Prop. 19 Passes: Probably Means Higher Taxes for Your Kids
Proposition 19 Restricts Parent-Child Transfer of Low Property Tax Rates
As I’m sure all of you are all too aware, we just had a significant election on many levels. I’ll leave national commentary for others. For homeowners in California, though, Proposition 19 is making big changes to property tax rates upon the sale or transfer of property.
Proposition 19 has two main effects. The first makes big changes for homeowners over 55, or those who are severely disabled, or victims of fire, who want to sell their residence and purchase another home, either in their same county or elsewhere while keeping their current low property tax rate. While an important change for many of us, I want to focus here on the estate planning implications of Proposition 19, which stem from the second part of the law.
Proposition 19 makes significant changes to the basic rules for property tax transfers between parents and children (and grandparents to grandchildren) as of February of 2021. Spoiler alert: your children are most likely going to be paying more property taxes than you are.
Here are the basics. The complexities are still be worked out as the Board of Equalization and the County Assessors work to implement the new law.
PRIMARY RESIDENCES
If you leave your primary residence to your children at death, you WILL be able to transfer your property tax rate to them, but with new restrictions. The biggest restriction is that your children are going to have to use that residence as their primary residence, no later than one year after the date of transfer. (How does this work if there are multiple children? We don’t yet know.)
The property tax rate that you transfer to your children will be adjusted upward if the house is valued at more than $1 million plus your adjusted base-year value (the value on your property tax bill that the assessor uses to calculate the tax due, which is based on the purchase price with a small annual adjustment). To put this another way, if the house is currently valued at more than $1 million plus that adjusted base-year value, the kids will pay more than you were paying, but less than a new owner would pay, using a formula that is complex, but that results in excluding only $1 million from property tax reassessment.
OTHER REAL PROPERTY
Parents WON’T be able to transfer any additional real property to their children without a property tax reassessment. Until now, a parent could transfer up to $1 million in such property, calculated by using the adjusted base-year value (which was generally much lower than the current fair market value of property). In fact, Proposition 19 was motivated, in part, by public outrage at the “Lebowski loophole” reported by the LA Times, in which actor Jeff Bridges and his siblings were renting out their deceased father’s Malibu home for big bucks, while paying their father’s low inherited property tax rate.
PLANNING IMPLICATIONS
If you own rental or vacation properties and you want to preserve your current low property tax rates for your children, you might simply sell them these properties. You might also gift them these properties before February 15, 2021. Such a gift, however, has gift and income tax implications:
You will have to report the gift by April of the following year on a gift tax return, which will then reduce your lifetime gift and estate tax exemption by the fair market value of the gift.
Your children’s tax basis in the property will be your tax basis, which means if they sell the property, they will have to pay capital gains tax on the gain. If, for example, you purchased the property in 1980 for $200,000 and it is worth $1.2 million when your child sells it, they will owe capital gains on that $1 million of gain. Using 33% as a rough estimate of that tax, they will owe $330,000. If instead, they inherited that property at your death, and it was worth $1.2 million at that time, they would inherit it at that basis. If they sold it immediately, they would owe no capital gains at all. So, families need to identify their long term goals for a property—if it will be sold ultimately, the capital gains savings may be greater in the long-term than the property tax savings in the short term.
It won’t be your property anymore. If you want to use it, you will need to pay rent to the kids. If they want to remodel it, or fail to take care of it, or have to sell it as a result of divorce, you will have no control over those decisions.
Another option is to take advantage of the fact that the rules for property tax reassessment did not change for entities, like LLC’s, as a result of this election. Property held within an LLC does not get reassessed unless more than a 50% ownership interest is transferred. Lawyers, of course, have become adept at making sure that this majority control rule is not triggered.
EXAMPLES
Some families are taking advantage of this fact by combining gifting some of their interest in additional properties to their children and forming LLC’s, in various orders depending upon the facts, to both protect current low property tax rates now and prevent reassessment later when a parent dies.
Example: Mom owns a residence with a fair market value of $900,000. Her assessed value (that adjusted base-year value) is $300,000. When Mom dies, she leaves the house to her son, Lewis. Within one year of Mom’s death, Lewis makes the house his primary residence. Because the fair market value plus the assessed value (1.2 million) is not more than $1 million plus the assessed value ($1.3 million), there will be no reassessment for Lewis. Using a rate of 1.25%, he would owe $3750 per year in property tax, which is based on Mom’s assessed value of $300,000.
Example: Dad owns a residence with a fair market value of $2 million. His assessed value (that adjusted base-year value) is $500,000. When Dad dies, his daughter, June, inherits the house and makes it her primary residence. June will be taxed as if the property she inherited was worth $1 million. The calculation is this: she pays taxes on the current fair market value of the house ($2 million) – $1 million because that fair market value ($2 million) is more than Dad’s assessed value ($500k) plus $1 million ($1.5). If we use 1.25% as an estimated rate of property tax, her property tax bill would be $12,500 annually. Her Dad would have paid $6250. A new owner would pay $25,000.
Example: Mom owns a residence with a fair market value of $3 million. Her assessed value (that adjusted base-year value) is $53,000 because she and her now deceased husband bought the house in 1953. All of her three children already own their own homes. They decide to keep the property anyway, set up an LLC, and use it as a rental. The property will be reassessed at a value of $3 million, and the annual property taxes would be approximately $37,500 annually. Mom was paying $662.50 annually.