How to keep a low Proposition 13 property tax when you transfer property in California

Thu, 12 Oct 2017

Property owners in California know that their property taxes only go up about 2% per year, no matter how valuable the property has become, until the property undergoes a change in ownership or new construction. Many property owners are also aware of the exclusions from change in ownership for transfers between parents and children. But what is less known is that upon death, inexperienced trustees typically divide the property evenly, leaving siblings, aunts/uncles, and cousins to sell the property amongst themselves and undergoing a majority change in ownership and large tax increase. But with a little foresight, the owner or trustee can divide the value of the property evenly while ownership of the property goes to one descendant, keeping the assessed value low indefinitely.

If you are a property owner contemplating passing away at some point, or if you are the trustee of an estate, you may consider some of these tricks to keep your family’s taxes low. Note that the principal itself is much greater than the taxes, so the tax considerations probably shouldn’t be enough to incentivize you to make big changes to the beneficiaries of your trust. But it is still worth checking to see whether small changes can save your beneficiaries hundreds of dollars per month.

If you are a policy wonk interested in the effects of Propositions 13, 58, 60, 90, and 193, then read on to learn some of the wondrous ways they can be used to protect inherited wealth. Warning: this post is longer than usual.

Examples

Transfer to one child only

If a parent has only one child, then passing the property to the child is easy. When a parent transfers his primary residence to his child, or when he transfers up to a lifetime limit of $1 million of assessed value of other property, the transfer is excluded from change in ownership, and the child pays the same low property taxes as the parent.

Transfer equally to multiple children

Things get trickier when there are multiple children. When a parent has multiple children, a typical trust will divide the possessions on a share and share alike basis among all the children, and the trustee then typically gives each child equal ownership of the house (tenants in common). But the children often do not want to co-own the property with each other, so they decide to cash out by selling the property to the sibling who does want to own the property. Since there is no exclusion for sibling-sibling transfers, these sales are changes in ownership that result in the assessed value increasing most of the way to market value. If there are 3 siblings, then two of the siblings selling it to the third will result in a ⅔ change in ownership, and the assessed value goes up ⅔ of the way from the previous assessed value to the current market value.

To put a dollar figure on it, suppose that the home is currently assessed at $200,000 (and property tax of $200,000 × 1.2% = $2,400 per year) but the fair market value is now $1,000,000. If one sibling buys out the other two, then the new assessment will be $200,000 × ⅓ + $1,000,000 × ⅔ = $733,333, and the new property tax will be $733,333 × 1.2% = $8,800 per year. This is a tax increase from $2,400 per year to $8,800 per year.

On the other hand, if the trustee gets a mortgage on the property prior to distributing it, then the trustee can distribute the house with mortgage to one child, then distribute cash of equal value to the other children, so that the child doesn’t have to buy out his siblings. There is only one transfer, the excluded transfer from the parent to the child, so the sibling pays the same taxes as the parent (plus 2% more property tax per year, minus the mortgage interest deduction). This figure shows the distinction between a sibling to sibling transfer and a transfer of a mortgaged house:

Sibling buyout is worse than transferring principal with debt

Figure: Buyout vs. transferring principal with debt. (a) If the trustee simply transfers ownership of the property equally to the three children, then the assessor will record each child’s 33% ownership at 33% of the assessed value (excluded from change in ownership). Then, when one brother buys out the property from the other two siblings to acquire 100% ownership, the assessor will record a 67% change in ownership. (b) If, on the other hand, the trustee mortgages the property before transferring it to the brother and gives the other siblings cash, then the brother receives 100% of the property excluded from change in ownership.

The disadvantage of the trustee getting a mortgage to make a non-pro rata distribution is that it may be difficult for a trustee to get a mortgage on a property. If the original owner thinks ahead, he can have a carefully written trust that avoids the need to get a third-party mortgage (see details below on using a debt to other beneficiaries or option to purchase).

Transfer to grandchildren

For the most part, grandparents or their trustees should transfer the ownership of their property to a child (using a mortgage or other trick), who can in turn transfer it to a grandchild.

