In 1978 the citizens of the State of California voted in an initiative to limit property taxation which is now embodied in Article 13A of the California Constitution (“Prop 13”). After the law was passed the resulting litigation went all the way to the U.S. Supreme Court and the law was affirmed in Nordlinger v. Hahn, (505 U.S. 1 (1992)). 1975 became the base year of real property values for every parcel in California, which were and are limited to 1% of assessed value (plus voted indebtedness and direct and special assessments). The important take away from Prop. 13 is that property taxes may not increase more than 2% annually.
Most localities have voted in special assessments like Mello Roos (which created Community Facility Districts) that levy new taxes and fees for services that used to be paid from the property tax: streets, water, sewer, lights, schools, parks, police, etc. If you look at your property tax bill and you live in the City of Los Angeles you will likely see the voted indebtedness for City of Los Angeles, Metropolitan Water District, Community Colleges and the Los Angeles Unified School District. It also includes direct assessments for items like flood control, vector control, light maintenance, storm water, city parks, county parks and trauma services.
Prop. 13 was amended by Prop. 8 which created a true ad valorem property tax system in California. An ad valorem tax is one that goes up and down with the fluctuating fair market value of the underlying asset being taxed. As such, we now have a reduction in our base year value due to deflation.
It used to be political suicide to try to repeal Prop. 13 but recently Democrats have aggressively been lobbying to repeal Proposition 13.
It is interesting to note that Massachusetts and Oregon have similar laws to the law in California.
A reassessment of your base year to the current fair market value can occur for a number of reasons besides buying or selling your property. Any reassessment will usually outweigh the benefit of any estate planning (gifts, family limited partnerships, trusts, freezes) or complicated transactions (mergers, tax credits, sale-leasebacks) if the property has been owned by the same owner for a long time. As such, it is important to understand what will trigger a reassessment:
(i) a change in ownership, or
(ii) completion of new construction.
The county assessor reassesses a parcel’s value for any “change in ownership” to full fair market value as of the date thereof. The key to understanding the exceptions to reassessments is that a change in ownership does not necessarily mean a change in ownership in the traditional sense. A “change in ownership” is defined as “a transfer of a present interest in real property, including beneficial use thereof, the value of which is substantially equal to the value of the fee interest.” The property owner will only receive the benefits of the exceptions below when the deed is properly worded, the preliminary change in ownership report is completed properly and the appropriate other forms are completed properly and timely filed with the respective county assessor and in some cases the California Board of Equalization.
• Transfers Between Parents and Children (R&T 63.1): A transfer of a principal personal residence and up to $1,000,000 (of assessed value before death) of other (i.e. commercial) real property is exempt for reassessment, if the proper forms are filled out on a timely basis. It is important to note that these interests must be held individually or in trusts and not in business entities. This exception includes the grandparents to the grandchildren if the parents are dead. It is important to note that there is no exception for transfers amongst siblings.
• Interspousal Transfers (R&T Code 63): Transfer between husbands and wives are exempt from reassessment. This exception includes legal entities owned by spouses and also includes the death of a spouse.
• Eminent Domain or Inverse Condemnation (R&T 68): Transfers due to a governmental taking are exempt from reassessment.
• Less than 5% of the Property Interest and Less than $10,000 of Market Value (R&T 65.1): For transfers amongst Tenants in Common or certain Joint Tenancies of 5% that is less than $10,000 during a calendar year, there is no change in ownership.
• Joint Tenancy (R&T 65(b) & (d)): Transfers from original joint tenants to new joint tenants and transfers from the new joint tenants back to the original joint tenants are exempt.
- Transfer to owners who are not joint tenants.
- The death or transfer of the last of original joint tenant’s interest.
• Brand New Exception - Principal Residence Co-Tenancy (R&T 62.3): Transfers at death between Co-Tenants who own 100% as tenants in common or joint tenants are excluded from reassessment. The surviving co-tenants must own 100% of their home after death. This is to give the same benefit to surviving co-tenants that surviving joint tenants had.
• Persons aged 55+ and Disabled Persons (R&T 69.5): Persons who are somewhat elderly or disabled can transfer their prior home’s base year to a newly purchased home. The homeowner must sell principal residence and purchase or build a new one of equal or lesser value within two years. However, some counties require the previous home to be located within their county.
· Transfer to Revocable Trusts (R&T 62(d)): Any transfer to or from a revocable family trust is exempt from reassessment. This includes transfers to a Qualified Personal Residence Trusts because the trustor-trustee is the sole present interest beneficiary.
· Transfers to Irrevocable Trusts (R&T 61(h)):
- Grantor Retained Annuity Trusts: Exempt.
- Intentionally Defective Grantor Trusts: Exempt.
- Charitable Remainder Trusts: For the Charitable Remainder Trust to be exempted from revaluation the trustor-trustee must retain the present right to the income and not another beneficiary.
- Does not apply to Charitable Lead Trusts: Charitable Lead Trusts are not exempt unless if one of the other exceptions applies (like the parent child $1M of other property).
• Non Pro-Rata Distributions: If equal shares are required and the beneficiaries decide not take equal shares, the difference between the portion of the equal share and actual share is subject to revaluation even if one of the other exceptions apply.
