Mon, 23 Nov 2020
On November 3rd, 2020, California voters passed Proposition 19 (a.k.a. ACA 11) which allows qualified individuals (seniors, fire victims, disabled) to transfer their home’s property tax when they move, but when a child inherits property from a parent, their property will be reassessed unless they live there.
If you’re reading this, you probably are looking for some loophole to avoid the increase in property tax.
The good news for owners is that there are some options. The law has changed a lot though, so the loopholes that applied pre Proposition 19 are different than the ones that exist once the new law takes effect in February.
But honestly, you don’t even need to consider the new loopholes if you are able to transfer everything by Valentine’s Day 2021 before the law kicks into effect.
Before you just jump into loopholes, please try to understand this law fully. I’ve thought through as many options as I could about Proposition 19 so this can be your starting point for your Proposition 19 inheritance needs, but definitely do your due diligence, as always, before considering any loopholes.
In case you’re not familiar with Proposition 13, here’s a brief overview. Before Proposition 13, the job of the county assessor was to estimate the value of properties fairly, so that homeowners of similar properties would pay similar taxes, and the owner of an expensive mansion would pay way more than the owner of a cheap condo, and the owner at a prime location would pay more than a homeowner further away from the town center.
After Proposition 13 of 1978, the assessor only estimates the fair market value of the property when there is a change in ownership or new construction. Every year, property taxes only go up 2% as long as the owner does not transfer the property or renovate. So those that buy today pay the most taxes and those that bought previously pay less taxes. In a way, fairness goes out the window.
Proposition 13 is a very controversial social safety net because it restricts local governments from funding services, and its benefits are highly uneven. Basically, older homeowners are subsidized at the expense of newer residents and governments. But it remains very popular among older homeowners.
In the 1980s and 1990s, Proposition 13 was expanded in two ways: one set of amendments (Proposition 58 and 193) allowed parent-child and grandparent-grandchild transfers without increasing property tax. Parents could transfer their principal residence as well as the first $1 million of assessed value of other property to their children without triggering a reassessment to fair market value. Grandparents can transfer to grandchildren too, but only if the parents have already passed. Another set of amendments (Proposition 60, 90, 110) allowed seniors over 55 years old, people with disabilities, and victims of a disaster to buy a replacement home and transfer the low tax to the new home. But the replacement home had to be less expensive than the old house, and the replacement home had to be in the same county or in one 10 other counties (Alameda, Los Angeles, Orange, Riverside, San Bernardino, San Diego, San Mateo, Santa Clara, Tuolumne, Ventura).
Proposition 19 (which adds Article XIII A Sec. 2.1, 2.2, and 2.3 to the California Constitution) expands property tax portability in exchange for limiting property tax inheritance:
The expansion of portability gives seniors, disaster victims, and disabled people more options of replacement homes when they need to move. As I mentioned above, before Proposition 19, tax portability only worked when you sold your home and bought a new one in the same county or one of 10 other counties, and you had to buy a house that was the same price or less than the one you sold. Before Proposition 19, if you could not find a home that was less expensive, then you would lose your tax benefit completely. After Proposition 19’s portability expansion takes effect in April 2021, you can buy any replacement house in the state three times in your life. If the new house is less expensive than the old one, you pay the same tax as before, and if the new house is more expensive you don’t lose the tax benefit, but you do have to pay extra taxes on the difference in price between the old house and the new house.
The flip side of Proposition 19 is the rollback in property tax inheritance. After Proposition 19, most people who inherit a property will have their property reappraised to fair market value, unless it is a family home that the parent lived in before the transfer and the child lives in after the transfer, or unless it is a family farm. See the following sections for more details.
This change makes the property tax cap somewhat better targeted at those who need it; seniors, disabled people, and victims of a disaster are more in need of a tax discount than heirs who inherit a valuable property. However, in their infinite wisdom, the legislature made the provisions kick in on February 16th, 2021, which gives parents a little bit of time to adjust their estate plan to minimize the tax burden on their family. This blog post examines some of the options that people have to act before Proposition 19 goes into effect.