But there are certain cases when it makes sense for the grandparent to write a trust to transfer property to a grandchild. For example, the child in the middle generation may not be responsible enough to transfer the property to the grandchild, or the child may already have used up her $1 million parent-child exclusion on a different grandchild. In such cases, the grandparent can write a trust that uses the property to provide income for the child for her life and then transfers the principal to the grandchild. The life estate of income to children is needed because the parents need to be dead before a grandparent-grandchild transfer is excluded. By using a trust, the grandparent can ensure that the principal as well as the low property tax will be transferred to the grandchild after the parents’ death.

Such a trust that creates a life estate of income followed by a principal transfer can also be used to avoid non-excluded sibling-sibling and aunt-nephew transfers, as shown in the following illustration.

Life estate followed by principal transfer is better than aunt-nephew transfer

Figure: Transferring principal vs. Life estate. (a) If Grandma wills the property to her children, they may sell it and leave out the grandchild. (b) Or, if Grandma wills a property to her two children, Mom wills her 50% to the grandchild, and Aunt also wills her 50% to the grandchild, then the aunt-nephew transfer is a 50% change in ownership. (c) Grandma can make a trust that provides income to the middle generation followed by a transfer of principal to the grandchild. This protects the property from sale, provides income for the middle generation, and ensures that all the transfers can be excluded from change in ownership.

If you are a grandchild in the line of succession and the middle generation already has secure housing, then it may be advantageous to have a conversation with your elders about estate planning to minimize your future tax burden.

Property tax law in California

Now let’s get to the nitty-gritty.

Article XIII A of the California Constitution, which was added by Proposition 13 of June 1978, limited ad valorem property taxes throughout the state to 1% per year (plus a bit more for voter-approved bonds) of the taxable value (also known as “full cash value,” or assessed value). Unlike every other state, the taxable value is not based on regular appraisals. Under Proposition 13, the “base year value” is the appraised value at the date of acquisition, and the “factored base year value” for a later year is the base year value increased by inflation capped at 2% per year (for the official inflation rate, see the Consumer Price Index update for 2017-18, found in the Letters to Assessors). Proposition 8 of November 1978 further limits the taxable value to the fair market value to account for declines in value.

Assessed value is the min of market value and factored base year value

Figure: assessed value for a hypothetical property that was last purchased in 1987. The base year value is the market value at the date of purchase (which is the purchase price for a normal arms-length transaction). Thereafter, the Proposition 13 factored base year value grows up to 2% per year. When there is a decline in market value, the assessed value is the lesser of the factored base year value and the market value according to Proposition 8.

Besides the 2% inflation, the “full cash value” only increases when there is new construction or a “change in ownership.” The assessed value of a property is split into the value of the land and the value of the buildings. Each time there a renovation, the assessor adds the current value of the improvements to the assessed building value but does not increase the assessed land value. When a property is sold, it undergoes a full change in ownership, and the entire assessed value increases to market value. When it is partially transferred, a partial change in ownership occurs, and a fraction of the base year value increases to the fair market value. To calculate partial transfers, the assessor also keeps track of the percentage ownership and base year value for each co-owner (Letter 85/85). In summary, in order to calculate the new total base year value after new construction and changes in ownership, the assessor tracks the percentage ownership of each owner, the factored base year value of the land for that co-owner, and the factored base year value of the improvements for that co-owner.

Proposition 58 of November 1986 further amended Article XIII A to exclude from “change in ownership” unlimited spouse transfers and limited parent↔child transfers (any principal residence, and the first $1 million of other property). Proposition 60, also in November 1986, allowed a transfer of a house’s base-year value when a person (over 55 years old or disabled) purchases a replacement dwelling of equal or lesser value. Proposition 193 of March 1996 allowed grandparent→grandchild transfers with the parents are dead. As a result of these propositions, property taxes in California are extremely favorable to long-time property owners and their descendants. The property tax discount follows the property as it passes from one generation to the next, and the discount can also follow a person as he moves from one house to another.

