they love, these people opt to sell one or more fractional ownership interests to others who will use the home when the original owner does not and will help share the costs and burdens. Besides lowering cost and time burdens, shared ownership can free capital for the purchase of other resort property, or for alternative investments. It can also provide an alternative when selling the entire home proves difficult due to market conditions.
For more about the process of evaluating whether selling an individual home fractionally makes sense, visit Will This Home or Condo Sell as Fractional Ownership?
Why Would a Developer or Builder Consider Offering Fractional Ownership Interests?
Shared ownership can be a significantly less expensive and more attractive option for some prospective purchasers of a new development, giving some buyers an incentive or opportunity to purchase that would otherwise be lacking. The builder or developer can thus open up a new market and access a different group of potential customers by offering fractional ownership, a particularly attractive opportunity when whole ownership sales are slow. Marketing a less costly ownership option may also increase the overall visibility of, and traffic to, the project sales sites, and increase sales volume of whole ownership. Finally, opening a project to fractional ownership will generally increase overall usage of the property, which can enhance the viability and financial performance of amenities and ancillary services such as a spa, golf course, ski resort, or restaurant.
For more about the process of evaluating whether to include fractional ownership as part of a new resort or other development, or to convert an existing hotel or multi-unit property into fractional ownership, visit Fractional Ownership, Timeshare, PRC, Destination Club Feasibility Analysis Tools.
Why Would a Realtor Consider Suggesting Fractional Ownership to a Potential Seller or Buyer?
The concept of fractional ownership is unknown to many developers, builders, sellers and buyers, and even those aware of the concept are often unclear on its potential advantages. A Realtor who understands shared ownership concepts can often obtain a listing or make a sale that other Realtors cannot, open up a new avenue of marketing, or achieve a higher sales price. Knowledge and understanding of fractional ownership can be a particularly useful tool in times or areas where transaction volume for traditional sales is slow or seasonal.
For more about the involvement of real estate agents in the marketing and sale of fractional ownership, visit Achieving Higher Sales Volume, Pricing and Commissions Using Fractional Ownership and Using Real Estate Agents to Sell Fractional Ownership and PRC Offerings. For more about the process of evaluating whether selling an individual home fractionally makes sense, visit Will This Home or Condo Sell as Fractional Ownership?
What Legal Restrictions Apply to Fractional Ownership?
Legal restrictions on fractional ownership can be grouped in four general categories: (i) national or state real estate law, (ii) local real estate law, (iii) private deed restrictions, and (iv) national or state securities or investment law. Even where a group of friends and family is purchasing the property to share, and therefore fractional interests will not be marketed to the general public, legal restrictions on fractional ownership may apply at some point in time, particularly when one of the co-owners needs or wants to re-sell his/her fractional share.
In the US, fractional ownership real estate law varies from state to state. Which law applies depends on where the shared property is located, how and where the interests will be marketed and, in some cases, where the buyers live. To determine which national or state real estate laws apply to a particular fractional ownership arrangement, it is necessary to determine how many interests will be offered, the general structure of the offering, how and where the interests will be marketed, and who will be permitted to buy. When regulatory approval is required, the cost and delay associated with obtaining the approval can be significant, and in some cases approval may be denied based on the location of the property or other restrictions.
Local regulation of fractional ownership is rare but increasing, particularly in resort communities. Private deed restrictions found in the governing documents of homeowners’ associations (such as CC&Rs, Bylaws, Coop Agreements etc.) may also restrict or prohibit fractional ownership arrangements. Most local fractional ownership laws and private deed restrictions are triggered by the usage rights to be offered with the fractional shares, rather than by the number of owners or by the ownership structure. In other words, these restrictions are not imposed because fractional shares of property are being sold, but rather because they are being sold with the promise that one owner will be allowed to use a home or apartment at a particular time. Of course without the promise of some sort of defined and recurrent usage right, the fractional interests are probably unmarketable.
National or state securities or investment law may also apply to fractional ownership arrangements. In general, these regulations will apply where rental income is pooled among the owners, management responsibilities are delegated completely, or the purpose of the co-ownership is primarily investment. Application of these laws may result in expensive registration and compliance requirements, advertising restrictions, securities deal licensing, and requirements relating to the wealth and sophistication of each purchaser.
How Are Fractional Ownership Usage Rights Divided?
Regardless of whether one is a fractional developer of a multi-unit fractional property, Realtor or seller for a single home to be offered factionally, or organizing a group of family or friends for a shared property purchase, deciding how the shared property will be used is usually the first step in structuring the fractional ownership arrangement. Usage structure will dictate most other elements of the fractional ownership arrangements, and become the most important and valuable benefit of ownership for the fractional owners.