The California Association of Realtors® has long wanted to expand portability so that older folks could move to any house in any county because real estate agents benefit from increased turnover. However, their last attempt, Proposition 5 of November 2018, failed 60%-40% after the Legislative Analyst warned in the Voter Guide that it would cost local governments up to $1 billion per year. So the realtors needed to find a compromise that would pay for their desired portability expansion. Fortunately for them, an LA Times article showed that many people who inherit a house keep the low tax assessment but rent out the property for profit, including an actor from the movie The Big Lebowski (1998) (Liam Dillon and Ben Poston, “California Homeowners Get to Pass Low Property Taxes to Their Kids: It’s Proved Highly Profitable to an Elite Group,” Los Angeles Times, August 17, 2018), and there’s no public purpose in giving one set of landlords a subsidy compared to other landlords merely because they happened to inherit their property. So this year the Realtors® came back with Proposition 19, which is a compromise that will raise more revenue by curtailing the inheritance exclusion and will dedicate most of the funding to firefighting efforts. It won endorsements from almost everybody who opposed Proposition 5 two years ago (including the firefighters), and voters barely approved Proposition 19 with approximately 51%-49% (ballot measure results).
Proposition 19 severely limits the exclusion from reassessment for parent-child and grandparent-grandchild transfers.
Before Proposition 19, parents could transfer their house of unlimited value to their child without the assessment going up. And parents could also transfer a vacation house or commercial property or rental property to their children of a combined total of $1 million of assessed value (which could be much less than the market value) without reappraisal. (Propositions 58 and 193, Const. Article XIII A Section 1(h), RTC 63.1)
After Proposition 19, for residential property, only the parent’s principal residence, called the “family home”, is excluded from reassessment to market value, and even on that house only the first $1 million (of assessed value discount) is excluded. If the fair market value is more than $1 million above the old assessed value, then only the first $1 million of the difference is preserved when the property is transferred to the child. In other words, assuming that the tax rate is about 1.2%, the maximum property tax discount from a tax on fair market value that a child can inherit will be about $1,000 per month. In addition, the child must move into the house and claim the homeowner’s exemption within one year of the transfer. Depending on how the legislature implements the constitutional amendment, if multiple siblings inherit the house, then each transferee may have to live in the house, or else their portion will be reassessed to market value.
For commercial property, only “family farms” can be transferred to a child without reassessment to market value.
Proposition 19’s restrictive inheritance rules become effective for transfers that happen after February 16th, 2021. That means the deadline for parent-child and grandparent-grandchild transfers under the old rules is February 15th, 2021. If you have rental or vacation properties that you want to transfer to your children, or if your children will not be moving into the house within one year of the date that they receive the property, then that transfer will trigger a reassessment to market rate. If you want the child to pay the same property taxes as the parent on vacation or rental properties, then you must transfer them on or before the day after Valentine’s Day!
This table summarizes the changes to the inheritance exclusion from reassessment in Proposition 19:
|Before February 16, 2021||February 16, 2021 and after|
|Parent-Child||Parent could transfer principal residence of unlimited value to child; each parent could transfer first $1 million of other property to any children. Child did not have to live in the property||Parent can transfer only first $1 million of assessed value discount of family home or family farm to child. Child must live in a family home within the first year after transfer. If the property is not the principal residence (including the other units in a multi-unit building) or family farm, then it will be reappraised.|
|Note: Child can also transfer to parent|
|Grandparent-Grandchild||Grandparent could transfer principal residence of unlimited value to grandchild. grandparent can transfer first $1 million of other property to grandchild. Grandchild did not have to live in the property.
Grandchild could only receive one principal residence and $1 million of other property from any parent or grandparent at the time of transfer
Grandchild could not transfer to grandparent
|Grandparent can transfer only first $1 million of assessed value discount of family home or family farm to grandchild. Grandchild must live in a family home within the first year after transfer. If the property is not the principal residence (including the other units in a multi-unit building) or family farm, then it will be reappraised.
Restriction on the grandchild only receiving 1 principal residence and $1 million is removed.
Grandchild can also transfer property to grandparent.
|Note: Parents must be dead at the time of transfer to use grandparent-grandchild exclusion|
You can avoid Proposition 19 and use the old Proposition 58/193 rules instead if you transfer property before February 16th, 2021, to reduce the property taxes that the child will have to pay. So if you have a rental property, or your child will not live in your home, or your home is worth more than $1 million above its assessed value, then you can avoid reassessment if you transfer it to a child now.
But if you transfer now, then you may owe capital gains taxes and lose out on the step-up in basis, because the federal capital gains step-up in basis requires you to transfer the property upon death, not earlier (26 USC §1014, IRS Publication 551). The step-up in basis allows an inheritor to profit from all the gains of the previous owner when that owner dies without anyone paying capital gains tax on those gains.
So when deciding whether to transfer early, you should balance the present value of the property taxes (typically about 1.2% per year) against the value of the capital gains tax (15% or 20% federally, and the ordinary income bracket for state taxes of typically around 10%) that the parent and child will owe. You might also owe federal estate tax and gift tax if your estate is above $11.7 million. There are a range of choices available to you to transfer a home and $1 million of other property before February 16, 2021, to minimize your property and capital gains taxes. The following sections list different ways to transfer property early that have different capital gains tax implications.
