If you own property and want to transfer it to a family member or leave it to one when you die, California’s property tax is something to consider. This article will explain how you can plan for your children to receive California real estate from you without triggering an expensive property tax reassessment. A little planning can go a long way and save your loved ones thousands of dollars every year.
California Property Tax
California real estate is generally taxed at 1% of the property’s “assessed value.” The assessed value is the fair market value as of the date of a change in ownership. The law limits increases to the assessed value to no more than 2% each year. When there is a change in ownership, the property value is generally reassessed and the new owner pays more property tax. If the value of your property has increased more than the rate the tax has increased (up to 2% per year), a reassessment will result in significantly higher property taxes. San Francisco property owners have the most to save by planning because San Francisco property seems to appreciate more than property in other parts of California.
If you are selling your property to a stranger, you probably do not care
about reassessment. If you want to transfer your property to your
children, however, proper planning can save them thousands of dollars
every year. Here is a simple illustration: say you purchased your home
in 1998 for $1,000,000. The original property tax would be $10,000 a
year. The amount that is taxed each year can be increased by up to 2%
annually. So the property tax in 1999 would be no more than $10,200.
Assume that you now want to sell the home and it is worth $10,000,000.
The new owner would pay property tax on $10,000,000, which is $100,000
the first year - far more than what you were paying!
Property Tax Reassessment Exclusions
Certain transfers within families are excluded from the general rule that a change in ownership triggers reassessment. These exclusions include transfers between spouses and domestic partners. Note that domestic partners won the right to the same property tax breaks as husbands and wives in 2008 when the California Supreme Court turned down an appeal by County Assessors. This article focuses primarily on exclusions for parent to child transfers and the exclusion for transfers to certain trusts.
Parent to Child Transfers
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. 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.
Your principal residence is the property where you would take a homeowner’s exemption – the place where you actually live, not a rental or vacation property. 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 “full cash value” refers to the assessed value, not the fair market value of the property – so you can really transfer property worth far more than one million dollars without triggering a reassessment. For example, if you purchased the property thirty years ago for $100,000 and it is now worth well over $1,000,000, the assessed value ($100,000 plus yearly increases of no more than 2%) is the amount to be considered, even though the child will receive a property worth well over $1,000,000.
Since each parent can transfer to the child, one child could theoretically receive two principal dwellings (although usually there will be only one) and up to $2,000,000 of the full cash value of other properties. 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.
While the concept of “parent and child” seems simple enough, there are some unique scenarios to consider. In addition to all “natural children,” children born to a parent with a registered domestic partner, step-children, and those adopted before they reach age 18 are also eligible for the exclusion. 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. There are also circumstances where foster children and foster parents can qualify.
Also, a grandparent may take advantage of this exclusion under specific circumstances and transfer to a grandchild without reassessment. The child's parents must be
deceased before any grandparents qualify. Further discussion of additional restrictions on grandparent-grandchild transfers exceed the scope of this article.
Beware of Limited Liability Companies and Other Entities
Many owners transfer their property to an entity such as a limited liability company to protect their other assets from lawsuits. One downside of doing so is that the property may be reassessed when the interest in the limited liability company 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. For example, if you transfer your property to a limited liability company and then transfer at least a majority interest to your child, there will be a change in ownership and reassessment of the entire property. For property tax purposes it usually makes more sense to simply transfer the property to the child directly rather than going through an entity such as an LLC. A discussion of the entity rules is beyond the scope of this article. Don't make the costly mistake of holding your real estate in such an entity without legal advice if you plan to leave your real estate to your children or grandchildren!
If you do not have children, however, transferring your property to an
entity may be a good idea. Most transfers to entities that result in one
spouse gaining an ownership interest over the other do not trigger
reassessment. This is because the inter-spousal exclusion from
reassessment is broader than the parent-child exclusion.
A transfer of real estate to entities that does not result in a change in the beneficial ownership interest will not trigger reassessment. These rules can not be fully covered here, so consult a qualified lawyer before making any transfers to make sure they best suit your situation.
Transfers to Revocable Living Trust
Another way to transfer your property without triggering a reassessment is to transfer it to your revocable living trust. This option may be used if you are not ready to transfer your property now and you want to make provisions for it after your death.
For a trust to be revocable, you as trustor must reserve the right to terminate the trust and retain all trust property. When property is placed in a revocable living trust, there is no “change in ownership” and thus no reassessment. All that changes upon death when the revocable living trust becomes irrevocable. 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.
Transfers to Irrevocable Trust
When property is transferred to an irrevocable trust during your lifetime or upon your death, or the beneficiary of such a trust is changed, there has been a change in ownership for property tax purposes and there will generally be a reassessment.
There will not be reassessment, however, if the parent-child exception applies. With proper planning, you can leave your property to your child in trust, not have to worry that they will be burdened with high property taxes, and you can still hold on to the property for the duration of your life if you so choose.
When property is left to more than one child, one child may want the property and the other will want money or assets of equal value. If the trust 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.
To avoid this outcome, create a “non-pro rata” trust – one that provides for unequal distribution of the trust assets. A non-pro rata trust can allow one child to get the property without triggering reassessment and others to get other trust assets of equal value.
Property transferred by trust and by will is treated differently. 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.
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.
Keep in mind that all beneficiaries must qualify for an exception to avoid reassessment. The entire property will be reassessed if even one beneficiary does not qualify!
These are just some of the ways you can plan to avoid reassessment. There are many more nuances in the law that we have not mentioned. Discuss these ideas with your estate planning attorney if you want to transfer real estate to your loved ones without reassessment.
© 2008 John E. O’Grady & Katherine M. Watts
The information contained in this article is general in nature and should not be relied upon for any specific situation. Consult a qualified attorney for any specific legal advice.