In analyzing the various fractional ownership usage options, it is important balance predictability against flexibility, and also to remember that co-owners will exchange usage rights among themselves regardless of which system is adopted. The choice of fractional ownership usage allocation structure should be driven by the property location and size, its seasonality, the likely length of visits, and the manner in which people are likely to travel to the shared property. In addition, consider the complexity and cost of operating the fractional ownership usage system in light of the number of co-owners, and remember that a complicated or labor-demanding system will be subject to failures and manipulation and add to the co-owners’ dues.
What are Some Examples of Common Fractional Ownership Use Plans?
Broadly speaking, shared vacation home use plans fall into two categories: (i) fixed usage structures, where each fractional ownership interest is permanently assigned specific days, weeks or months; and (ii) variable usage structures, where each owner or family uses the shared home on a rotating or reservation basis.
Broadly speaking, variable use plans fall into four general categories:
- Fixed rotations, each owner rotates through a system ensuring he/she gets every usage period of the year over a period of years equal to the number of owners
- Annual “draft” reservations, where owners select their usage each year with a rotating system of selection order or priority
- Supplemented draft reservations, where an annual usage reservation “draft” is used to reserve less than all of each usage year, with the remaining time allocated using a rule-based first-come-first-served
- Rolling Reservations, where owners can reserve the property any time subject to certain limits and based on availability
For a detailed description and comparison of fractional ownership use plans, please see Fractional Ownership Usage Plan Options and Comparisons.
What Fractional Ownership Use Plans Make Sense if the Owners Also Want to Rent Out the Property?
Before answering this question, it is important to distinguish between rentals by (and for the exclusive benefit of) individual owners and rentals where the rental income will be shared by the entire owner group. In the former case, owners have the right to rent out their assigned or reserved time, typically through an in-group rental manager or outside management company, and each owner retains all of the net rental income generated from his/her time. This type of rental is compatible with fixed usage structures and with certain variable usage structures (including fixed rotations and annual reservation drafts).
Where the group will jointly undertake vacation rentals for their shared benefit, there are two alternative usage allocation approaches worth considering. The first is to block out certain periods each year for vacation rentals, and then apply an owner use plan only to the remaining portions of the year. This approach can be made compatible with any of the owner use plans described above. It has the advantage of ensuring that a certain amount of owner use time is available each year, and allows each owners to plan out his/her usage in advance. But because certain periods are not made available for rental, it will not maximize potential rental income.
If maximizing potential vacation rental income is preferred, it is better to adopt some sort of “pay-to-use” approach. This means that owners reserve and pay for time using the same system as renters. It can be combined with various owner preferences such as allowing owners to reserve time before the time is made available to renters and/or giving owners a discount on rent. Often, even when the owner occupancy is based on the “pay-to-use”, owners are permitted to make last-minute reservations without paying on the theory that the property would otherwise sit vacant and, consequently, no rental income is being lost.
How Are Fractional Ownership Expenses Divided?
In shared ownership arrangements involving a single home, operating expenses such as insurance, maintenance, repairs, improvements, utilities and management are usually divided in proportion to ownership, so that a 20% owner will pay 20% of each of these expenses. When using the Pay-To-Use Approach, owner usage fees and rental income would be offset against expenses, and the 20% owner (after paying the usage fees for any days or weeks he/she spent in the home) would get 20% of any surplus if income exceeds expenses, or pay 20% of any deficit if expenses exceed income. In jurisdictions where property tax is increased as the result of the resale of a fractional share, the buyer should pay the entirety of the increase. A resale by one co-owner should never increase a non-selling co-owner’s property tax burden. In states where resale does not trigger reassessment, property tax can be allocated like other operating expenses.
In fractional ownership arrangements involving multiple units, the developer must first determine whether usage of each co-owner will be restricted to a particular unit or units, or whether all co-owners will share use of all units. In the former case, the developer may opt to have each co-owner contribute only to the costs of operating the unit or units to which he/she has usage rights.
How Are Fractional Ownership Transactions Financed?
Although the majority of fractional ownership participants pay all cash for their fractional ownership interests, the availability of financing is a significant factor for many aspiring fractional owners. From 2008 until recently, purchase money financing of fractional ownership interests was available only to those buying into large timeshare or private residence club developments. Today, several of the web-based fractional ownership facilitation and management companies offer purchase money financing. Moreover, privately-organized vacation home sharing groups can sometimes find a traditional home mortgage lender willing to make a loan to the entire group as a collective.
When financing is an element of a fractional ownership arrangement, it is critical to analyze the additional owner-default risk created by the presence of the loan or loans. Specifically, to what extent can a loan default by one owner affect the other owners? The answer to this question will depend on whether or not the financing is secured by a lien on the property that would allow the lender to foreclose if it did not receive its full payment. If the lender has a lien on the property, there should be mechanisms in place to diminish the likelihood that an owner’s mortgage nonpayment will lead to a foreclosure on the entire shared property.