First let’s consider what happens if the parent gifts a property to the child on or before February 15, 2021 while the old Proposition 58/193 rules still apply. If you transfer your principal residence and other property assessed up to $1 million now, then the transfer is excluded from change in ownership so the child will pay the same property tax as the parent.
The downside of a gift from a parent to a child is that the child will lose out on the step-up in basis for capital gains taxes. If a parent gives the child a property while he’s still alive, then the child will have the same capital gains basis as the parent, so the child will be on the hook for all of the capital gains taxes starting from the parent’s purchase price to the child’s selling price. So you need to think hard before gifting a property to a child if the child will ever sell the property.
Instead of gifting property to a child before February 16th under the old Proposition 58/193 parent-child rules, it may be better to sell to a child in order to reduce his capital gains taxes. If you sell to a child, then you pay some of the capital gains taxes now based on today’s sale price, and then when the child sells in the future, he will pay capital gains taxes only on the increase after today.
A plus side of selling is to take advantage of the principal residence exclusion. If the house was the seller’s principal residence for 2 of the past 5 years, then the first $250,000 of gains for one person, or $500,000 for a married couple are excluded from capital gains taxes (IRS Pub 523, FTB: Income from the sale of your home, 26 USC §121). So similar to the step-up in basis, it is possible to completely avoid paying capital gains taxes on some of the gains. In particular, if a married couple’s home has appreciated less than $500,000, then they would not owe any capital gains taxes if they sold their home at fair market value, so they might as well sell today instead of waiting for the step-up in basis at death.
But if there’s more appreciation than $500,000, or if it’s an investment house instead of the parents’ home, then the parents will owe some capital gains taxes when they sell, so you may want to consider a partial gift or installment sale (as explained below) in order to reduce the capital gains taxes owed by the parents.
The parent transferring a property to a child before February 16, 2021, can do a blend of selling and gifting by selling at a price between the parent’s purchase price and the current value. If the parent sells the property at a price above his tax basis but below the current fair market value, then the parent and child will share the capital gains tax burden. For example, suppose two parents bought their home for $500,000, and it is now worth $1.2 million. The two parents can sell their house to their child for $1 million, in which case the child will owe no increased property tax, the parent will owe no extra capital gains tax (since a married couple can exclude a gain of $500,000 on their home), and at the time that the child sells the house, the child will owe capital gains taxes on his gains above $1 million, including the $200,000 that was partially a gift (26 CFR 1.1015-4).
Another option to reduce capital gains taxes if the parents sell to a child is to spread the purchase over time. The child can purchase the property from the parent with an installment sale (a.k.a. seller financing) over 30 years. The change in ownership for property taxes would happen right away on the date of the purchase agreement, which can be excluded from parent-child transfer if done before February 16, 2021 and the property qualifies under Proposition 58/193. Then the parent can elect to pay capital gains taxes each year rather than all at once (IRS Pub. 537), which can reduce capital gains taxes compared to an up-front sale by keeping the parent’s income tax bracket low. And if the stepped-up basis still exists when the parent dies and the property is not paid off, then the remaining balance will be stepped up to market value, reducing the child’s eventual capital gains tax. By the way, the parent is also required to pay income tax on a minimal interest rate of at least 1.31% (Applicable Federal Rates).
If the parent owns combined property that is assessed at more than $1,000,000, then he can transfer that part of it to a child that would be excluded from reassessment under Proposition 58 and 193, and keep the part that would not. For example, if two parents own a rental apartment building that is assessed at $3 million (but worth much more), then they can sell or gift 66% of it (or $2 million of assessed value, which is $1 million per parent) to their children now under Proposition 58/193 before the February 16 deadline but keep the remaining 33% in their own trust. The first $2 million of total transferred value would qualify for parent-child exclusion from reassessment if you do it before February 16th, 2021. There’s no rush to transfer the remaining 33% since it couldn’t qualify for the Proposition 58/193 parent-child exclusion anyway so transferring that portion now would only raise the property tax. When the children later inherit the remaining 33%, that portion will inevitably be reassessed at fair market value for property taxes, but the basis will be stepped up to pay no capital gains taxes.
There are a couple more esoteric options that you can pursue with your tax attorney to transfer the property before February 16th, 2021 for property tax purposes but not for capital gains tax purposes. In the definition of “change in ownership” in RTC 61, it says the parent could make a long-term lease to the child (a lease with options to renew for more than 35 years), or the parent could give a life estate of income or occupancy to the child, and this would be considered an immediate “change in ownership” for property tax purposes but may allow the child to defer “acquiring” for income tax purposes. Or maybe you could figure out a way to transfer the land but not the building.
