As discussed in previous columns, Proposition 19 has arrived like a Trojan horse.
When the citizens of California let the Prop. 19 horse in, they believed they were voting to allow homeowners 55 and older, disabled, or victims of disasters, to transfer their property tax base value from one home to the next throughout California.
Many have been shocked to learn that in the belly of that wooden horse was a law preventing parents, in all but the narrowest of circumstances, from passing their real estate to their children free from property tax reassessment.
What can you do before Feb. 16, 2021, to keep the horse out of your living room?
Any decision you make requires an analysis of property, income and estate taxes. Unfortunately, there are no easy answers.
Option 1: Transfer property now
A) If a transfer by deed is completed before Feb. 16, this is a change in ownership that will qualify for the parent-child exemption from property tax reassessment under the current law. (Note that the assessor’s offices are closed Feb. 12-16, so the real deadline is Feb. 11.)
B) This is a gift.
C) You’ll need to file a gift tax return and claim a part of your estate/gift tax exemption. This requires an appraisal of the property’s value as of the date of the gift. The appraisal must be done by the time the gift tax return is filed (April 15, 2022).
D) You will not be able to take the property tax basis of your transferred home with you to your next home.
Related Prop. 19 links
How property transfers to children changes Feb. 16
State offers guidance on new property tax transfer law
California’s Prop. 19: Key things the new property tax law gives and takes away
E) If it’s your home you’ve transferred, you’ll need to pay rent to your children if you remain in the house (though there may be workarounds). They can evict you.
F) If it’s a rental property, the rental income now goes to your children.
G) Your children own the property and therefore it’s subject to claims of their creditors; they also must carry insurance and pay the property taxes.
H) Your children will not get the step-up in income tax basis at your death. This can be significant.
That last part is important. Here’s what a difference it makes:
Assume Polly bought her home decades ago for $100,000. It’s now worth $1 million. If Polly transfers her home now to her three children, their income tax basis in the property is $100,000.
Maggie bought the home next door for the same price and it has the same value. But Maggie doesn’t transfer her home until her death. Her children have an income tax basis of $1 million.
If Polly’s kids sell Polly’s home immediately, they have a taxable gain of $900,000 (the sales price of $1 million less their gifted income tax basis of $100,000). They will face a federal income tax bill of about $333,000.
If Maggie’s kids sell her home, they have no taxable gain ($1 million sales price less $1 million stepped-up income tax basis). They’ll have $333,000 more than Polly’s kids.
Polly’s kids aren’t going to care about the property taxes since they’re selling the house anyway, but they’re sure going to be upset about the income taxes. If the kids don’t sell the home, they may be happier to have the property tax base value carry over.
Option 2: Sell the property to your children
A) A sale of property to your child in exchange for a promissory note is a change of ownership for property tax purposes and the current parent-child exemption applies to avoid property tax reassessment.
B) You can forgive the note over time ($15,000 per parent, per child annually) with no gift tax consequences. At your death, any remaining balance can be forgiven with no estate tax consequences if your estate is under the estate tax exemption (currently $11.7 million per person).
C) You have sold the property, so you will recognize any taxable gain for income tax purposes.
D) Appreciation of the property will occur outside your estate, which is good if you have a potentially taxable estate.
E) Your child’s income tax basis will be the sales price.
F) You have the same issues as D-G in option 1.
Option 3: Transfer the property to an irrevocable trust
A) A transfer to an irrevocable trust for the sole benefit of your children is a change in ownership that would allow the use of the current parent-child exclusion from reassessment.
B) Your revocable living trust does not qualify, as the transfer of the property does not occur until your death (presumably after Feb. 16).
C) The irrevocable trust can be drafted to allow for the application of the parent-child exclusion from property tax reassessment, while not meeting the estate and gift tax requirements for a completed gift. This means for those purposes you still “own” the property at your death and therefore it will be subject to estate tax and will then get the step-up in income tax basis. This is a win from property and income tax perspectives but could be an issue if you have a taxable estate.
D) As an alternative, if you have a taxable estate, the trust can be drafted to complete the gift and get the property out of your estate, but your heirs won’t get the step-up in income tax basis. (If they are going to keep the property anyway, this is less of a concern.)
E) The same rent issue applies to your principal residence, but your children’s creditors won’t be an issue.
F) You will not be able to transfer the property tax base year value to your new home, but the trust could sell the current home and you would have the federal income tax exclusion of $250,000 per person on the sale of a principal residence.
Option 4: The use of entities
For transfers of real property other than a principal residence, the use of entities such as a limited partnership should be considered. As one example, a parent could transfer 51% of a property with less than $1 million in assessed property tax value to the children using the parent-child exclusion. The children and the parent then create an entity with the parent owning 49% and the child owning 51% without any property tax reassessment. At the parent’s death the transfer of the 49% interest will get the step-up income tax basis but will not cause a property tax reassessment.
There are variations and combinations of Options 2 through 4 that are more technical that can be covered here. In addition, it’s important to know that laws change. The estate tax exemption is currently $11.7 million per person, but that will drop to $5 million (adjusted for inflation) in 2026, and under President Biden’s proposal would drop to $3.5 million. Additionally, the step-up in basis would be eliminated under Biden’s plan. Also, there may well be efforts in the future to send the Prop 19 Trojan Horse back to pasture.
California real property owners concerned about the effects of Prop 19. should seek legal advice. This article has been provided for information purposes only and should not be construed as legal advice or opinion on any specific facts or circumstance. You should not act or refrain from acting upon this information without seeking professional counsel.
The State Board of Equalization at its Jan. 14 meeting said it is proposing legislation to clarify the following items:
–For the parent-child exclusion after Feb. 15, for transfers to multiple children, it is only necessary for one child to make the transferred home their principal residence. Once that child moves out, the exclusion no longer applies and reassessment will occur unless another child makes the home her principal residence.
–A “family farm” need not have a residence to qualify, and the $1 million value limit is per farm unit not per parcel.
–Legislation is being proposed to clarify the Prop. 19 parent-child exclusion law with the hope that more guidance is available by the end of January. The BOE has no authority to extend the effective date of Prop. 19.
Teresa J. Rhyne is an attorney practicing in estate planning and trust administration in Riverside and Paso Robles. You can reach her at [email protected]