Here are some examples of mortgage foreclosure risk management mechanisms for fractional ownership arrangements where there is a loan secured by the entire property:
- Ensuring the each owner’s loan payment is made to the group (rather than directly to the lender), so that the group can monitor the loan payment process and know immediately when a late payment or nonpayment occurs
- Having a financially strong fractional ownership management company guarantee the loan payments
- Where there is no third-party guarantor of the loan payments, having a significant default reserve fund in place that the owner group can draw from to keep the loan current while it forces out the defaulting owner
How Are Fractional Vacation Homes Managed?
It is useful to divide fractional ownership management tasks into four categories: usage allocation, accounting, cleaning, and repair. Any of these jobs can be handled by either co-owners or outside professionals, can involve compensation or not, and can be combined as needed for efficiency or convenience.
Usage allocation management is necessary only in relatively complex usage systems, such as those that are based upon reservations or involve a pay-to-use element. Simple usage systems, such as fixed assignments or fixed rotations, do not require any management and are therefore less expensive and more reliable. Keep in mind that systems that are supposedly automated or web-based still require monitoring, upkeep and backup (when (not if) the system fails), so someone must be in charge of managing even the most automated usage system.
Accounting management involves collecting payments from co-owners, paying bills, and keeping records. To avoid shared ownership disputes and cash shortfalls which could result in credit blemishes and even loss of the shared property, it is absolutely essential to collect co-owner payments based on a budget and regular assessment system rather than “as needed”. This means that at the end of each year, an owner or manager estimates all of the expenses for the following year, including group mortgage (if any), property tax, insurance, maintenance, repairs, improvements, utilities and management, and determines the amount, if any, that will be needed from each co-owner to pay the bills. The anticipated expenses should include some reserves for long-term recurring expenses such as painting, roofing, system upkeep, and furniture and appliance replacement. Each owner should be required to contribute his/her payment on schedule. In this way, each co-owner knows with a fairly high degree of precision what will be expected of him/her in the coming year, and it is easy to track whether a co-owner is meeting his/her obligations before a significant problem develops.
Cleaning is a management task with a surprisingly high potential to cause displeasure and discord among fractional owners, particularly in small co-ownership groups sharing one home or apartment. Most co-owners enjoy using their vacation home much more when they arrive to find it clean and orderly, and cleanliness is essential for successful rental to non-owners. Unless an unusually consistent and high standard of cleanliness and order prevails among all of the co-owners in the group (and their families and friends), it is likely that resentment and even anger will develop over the condition of the home when certain users leave. It is also true that one is supposed to be on vacation when using the home, and may not want to have to spend the last day of vacation cleaning. For all of these reasons, I strongly advise even the smallest and least formal vacation home co-owner groups to employ a cleaner or cleaning service to clean the property on a regular basis. The cleaning person can also monitor the condition of the property, and inform the co-owners when a particular co-owner or guest has damaged, broken or stolen something. One of the best things about shared ownership is that the cost of this type of service can be spread over the entire group.
Repair management is important because without it, no one person is responsible for keeping the fractional property in good repair, and small inexpensive problems can develop into large expensive ones. The repair manager should be responsible for periodically inspecting the property, fielding comments and complaints from co-owners, and arranging for and supervising repairs. If the repair manager will be doing any major repairs him/herself, it is important to establish, before beginning work, whether the repair manager will be compensated and, if so, how much. “Time and materials” compensation should be avoided because it often leads to disputes, particularly where the repair manager is not a professional contractor and may not use his/her time and/or the materials efficiently. A much better approach is to establish a scope of work, time for completion, and payment amount in advance. This avoids most potential disputes and allows the group to compare the repair manager’s proposal to bids from outside contractors.
How Do Vacation Home Fractional Owners Make Decisions?
In fractional ownership projects organized by a developer or property seller, the developer/seller must determine how much power to give the owners, how various types of owner decisions will be made (managing board versus owner vote, majority vote versus super majority versus unanimous), and how the transition between developer control and owner control will be handled. Where the fractional project involves multiple units, the seller/developer must also decide whether certain decisions should be made by subgroups of owners (or governing board elected by subgroups) based on divisions of usage rights and/or maintenance obligations. In other words, should decisions about a particular unit or units be made by all owners, or only those owners whose usage and/or payment obligations will be affected?
Even in a fractional ownership arrangement involving a single home, a decision-making hierarchy and system is essential. In some fractional ownership groups, virtually all decisions are made by a third-party manager or management company, with only a few major decisions reserved for the owners. At the other extreme, every decision is make by the owners themselves. In between, there are arrangements that carefully allocate design-making power between a third-party or in-group manager, an elected management committee, and the entire owner group, spelling out which decisions are made by who.
