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WHAT HAPPENS IF A FRACTIONAL INTEREST OWNER DOESN'T FULFILL HIS/HER OBLIGATIONS?

While co-owner default is a major potential risk of shared ownership, it is important to keep the problem in perspective. In my experience, the type of default that co-owners are most worried about, failure to make a required payment, is extremely rare. Far more common, but still rare, are defaults related to usage of the shared property, such as damaging the property, failing to keep it clean, using it at unauthorized times or in improper ways, and altering or cluttering it without group approval.

While it is necessary (from both a legal and an ethical point of view) to protect the rights and equity of each fractional owner even if he/she has defaulted, it is also important that a fractional ownership agreement give the group the power to deal with a default quickly and effectively. The group can always decide not to use all of its power if the circumstances warrant leniency, but the group should not be forced to be lenient if one member is ignoring the rules or putting the property or the investment at risk.

A typical shared property agreement will provide that an owner who has been accused of a violation be given notice of the accusation and a limited time to either contest it or cure it. If the accused fractional share 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, his/her interest in the fractional property is sold at market price using a carefully described procedure. Sale proceeds are applied to pay any arrearages, transaction costs, legal fees and penalties, and any remaining amounts go to the defaulting co-owner. 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.

It is advisable for fractional ownership groups to establish a default reserve fund that will be used to pay mortgage interest, property tax or insurance if a co-owner fails to contribute his/her share. But it is important to understand that this fund is not intended to be a pool from which a defaulting fractional interest owner can borrow at will. If a co-owner fails to make a payment, and the group chooses to use a portion of the fund to make up the shortfall, the defaulting co-owner has still defaulted and the group should still have the power to take the same remedial action that it would be entitled to take if the default reserve fund had not been used. In other words, the defaulting fractional owner should not be able to escape responsibility by claiming that since it was his/her own money in the default reserve fund that was used, he/she has not really defaulted.

SHOULD THE SHARED OR FRACTIONAL OWNERSHIP USE A LIMITED LIABILITY COMPANY (LLC), OR LIMITED PARTNERSHIP (LP) OR LIMITED LIABILITY PARTNERSHIP (LLP)?

Owning a vacation home as a limited liability company ("LLC"), limited partnership ("LP"), limited liability partnership ("LLP" which is not possible in the US), corporation, or other entity (rather than in the names of the co-owners) can offer several advantages, including (i) protecting other assts from liabilities arising from fractional ownership, (ii) protecting the shared property from seizure by creditors of co-owners), (iii) increasing flexibility for ownership changes, and (iv) adding the structure created by the large body of law that is applicable to these 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. The vast majority of groups consisting of U.S. residents co-owning U.S. vacation property opt for direct ownership rather than ownership as an LLC or other entity.

SHOULD FRACTIONAL OWNERS BE ALLOWED TO SELL FREELY THEIR SHARES OF THE SHARED VACATION HOME?

Those who own a shared property 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).

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