• Powers of Appointment:
- General Power of Appointment = Beneficiary owns property.
- Limited Power of Appointment / Special Power of appointment (and not a present interest beneficiary) = Beneficiary does not own property.
If the beneficiary has a general power of appointment, they are considered owners of the property. Therefore, if one of the other exceptions applies to the beneficiary, the property is exempt. However, if the beneficiary only has a special power of appointment and is not a present interest beneficiary, they are not considered the owner of the trust and a revaluation event may occur if the trust is irrevocable and the other present interest beneficiaries do not qualify for an exception.
• QTIPs, By-Pass and Survivor’s Trusts: Interspousal and revocable exceptions apply.
- Qualified Terminable Interest (“QTIP”) Trusts: QTIP trusts are exempt so long as the surviving spouse is a present income beneficiary.
- By-pass Trusts: Bypass trusts are exempt so long as the surviving spouse retains a present interest.
- Survivor’s Trusts: Survivor’s trusts are exempt so long as the surviving spouse has a general power of appointment and the trust is revocable.
• Life Estate for Years (R&T 61(g) and 62(e)), Life Estate Reserved and Charitable Gift Annuity for Home: A life estate is when a property owner grants someone the right of use, occupancy and control during their lifetime. The exception only applies when the original property owner grants them self (the transferor or their spouse) the right of use, occupancy and control during their lifetime and grants someone else the remainder interest. As such, both gifts of life estates and charitable annuities granted in exchange for a gift of a life estate are exempt from reassessment. One useful strategy here is if the parents want to get their home out of their estate, they can transfer the home to their kids, retain a life estate, still live in the home and when the parents die the kids still get a step up in basis and no property tax reassessment will occur because of the principal residence exception. Gift tax will be due for the initial gift of the home (if the value is over the exemption amount) but perhaps it is better to make that gift at a value lower than the appreciated value at the time of death.
• Leasehold Interests (R&T 62(g)): Transfer of a lessor’s interest subject to a 35 year (including options) term lease. Residences eligible for the homeowners’ exemption (all California homeowner’s get a $7,000 exemption) are presumed to have a renewal option of 35 years or more. This exception does not apply to property held by entities.
• Sprinkle and Spray Powers (Rule 460.160): If a trustee has the discretion to distribute income and principal to beneficiaries and all of the beneficiaries can meet one of the other exceptions, the property is exempt from revaluation. However, if only one of the beneficiaries does not meet the exception the property is subject to revaluation since the trustee could potentially distribute to a nonexempt beneficiary.
• Transfers that Retain Proportional Interests of the Owners (R&T 62(a)(1)): Transfer between different legal entities are exempt so long as proportionate interests of the individual underlying owners are retained in both capital and profits. This exception applies to:
- Limited Liability Companies
- Limited Partnerships (R&T 62(a)(2))
• Transfers Between Partners (R&T 64(c)(2)): When a majority owner (this person owns over 50% of the property prior to the transfer) of an entity acquires the minority interests and becomes the sole partner, no change in ownership has occurred. The limited partnership agreement must include language that the partnership will not terminate upon the death of the general partner, provide for withdrawal of the general partner and provide for incapacity of the general partner.
• Transfers Between Affiliated Corporations (R&T 64(b)(1)&(2)): Transfers amongst wholly owned subsidiaries are will not be reassessed. This exception also includes transfers pursuant an IRC 368 reorganization.
• Transfers of Control or Transfers of Interest Greater than 50% (R&T 65(c)): Any transfer less than 50% is not a change in ownership and does not trigger a change in ownership. This is a cumulative calculation that is calculated beginning the date of contribution or purchase.
Use Caution with Family Limited Partnerships: Under the original Prop. 13 rules, a change in ownership did not occur when ownership interests of the entity changed, only if a new deed was recorded with a new entity owning the property. Today many people unethically side step the cumulative rule by transferring more than 50% over time and not filing the required Form BOE 100-B when the 50% threshold is reached. It is important to note that 50% does not include spouses but does include children. If parents contribute property to a family limited partnership and then transfer more than 50% to the children, reappraisal will occur because the parent/ child transfer exclusions do not apply to interests in entities. However, if the parents transfer the property to the kids (up to $1,000,000 in commercial property) and then transfer the same proportionate interest in the real estate to a family limited partnership, no reappraisal will occur. The parents would retain a portion of the property in this family limited partnership example.
The rules surrounding California real property changes in ownership are complex and a simple misstep can be very costly. The cost of an unintentional reassessment of real property value can easily outweigh the estate or tax planning strategy that was intended to be implemented and can greatly increase the cost of any contemplated transaction. As such, it is essential to fully understand the revaluation exemptions, avoid unintentional increases in property taxes and structure your transaction to defer or substantially reduce the increase in property taxes. Please call the Caldwell Law if you need guidance and wise counsel on these issues.
The information in this article is intended to be a general description of tax laws and is not advice as to any transactions, nor is this article advice to any person or to any client and should not be relied upon as such. If you or your client desire to receive specific legal or tax advice on a specific transaction, then please call Caldwell Law at (818) 992-2921.