Whenever some or all decisions will be made by owner vote, there should be a tiered voting system where certain decisions are made by a majority and certain decisions require unanimity (or alternatively, a larger majority). Decisions requiring a higher level of approval are typically those involving major physical changes to the property, large expenditures, changing usage rights allocations, selling the entire property, and borrowing money against the property, and could also include anything else the group thinks is particularly important.
When analyzing how decisions should be made, keep in mind that allowing a decision to be made by a majority allows the majority to take usage rights away from, or add cost burdens to, the minority. On the other hand, requiring a decision to be made by consensus can paralyze the group if there is a co-owner who is uninterested, unreasonable or angry. The personalities and relationships of the original co-owners may change over time, and new people may come into the group through resale or death, so don’t assume that the level of cooperation, ease of consensus-building, and rationality you experience now will continue into the future.
In groups of only two owners, voting is obviously problematic. If the co-owners do not agree, the outcome depends on how the co-ownership agreement treats the item under consideration. If the agreement states that the action under consideration requires the consent of both owners, no action will be taken since the owners did not consent. If the agreement is silent on the issue, the co-owners will need dispute resolution assistance, typically mediation and/or binding arbitration.
Regardless of how many owners and homes will be in the fractional ownership group, and whether the shared ownership arrangement has been created by a seller/developer, a fractional ownership facilitation and management company or web platform, or by the fractional owners themselves, it is useful to establish certain mandatory duties, things the group will be required to do unless all owners otherwise agree. These mandatory duties should include paying the recurring operating expenses and maintaining the building in good condition. Establishing mandatory duties prevents an individual owner (in a group of only two owners), or a majority of owners (in a group of three or more owners), from taking actions that endanger the group investment.
One particularly important but often overlooked area of decision making and potential dispute is the layout and furnishing of the shared vacation home. The property can become an overly cluttered repository for all of the co-owner’s unwanted furnishings, or an unpleasant maze of clashing tastes. I suggest that the co-owners initially agree on a furniture layout and, if items must be purchased, a budget and plan for how purchasing decisions will be made. Once the initial furnishing and decorating is completed, any additions or changes should require group approval.
Are Payments on a Fractional Ownership Vacation Home Tax Deductible?
Tax treatment of vacation homes depends on how often the property is used for “personal use” and how often it is used as a “rental”. There are three possible tax treatments, each with their own rules on tax deductions: “Pure Second Home”, “Pure Rental Property”, and “Second Home/Hobby Rental”.
“Pure Second Home” tax treatment is used if the property is a “rental” for no more than 14 days in a particular tax year. With this tax treatment, mortgage interest and property taxes are generally tax deductible, but other expenses are not. Rent income is entirely tax free.
“Pure Rental Property” tax treatment is used if both of the following two things are true: (i) the property is a “rental” for more than 14 days in a particular tax year,” and (ii) the total number of “personal use” days is either no more than 14 or no more than 10% of the total number of “rental” days. (For example, if there were 220 “rental” days, there could be up to 22 “personal use” days; if there were 100 “rental” days, there could be up to 14 “personal use” days.) With “Pure Rental Property” tax treatment, divide the year in two parts, “rental” and “personal use”, and allocate each expense proportionally. For the “rental” portion, expenses (including mortgage interest, property tax, insurance, maintenance, repairs, improvements, utilities, management, and even depreciation) are deductible to the extent they exceed rental income, but the deduction cannot be taken against all types of income, and in some cases must be carried forward and deducted in future years. For the “personal use” portion, only property tax is reliably deductible; other expenses, including mortgage interest, generally are not.
“Second Home/Hobby Rental” tax treatment is used when neither of the other categories apply. With this tax treatment, divide the year in two parts, “rental” and “personal use”, and allocate each expense proportionally. For the “rental” portion, expenses (again including mortgage interest, property tax, insurance, maintenance, repairs, improvements, utilities, management, and even depreciation) can offset income, but are not otherwise deductible. For the “personal use” portion, mortgage interest and property taxes are generally deductible, but other expenses are not.
When determining how often the property is used for “personal use” and how often it is used as a “rental”, these rules apply:
- Use by a co-owner, even when the co-owner pays a usage fee, is “personal use”.
- Use by a relative of an owner, even if the relative pays full rent, is “personal use”.
- Use by a non-owner under a vacation home exchange or swap arrangement is “personal use”.
- Days spent primarily repairing or maintaining the vacation home are not “personal use”, but need not be counted as “rental” days either.
- A day when the home is available for rent but is not actually rented cannot be counted as a “rental” day.