The change in ownership language of Article XIII A §2 in the California Constitution is implemented in statute by Revenue and Taxation Code (RTC) §60 onwards, and the Board of Equalization regulations, The Board of Equalization also publishes Property Tax Annotations, which are collections of Letters to Assessors to answer specific questions of interpretation but are not binding on assessors or courts. All the information here comes from one of those areas of the Board of Equalization website.

The overarching definition of change in ownership in RTC §60 still matches the recommendation from the 1979 Report of the Task Force on Property Tax Administration, which was convened after Proposition 13 and 8 passed: “A ‘change in ownership’ means a transfer of a present interest in real property, including the beneficial use thereof, the value of which is substantially equal to the value of the fee interest.” This is the general rule which is followed for any situation not covered by sections 61 and 62. Under the specific rules, a change in ownership does not include giving renters a short lease (under 35 years), getting a loan and deed of trust, and putting the title of the property in a revocable trust. A change in ownership does include selling the property, creating or terminating a long lease (over 35 years), and creating or terminating a life estate of income or tenancy (Annotation 220.0780, Leckie v. County of Orange (1998) 65 Cal.App.4th 334), unless the beneficiary is the transferor himself or a spouse/parent/child/grandchild who qualifies for an exclusion.

When a trustor creates a trust, the assessor ignores the trustee (who holds legal title) and reads the trust to see who has beneficial use of the property. For a property held by a revocable trust that becomes irrevocable on death, the date of death is a change in ownership, a change in the beneficiary is a change in ownership, and the transfer of property out of the trust is a change in ownership, unless the new beneficiary is a spouse/parent/child/grandchild who qualifies for an exclusion (Rule 462.160). For both the creation of the life estate and the transfer to the remainderman (the beneficiary of the remainder after the life estate terminates), the creator of the trust is the transferor. Change in ownership can be avoided if the trust creates life estates and principal distributions to excluded beneficiaries.

Tricks

Here are various techniques that can be used to pass on your Proposition 13 factored base year value from one generation to the next.

Transferors can mix and match these tricks as needed. For example:

Warnings

Conclusion

This blog post shared some of the tricks that can be used to keep property taxes low in California. There are even more tricks that I did not detail here that wealthy people can use. For example, Michael Dell’s “too good to be true” beachfront hotel purchase was not a change in ownership because the property was held in a LLC of which nobody owned a majority (he owned 42.5% and his wife owned 49%) (Ocean Avenue LLC v. County of Los Angeles (2014) 227 Cal.App.4th 344). Malcolm Gladwell also has an entertaining Revisionist History podcast on exclusive golf equity clubs, which do not ever undergo changes in ownership because members technically purchase an expensive “license to use” instead of an ownership interest, along with minority voting rights that are akin to shareholders of a corporation (Annotation 220.0439). Proposition 13 protects property investors of all shapes and sizes.

Proposition 13 is one of California’s biggest entitlement programs. When assessment practices were modernized in the 1960s and 1970s, some states created circuit breakers to protect low-income and elderly homeowners, some states classified residential property at a lower tax rate than commercial (Isaac William Martin, The Permanent Tax Revolt), and California ended up with a highly regressive acquisition value-based tax system with exceptions so big that a multimillionaire’s entire estate can fit in its change in ownership exclusions. Could you imagine if Social Security’s greatest individual recipients were corporations and old estates, the benefits could be passed down from generation to generation, and for new households it was only available to the upper-middle class? That’s the entitlement program we have created in California. It’s more pyramid scheme than safety net.

For house-rich residents who have witnessed extraordinary appreciation on your home, by all means, use every exclusion available to you to pass your low assessment as well as your property to your heirs. But I hope you also can also understand that California really should have a better-designed safety net that supports all residents in need, not only property owners and children of property owners.

Disclaimer: this is information, not legal advice. Talk to your lawyer to see if tax avoidance is right for you.

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