First The Good News: Prop. 13 and 58
For Californians avoiding reassessment of real property is often a critical estate planning issue. One of the most important tax breaks my clients have in California is the ability to transfer a low property tax rate to their children.
Property tax, just to remind you is that twice-yearly tax bill you get regardless of whether or not you have paid off your mortgage.
California real estate is generally taxed at 1% of the property’s “assessed value.” Proposition 13, which California voters passed in the 1970’s to hold the line on property taxes, limits increases to the assessed value to no more than 2% each year. However, the County Assessor is allowed to reassess property whenever there is a “change in ownership.” The assessed value is the fair market value as of the date of a change in ownership. If the value of the property has increased more than the rate the tax has increased, a reassessment will result in significantly higher property taxes.
When you sell your property to a stranger you usually don't mind that the transfer of ownership will result in a reassessment at today's market value. However, unless the housing market has recently crashed, most people would like to preserve their low tax assessment for their children. Proposition 58 provides that a transfer of a home between parent and child would not be considered a “change in ownership,” if a Claim for Reassessment Exclusion is timely filed with the county assessor. (The “Claim for Reassessment Exclusion” form must be filed within three years of the transfer or before the property is transferred to a third party. Failing to file the appropriate form can result in a reassessment.) Prop 58 has enabled many children to be able to afford to keep the family home in situations where the market value has increased significantly over their parents lifetimes.
However, without proper estate planning, children may not be able to make full use of the parent-child exclusion. The estate plan should be structured to avoid reassessment traps.
Background: A little primer on the definition of children.
While the concept of “parent and child” seems simple enough, there are some unique scenarios to consider. In addition to all “natural children,” of two married people, children that fit under the Prop 58 exclusion include:
- Step-children, even if the owner's spouse has predeceased the owner, unless the owner has remarried.
- Children adopted before they reach age 18,
- The spouse of a child (son or daughter in-law) is eligible unless the relationship ends in divorce. If, however, the relationship ends because your child dies, the parent-child relationship is deemed to continue with the child in-law until he or she re-marries.
- Sometimes less usual situations like foster children and grandchildren can qualify (these situations need specific fact patters that are beyond the scope of this post).
Many owners transfer their property to an entity such as a limited liability company (LLC) to protect their other assets from lawsuits, like trip and falls that happen on that particular property. There is a different exclusion that allows most people to transfer their wholly owned rental unit to their wholly owned entity, like their LLC without triggering a reassessment. A full discussion of the merits of this plan is beyond the scope of this blog post, but one downside of doing so is that the property may be reassessed when the interest in the entity is given to the children by gift or inheritance. This is because the parent-child exclusion only applies to transfers of real property, not of interests in an entity. Therefore, before transferring real property into an LLC or other business entity property owners should carefully weigh the possible loss of the reassessment exclusion against the benefits of the entity structure.
Transfers to Revocable Living Trust are usually fine.
You can transfer your property to a revocable living trust without triggering a reassessment under most ordinary circumstances. However, your revocable living trust should contain planning to qualify your property for the parent-child or another exclusion to avoid a “change in ownership,” and thus reassessment, upon your death.
Now the bad news: Limitations on the Parent-Child exclusion
Generally speaking, a transfer of property from a parent to a child is not subject to reassessment, so the child will pay the same lower rate the parent paid. However, there are significant limitations to this general rule:
- Each parent may transfer their principal residence and
- up to the first $1,000,000 of the full cash value of another property to their child without triggering a reassessment.
A transfer of up to $1,000,000 of the full cash value of another property is where it gets a little more complicated. The good news is that the “full cash value” refers to the assessed value, not the fair market value of the property – so if the property increased in value over the years you can really transfer property worth far more than one million dollars without triggering a reassessment.
For example, if you purchased the property twenty years ago for $200,000 and it is now worth well over $1,000,000, the assessed value ($200,000 plus yearly increases of no more than 2%) is the "asset value", even though the child will receive a property worth well over $1,000,000.
For married couples with several rental properties, there is a way to double that $ million cap with some relatively simple estate planning. At the death of the first spouse, instead of leaving all assets to the surviving spouse outright, the estate plan could instead leave up to a million dollars of assessed value of the rental property to the children. Alternatively, the first spouse’s $1 million exclusion could also be preserved by holding the inheritance of the rental property in a bypass trust for the benefit of the surviving spouse, with the children as mandatory remainder beneficiaries of the real property. The advantage of the bypass trust would be to allow the surviving spouse to use the rental income for support during his or her remaining life, while still using the first spouse’s parent-child exclusion to ultimately pass the real property to the children. A disadvantage of the bypass trust is that bypass trust assets will incur more capital gains tax in the long run. The relative tax impacts have to be evaluated on a case by case basis.