When vacation property is fractionalized, IRS Regulations seem to contemplate that usage of all the co-owners (and their relatives, non-paying friends, and swappers) should be added together to determine the total number of “personal use” days, and the days when the property was rented to paying tenants who are not owners or relatives (regardless of whether the rent went to an individual owner or was shared by the group) should be added together to determine the total number of “rental” days. The tax treatment should then be determined. If the home qualifies as a Pure Second Home, each owner can then generally deduct all of the mortgage interest and property tax he/she paid. If the home does not qualify as a Pure Second Home, the group will need to determine the collective “rental”/”personal use” expense allocation ratio. Each owner will then need to apply that ratio to the expenses he/she has paid, offset any income he/she received, and apply the appropriate tax deduction rules as outlined above. Nevertheless, at least one article that explores this topic in detail has concluded that this approach may not be either workable or fair in practice, and that it would be reasonable for each owner to determine his/her tax treatment separately based on his/her usage and rental of his/her interval.
This discussion of tax issues is intended as an introduction to the general rules only. Consult a qualified attorney or accountant for complete and personalized tax information. For more information on tax treatment of fractional ownership, visit Income Tax Aspects of Fractional Ownership.
How Will I Be Taxed When The Fractional Vacation Home is Sold or I Sell My Share?
Unless the seller has occupied the property as a primary residence for two of the five years immediately preceding the sale, he/she will not qualify for the $250,000 singele/$500,000 married exclusion from capital gains tax. But the seller is likely to qualify to have any profit taxed at the lower long-term capital gains rates, and may qualify to complete a tax-deferred exchange. In general, the tax treatment of profit or loss on resale will depend upon how the property was used in the 12 months preceding the sale. When contemplating a sale of a vacation property (or just your share of one), it is wise to consult a tax expert at least a year before the planned sale.
Why Would an Owner or Realtor Selling an Entire Property Develop the Fractional Ownership Structure and Agreement Before Marketing? Why Not Let The Buyers Develop Their Own Fractional Agreement?
Although it is theoretically possible to gather an entire buyer group, have them prepare a single offer as a group, then allow them the time and flexibility to create their own structure and agreement prior to close (while the property is held off the market), this approach fails much more often than it succeeds and consumes a huge amount of effort and time even when successful. Most sellers and Realtors find it much easier and more productive to accept individual offers from prospective buyers of each fractional share even when they intend to simultaneously close the sales to all the buyers at once. (Note that closing the sales one at a time is also possible.) Accepting individual offers on the fractional shares is virtually impossible without having a structure and documentation in place. The structure created by the agreement is necessary to avoid the uncertainty and risk that would otherwise be associated with a series of purchase contracts for percentages of the property.
What Type of Shared Ownership Agreement or Fractional Governing Document is Needed for a Fractional Ownership Arrangement?
Every fractional ownership group needs a document or group of documents detailing their rights (especially usage/rental, alteration, financing and resale) and obligations (especially cost allocation, dues structure, repair/replacement, and rules). The document or documents must be prepared in view of the fact that it/they will only be used if the owners disagree, and will only be useful if it can resolve the disagreement (more on this later).
Where the fractional owners will hold title to the property (a “direct ownership” arrangement), governing documents fall into two general categories: (i) those that are recorded in the chain of title and thereby become binding on each fractional interest owner without that owner’s signature, and (ii) those that are unrecorded and bind only those fractional owners that sign them. The principle advantages of recorded documents, often called “Declarations” or “CC&Rs” (which stands for “Covenants, Conditions and Restrictions”), are that they reduce the risks of shared ownership (particularly the risk that there will be a co-owner that is not bound by the documents because he/she has not signed them), and facilitate collection in the event of non-payment of co-owner obligations. The principle disadvantages of recorded documents are that they may violate a local or private regulation, are more difficult to modify, and are generally not compatible with group financing. A common misconception is that co-owners obtain “separate deeds” only if there are recorded fractional ownership documents. In fact, all fractional ownership arrangements involving direct ownership can have separate deeds, regardless of the type of documents used and whether the documents are recorded or unrecorded.
Many fractional ownership arrangements involve the creation of a legal entity such as an LLC, trust or corporation, and the entity may be for-profit or nonprofit. Typically, the entity actually owns the property and the co-owners own the entity (discussed more fully below). When an entity is formed, a formation document, often called the “Articles” or the “Certificate”, will exist, and annual filing and tax reporting requirements may exist.
Most vacation fractional arrangements involve a combination of recorded and unrecorded documents, and it is difficult to make generalizations about what the documents are typically called or say what documents (as opposed to what content items) are needed. Some common names (aside from “Declaration” and “CC&Rs” mentioned above) are “Operating Agreement”, “User Agreement”, “Bylaws”, “Shared Ownership Agreement”, “Co-Ownership Agreement”, “Owner Agreement”, “Management Agreement”, and “Usage Rules”, but there is no pattern as to what is in a document with a particular name, or how the various necessary provisions are distributed among the documents when a project has multiple documents. The key is to make sure all the important content items are present, and to assess the extent to which a particular content item will be enforceable against current and future owners.