If you have property that you wish to transfer to a child that does not qualify for Proposition 19 because it is not your principal residence, the child does not want to move in within one year, or its fair market value is more than $1 million above its assessed value, then consider transferring the property before Proposition 19 takes effect on February 16th, 2021.
If you are reading this message after Proposition 19 goes into effect on Feb. 16th, 2021, then it’s too late. Only the family home or family farm qualifies for the parent-child exclusion. Many of the tricks that I mentioned in the previous blog post, including the tricks to transfer property held by a trust long after the parent’s death, probably won’t work anymore. But there are a few tricks from that post that you still can use.
When a parent dies and her home is in a trust, the trustee can still arrange for one of the children to receive the house while the other children inherit cash. But due to Proposition 19, the child must move in within one year for the transfer to be excluded from change in ownership.
Although the child who inherits a family home must live in it initially, the child is still allowed to move out and rent out the house later. Unlike an alternate proposal to close the inheritance loophole for rental properties that did not pass the legislature (SCA 3), Proposition 19 does not trigger reassessment the moment that the child moves out of the house he inherited. However, if the child moves in only for the parent-child exclusion and then moves out right away, then the assessor may combine the suspicious steps into a single step under the “step transaction doctrine” and reappraise the property.
You can still transfer a principal residence to your child multiple times in your life, so you can transfer one house to a child, move into another house, and transfer that one to a child too. But you can’t plan to move into each property for tax purposes, or else the assessor may combine the suspicious steps into a single step under the “step transaction doctrine” and reappraise one or both of the houses.
You can still use tax portability to change the percentage ownerships with a third party, so you can sell your old house and buy a new house with someone else as co-owner to partially transfer the low assessment to them. Proposition 19 adds flexibility here by allowing you to purchase any house in any county.
Finally, Proposition 19 allows parents to transfer the first $1 million of assessed value discount of each “family farm”.
What’s a family farm, you might wonder? It turns out that a family farm is defined extremely broadly. A family farm is defined as “any real property which is under cultivation or which is being used for pasture or grazing, or that is used to produce any agricultural commodity, as that term is defined in Section 51201 of the Government Code [Williamson Act] as that section read on January 1, 2020”, which in turn is “any and all plant and animal products produced in this state for commercial purposes…”. But you don’t have to follow any other Williamson Act clauses; the property does not have to be 100 acres, for example. And what does “produce” mean anyway? Does fermenting beer or making jam count? Does cooking food or making cabinets count as “producing” an “agricultural commodity”? It’s up to the courts now.
And then there’s the question of the occupancy requirement. Family homes require the parent and child to live in the house. But do family farms require you to live on it? From the sneaky legal language, it appears that there is no occupancy requirement for family farms, since Sec. 2.1(c)(3) says to replace any reference to “family home” with “family farm” in (1) and (2), but the transferee occupancy requirement in (5) is not replaced and only applies to “family home” so would not apply to “family farm”, and the transferor occupancy requirement in the definition of “family home” does not apply to “family farm” either. So apparently you don’t need to live on a family farm in order to transfer it to a child with the same low assessment.
So if you own some property that is zoned for growing anything, consider turning it into a farm in order to save taxes. For example, if you own a warehouse, maybe you rent it to a company that will install some grow lights and turn it into your family marijuana farm (Proposition 19 doesn’t require the owner to do the farming himself). In addition, if your farm’s value is more than $1 million above its assessed value, you may be able to subdivide it into lots that are each worth less than $1 million above the assessed value in order to transfer it to a child in chunks that can be excluded. There is no limit on how many family farms you can transfer to a child.
But for any other property that the parent does not live in at the time of transfer and that cannot be used as a “family farm”, you’re probably out of luck.
Proposition 19 is one small step in the right direction in that it reduces the subsidies for inherited investments and instead emphasizes providing assistance to older people. But the delay before the effective date gives property owners an incentive to expedite their estate plan, and doubtlessly many owners will take advantage of this window of opportunity. You have until the day after Valentine’s Day to transfer your property under the old rule, which allowed transfers of non-principal residence property and did not require the child to live in the house. But don’t stress your old folks out too much; remember that the extra 1.2% property tax per year on the gains and 25% capital gains taxes are much smaller than the principal. And needless to say, family relationships are more important than property. But if you are comfortable having a discussion about succession plans, then this may be an interesting topic of conversation this Thanksgiving.
This blog post is information, not legal advice. Talk to your attorney to see if tax avoidance is right for you.
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