When property is left to more than one child, one child may want the property while the other wants money or assets of equal value. If the estate plan leaves the real estate to only one child or even gives one child a right of first refusal, then the transfer to that child qualifies for the exclusion.
However, if the estate plan merely provides the property to both children equally (each getting a one half interest), one will then have to transfer their interest to the other in exchange for an equalizing payment. This would no longer be a parent-child transfer, but would be a sibling-to-sibling transfer, which is not excluded from reassessment. Thus a change in ownership will have occurred and the property tax will be reassessed.
If the property is in a trust the law assumes that the trustee has the power to distribute trust assets non-pro rata, unless the trust instrument prohibits non-pro rata distributions. With a will, the property will pass to the estate beneficiaries in equal shares, unless the will specifically grants the executor the power to make non-pro rata distributions.
Before the parent dies there are methods to avoid the sibling problem that can go into the estate planning.
The full parent-child exclusion would apply where the trust instrument, itself, (1) gives one child the first option to purchase real property (“right of first refusal”): BOE Letter 625.0233 (August 19, 2013); or (2) the trust instrument gives one child the right to include the trust realty as part of his share, on condition that he provide sufficient assets to the other child to equalize the distribution. BOE Letter 625.0235.025 (February 22, 2010)
If parents have not taken these sort of precautions in the estate plan to avoid reassessment traps, then the children will have to attempt to avoid reassessment when administering the estate plan after both parents have passed away. Here are the three most common options:
- Equalizing Assets. If the estate plan allows non-pro rata distributions, and one child wants the residence, and there are sufficient other assets of equal value to distribute to the other children, then the distribution of the property to one child will qualify for the exclusion.
- Equity Loan. If there are no equalizing assets, or insufficient equalizing assets, then the fiduciary can attempt to create liquidity by obtaining an outside loan against the equity of the residence. The residence then could be distributed to one of the children subject to the loan, and the cash proceeds of the loan could be distributed to the child who opted out. It can be difficult or expensive, however, to obtain such a loan, which limits the feasibility of this approach.
- Disclaimer. If the child not only does not want the residence but also is willing to forgo all or a portion of her inheritance, and she timely executes a written disclaimer, then the residence can qualify for the parent-child exclusion upon transfer to the other children
Because these post-death options only work in the best of circumstances, it is generally advisable for parents to come up with an estate plan that avoids triggering deemed transfers from sibling to sibling.
To illustrate how this applies in various fact patterns, consider the following scenarios. In each case assume that the home has a value of $500,000, that the trust does not prohibit a non-pro rata division of assets, that it permits the trustee to borrow money, and that a timely Claim for Reassessment Exclusion is filed.
1) The only asset in the trust is the home. Child 1 raise her own $250,000 to buy out the interest of Child 2. Change in ownership as to his 50% thus purchased. Reassessment and increase in the property tax bill.
2) The only asset in the trust is the home. At the conclusion of trust administration, it is allocated by deed 50-50 to Child 1 and Child 2. They share the home. No change in ownership; No reassessment.
3) The trust is comprised of the home and $500,000 in cash. The home goes to Child 1 and all the cash to Child 2. Same result as in #2: No change in ownership. No reassessment.
4) The only asset in the trust is the home. Trustee borrows $250,000 from a third-party lender, and distributes the home encumbered by the loan to Child 1 and the $250,000 in cash to Child 2. Same result as in #2: No change in ownership. No reassessment.
5) The trust is comprised of the home and $100,000 in cash, for a total trust estate of $600,000. Trustee borrows $200,000 from a third-party lender, and distributes the home encumbered by the loan to Child 1 and $300,000 in cash to Child 2. Same result as in #2: No change in ownership. No reassessment.
Note: These transactions must be handled very carefully, a suitable lender engaged and adequate documentation furnished to the County Assessor. Also if it is a probate administration you may need court approval. Also note that if a beneficiary receives a present beneficial use of the property or income from the property, then it is deemed that there has been a “change in ownership” and the property taxes will be reassessed. To avoid this, the beneficiary generally should not live on the property or collect rental income without a proper tax plan.
In conclusion, while the parent-child reassessment exclusion is a powerful tool for reducing taxes on estate beneficiaries, beware of reassessment traps. Estate planning is crucial to make full use of the exclusion. The right estate plan can make it more financially feasible for children to retain ownership of real property after the parents have passed away. For help with reassessment issues in your estate plan, contact your estate planning attorney.
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