Do Friends Or Family Sharing a Vacation Home Really Need a Formal Agreement?
People and circumstances change in unforeseeable ways, and new people can come into a co-ownership group at any time as a result of death or other unexpected events. When these changes occur, even the best of friends, the closest of families, and the most agreeable and easygoing people in the world, can disagree. The purpose of an agreement is to help resolve these conflicts quickly, inexpensively, and without ruining the personal relationships of the group members.
Should Vacation Fractional Ownership Agreements Be Kept Short and Simple?
No one reads co-ownership documents for pleasure. The only time one is likely to read the documents is if there is a conflict that can’t be resolved informally. In that situation, one wants the shared ownership agreement to provide a specific and clear resolution. The shorter a fractional ownership agreement is, the less likely it is to address the specific problem that caused one to look at the agreement. The advantage of length is that it allows the co-ownership agreement to cover more issues, and makes it more likely to be helpful. There is no disadvantage to length, as long as the document has a complete table of contents. Simplicity is desirable, as long as it doesn’t come at the expense of breadth.
What Happens if a Fractional Interest Owner Doesn’t Fulfill His/Her Obligations?
Whether you are buying a single vacation home with a small group of family or friends, or a fractional interest in a luxurious, branded resort, the risk that other fractional owners will not pay their share of expenses is real and should not be ignored. The economics of sharing ownership of a vacation home is a zero sum game: the property’s operating costs must be paid even if one of the owners is not paying his/her share, meaning, in practice, that nonpayment by one owner means extra costs for the others.
It is critical to remember that unexpected and unforeseen events can cause a single-owner default or a default cascade even in what initially appears to be a very low-default-risk fractional ownership situation. For example, in a shared vacation home owed by a close-knit group of friends and/or family members, a co-owner with the best character and intentions can suddenly find him/herself struggling financially due to a job loss or illness. At the other extreme, a lack of sales, developer/manager bankruptcy, or a point where rising owner dues and/or poor maintenance make the property less desirable and/or too expensive, may cause multiple owners to decide to stop paying triggering a “default cascade” and, eventually, a financial collapse of the entire resort.
In a single-home fractional ownership group, there are two key ways to manage the risk of owner default: (i) accumulating and maintaining reasonable reserves, and (ii) having a forced sale or foreclosure mechanism to fall back on. Remember that having a path to force out a nonpaying owner does not mean the group must use it. The owners can always decide to wait, make loans, or come up with some other mutually acceptable plan. The forced sale or foreclosure process should be viewed as a kind of insurance policy that can be used if the co-owners cannot agree on an alternative. For the insurance to be useful, the forced sale or foreclosure process must be clearly expressed (so there is no basis for argument), and relatively fast and inexpensive to implement. Mechanisms that do not require the intervention or participation of a court or arbitrator are much preferred.
Recently, fractional ownership facilitation and management companies such as Pacaso have introduced the concept of an “assessment guarantee”. This arrangement means that the management company will step in and pay the ownership dues or expense share of a defaulting owner and take over the costs and burden of the forced sale or foreclosure process. So long as the management company remains financially strong, the assessment guarantee effectively eliminates default risk for the paying members of the group.
In larger fractional ownership arrangements involving multiple units or resorts, the owner default risk is mostly a function of the size and reputation of the developer, the affiliation of a brand, and the long-term commitment of the brand to the project. Buyers typically assume that the brand (such as Ritz Carlton, Four Seasons, Fairmont, etc.) is the developer, but this is typically not the case; rather, the developer is usually a separate entity that has a marketing and/or management contract with the brand. It is therefore important for the buyer to determine who the developer is and to investigate the developers past projects and solvency level. It is also useful to scrutinize the management contract between the fractional owners association and the brand to assess the likelihood that the brand’s commitment to the project will be long-term. For how long does the management contract bind the brand to the project, and how easy is it for the brand to abandon the resort? How much can the brand raise its management or affiliation fees, and can rising fees force the owners association to terminate the brand affiliation?
How do Fractional Ownership Default Forced Sale and Foreclosure Systems Work?
A typical fractional ownership document set will distinguish between financial and non-financial violations. Since the group must pay its bills, it cannot afford to leave an owner non-payment outstanding while a long arbitration or judicial process unfolds. So the fractional ownership documents should require each owner to pay any disputed expense under protest as a precondition to contesting the matter; if the owner fails or refuses to pay under protest after being given a demand and a reasonable opportunity to pay, he/she should be immediately subject to forced sale or foreclosure without regard to whether the disputed expense was properly imposed.
When the alleged violation of the fractional ownership documents was behavioral, the accused owner is typically given notice of the accusation and a limited time to either contest it or cure it. If the accused owner chooses to contest the allegation, the matter is submitted to dispute resolution, which is typically mediation, or if that is unsuccessful, binding arbitration. If the accused co-owner does not cure the violation or initiate dispute resolution within the specified time, he/she is either subject to some sort of fine or penalty or, in the case of a more serious violation or a long patter of violations, to forced sale or foreclosure. Note that a procedure that causes a fractional property owner to simply forfeit his/her ownership, investment or equity, is generally unenforceable and therefore useless to the group.
Should the Shared or Fractional Ownership Use a Limited Liability Company (LLC) or Other Legal Entity?
Owning a vacation home as a limited liability company (“LLC”) or other entity (rather than in the names of the co-owners) can offer several advantages, including:
- Making it substantially quicker, easier and less expensive to sell, gift, or inherit ownership interests
- Making it substantially quicker, easier and less expensive to enforce the owner agreement
- Protecting the owners (and their other assets) from liabilities arising from fractional ownership
- Protecting the shared property from seizure by creditors
- Adding the structure created by the large body of law that is applicable to LLCs and other entities (but doesn’t otherwise apply to co-ownership)
For properties located outside the United States, owning the shared vacation property through an entity offers additional advantages which are discussed below.
But owning a vacation home through a LLC or other entity also has drawbacks. Creating and maintaining the entity structure involves extra costs, including formation fees, special taxes, and the annual cost of preparing tax returns for the entity (which is required even if the entity doesn’t owe any tax). In addition, using an entity may deprive the fractional interest owners of some of the income tax benefits of vacation home ownership, such as the ability to deduct mortgage interest and property tax as a second home. Ultimately, the question of whether to hold a fractional property through an entity must be answered on a case by case basis in light of the particular circumstances of the group and the property.
Should Fractional Owners Be Allowed to Freely Sell Their Fractional Interests?
Those who share a vacation home with friends or family are often concerned that allowing co-owners to re-sell their shares will cause incompatible or unqualified co-owners to enter the group. But prohibiting individual re-sales, or requiring unanimous consent for them (which is really the same thing), may mean that there is no way for a fractional interest owner to exit the group without selling his/her interest to another fractional owner. The problem with this situation is that no other co-owner may be interested in purchasing an additional fractional share. Moreover, even if another co-owner or group of co-owners is willing to purchase, there is little incentive for them to pay fair market price since the seller has no choice but to take whatever is offered. (Requiring that the price be based on an appraisal will not be helpful if the effect is to dissuade the other co-owners from purchasing.)
An important thing to keep in mind when considering the issue of fractional share resale is that personalities change, and lives change, in ways that no one expects or can predict, and it is inevitable that people will need or want to leave the group over time. Examine the issue both from the perspective of someone who might be forced to accept a new co-owner, and from the perspective of someone who might need to sell because of financial difficulties or illness. Also remember that it generally hurts the group dynamic, and makes decision making and management much more difficult, to force someone to stay in the group when he/she needs or wants to leave.
I strongly recommend that individual fractional ownership re-sales be allowed, subject to restrictions intended to protect the group from incompatible or unqualified buyers. These protections may include rights of first refusal (the right of one or more of the existing co-owners to purchase the seller’s interest at market price) and rights of rejection (the right of the other co-owners to reject a proposed buyer if they can articulate a reasonable basis for rejection).
Where a third party such as a resort developer or fractional ownership facilitation/management company is involved, it is typical for additional resale restrictions to exist. Some examples of these are:
- A restriction on selling too soon after buying (designed to dissuade speculative purchasers and also to ensure that owners are not competing with the third party sales efforts)
- A requirement that resales be marketed exclusively by or through the developer or fractional ownership facilitation/management company or website
- A right of purchase by the developer or fractional ownership facilitation/management company (to allow the third party to prevent pricing from dropping)
Should Fractional Vacation Home Co-Owners Be Able to Force a Sale of the Entire Property?
As I mention above, it is critical to recognize that the lives of each of the co-owners will change in ways they do not expect, and there must be a way for fractional owners to leave the group. Allowing co-owners to sell individual shares is one way to make leaving possible, but selling shared property interests may be difficult or impossible due to market conditions, bad group dynamics, the condition of the shared property, or other unpredictable factors. So even if individual fractional interest sales are permitted, it makes sense to create a realistic, guaranteed exit strategy. Typically, this means picking a time in the future when it will become possible for any of the co-owners to insist that the others either buy them out based on fair market value, or sell the entire shared property.
What Kinds of Risks Does Vacation Fractional Co-Ownership Create?
Fractional ownership involves the risks of sharing use of property with others and relying on them to fulfill their obligations to you. Sharing use means that you will not be able to do what you want when you want, and that others may do things that displease you. Sharing obligations means that necessary maintenance and management might not be completed, or worse, that as the result of a co-owner failing to make a payment, a mortgage lender could foreclose on the entire building causing all of the other co-owners to lose use of the shared home and possibly all of the money they have invested. There is no way to eliminate these risks, but there are ways to lower them.
Perhaps the single most important thing you can do to lower the risk of shared ownership is to have a thorough, written, signed fractional ownership agreement that deals with all of the issues, including events you don’t expect to happen, the possibility that people you don’t know will be in the group as the result of a death or re-sale, and the reality that people change and you might not get along with the other co-owners as well as you do now.
Besides having a shared ownership agreement, these steps will help diminish the risk of fractional ownership:
- Carefully investigate the background and financial qualification of potential co-owners.
- Use a monthly assessment system for collecting payments from the group, and pay all bills from a group account.
- Assign each of the essential management tasks to a specific person either within or outside the group.
- Have each co-owner contribute to a default reserve fund that will be used to pay mortgage interest (if there is a group mortgage), property tax or insurance if a co-owner fails to contribute his/her share, and make sure you don’t accidentally spend the money on maintenance or repairs.
- Give the group the power to quickly force out a co-owner who is not fulfilling his/her obligations, and use that power before the group is in serious financial trouble.
What Additional Risks Arise if the Fractional Vacation Home is Located in a Foreign Country?
Where the fractional vacation property is located abroad, prospective co-owners are less likely to be familiar with either the real estate market or the local real estate transaction system. This lack of familiarity creates risk of overpayment for the property or its improvement and furnishing, or of wasting money and time in connection with the transaction formalities. In addition, the laws of many foreign countries do not offer the same level of consumer protection as U.S. laws. Ongoing management, enforcement of the co-ownership agreement, and resale transactions can also be problematic. All of these difficulties can be compounded by a language barrier. To manage these risks, it is essential to involve both a U.S. attorney, and an attorney licensed in the country where the property is located, in the formulation of the fractional ownership agreement and fractional ownership structure.
Owning the fractional property through an entity created in a jurisdiction with a well-developed and familiar legal system, and an effective alternative dispute resolution infrastructure (so that you do not need to rely on a slow and expensive court process) can help solve many of the difficulties associated with shared vacation property located abroad. This arrangement allows sales and rental transactions to occur in a familiar language and under familiar rules, avoiding the formalities and costs involved in transferring real estate in the country where the property is located as well as the expense and inconvenience of foreign lawyers, real estate agents and notaries. In addition, use of the foreign entity fractional ownership structure enables the relationship of the co-owners to be governed by well-developed and familiar laws, and any disputes the co-owners to be resolved more quickly, reliably, and cost-effectively. In some cases, certain types of transfer and inheritance taxes can also be avoided.
About SirkinLaw APC
SirkinLaw APC has focused on real estate co-ownership since 1985, and has been involved in the creation of more than 5,000 co-ownership arrangements throughout the United States and the world. This breadth of experience allows us to draw on a huge library of fractional project documentation as well as extensive knowledge of marketing and registration requirements for virtually any location where a project might be located or potentially marketed. We pride ourselves on our ability to write legal documents in plain English, develop simple and elegant usage and organizational structures, and offer efficient, reliable and cost-effective services for fractional projects ranging in size from a single house or condominium up to hundreds of factional interests. Our firm has offices in San Francisco California and Paris France.
About The Author
Andy Sirkin has been a recognized expert in fractional ownership for more than 35 years. Since 1985, he has focussed on advising and preparing contracts for small groups of families and friends who want to buy and share vacation homes as partners, and on advising and preparing contracts for sellers and real estate agents who want to market and sell fractional interests in a particular vacation home. While work with individual owner groups, buyers, sellers, and real estate agents remains a major part of Andy’s fractional ownership practice, his work now encompasses advising and preparing contracts for web-based platforms (such as Pacaso) that organize, facilitate and manage fractional ownership arrangements for specific homes, and advising and preparing contracts for fractional ownership developers (who buy properties to renovated and furnish for sale as fractional ownership interests), fractional ownership marketing and sales firms, and fractional ownership management companies.
Andy has worked on fractional ownership of properties located throughout the U.S. and the world, and has also advised fractional ownership startups, platforms, developers and related businesses based in, or focussing on, locations throughout the U.S. and many other countries. However, most of his work has involved fractional ownership in the U.S., the U.K., Western Europe, Mexico, and the Caribbean. He has been a featured speaker at many fractional ownership and timeshare conversions and symposia, an accredited instructor with the California Department of Real Estate, and a frequent interviewee on fractional ownership for podcasts and news coverage throughout the world. Andy is based in Paris, and can be contacted via the contact form.