AVOIDING THE PAIN OF SUPPLEMENTAL PROPERTY TAX BILLS

Hypotheticals and Examples in Real Property Ownership Structures
By Thomas Caldwell

Property taxes have been an unpopular but widely discussed topic point for a long time. Six thousand years ago in the city of Lagash in ancient Iraq archeologists have found clay tablets containing the king’s tax rolls called bala or rotation. Every month the tax assessors would focus on a neighborhood assessing land and taxing the peasants and merchants, then move on to the next area where citizens would grumble. Later ancient Babylon, Egypt, Persia, China, Greece and Rome all had real property tax undoubtedly creating complaints all over the ancient world. Today in California not all that much has really changed. This has especially been true since the California Association of Realtors sponsored a California state constitutional amendment known as The Home Protection for Seniors, Severely Disabled, Families, and Victims of Wildfire or Natural Disasters Act or Proposition 19. Proposition 19 effectively terminated Proposition 58’s parent child exemption as it pertained to commercial real estate effective February 16, 2021. Now more than ever property owners must be very strategic in the manner they take title upon the acquisition of real estate. Additionally, property owners must be very careful in regards to any changes in the underlying ownership after acquisition. A small mis-step can make the economics of continued ownership of the asset unfeasible. After all, making it economically unfeasible for families to continue to own commercial real estate after a death in the family was the design of Proposition 19. This article will discuss some of the key real property tax rules, outline some hypothetical examples and some well-known court cases as examples to help understand the rules to demonstrate ways to properly structure ownership of real property in California. No one likes receiving a supplemental property tax bill for a change in ownership reassessment, especially when it could have been avoided.

I. PARENT CHILD

For those that are not aware of the old Proposition 58 and the new Proposition 19 parent child exemption rules, I will summarize them briefly. Proposition 58 also known as California Revenue and Taxation Code § 63.1 used to state that a transfer of a principal personal residence and up to $1,000,000 (of assessed value before death) ($1,000,000 per spouse) of other (i.e., usually commercial or a second home) real property is exempt for reassessmenti, if the proper forms were filled out and filed with three years of the date of death or inter vivos transfer. This exception included the grandparents to the grandchildren if the parents were deceased. It is important to note that there is no exception for transfers amongst siblings.

Unfortunately, on November 3 2020, California voters approved a ballot initiate to terminate the parent child exclusion under Proposition 58. Effective February 16, 2021, parents can only transfer their primary residence to their children if a child uses the residence as their primary residence. If the fair market value of the property, on the date of death or the date of the inter vivos transfer, is greater than $1,000,000 over the assessed value, the value over that

$1,000,000 will be reassessed.ii The exemption for $1,000,000 of other property is no longer effective. The California legislature has yet to pass the rules to interpret the exact implantation of Proposition 19 although it has already been implemented. It assumed that in addition to the family home, parents can transfer a family farm to children but we are still waiting for the exact rules to come out.

The Howard Jarvis Taxpayers Association, who originally successfully lobbied for the passage of Proposition 13 (which limits the annual increase in real property tax to 2%) in 1978, is attempting to have a ballot initiative place on November’s ballot to repeal Proposition 19 and reinstate Proposition 58. The California Association of Realtors is rumored to not to plan to run a campaign against this new ballot initiative because the publicity nightmare created by Proposition 19. There are additional ballot initiatives and proposed bills in the state legislature being discussed to repeal Proposition 19.

Example:

Harry and Wendy pass away leaving their multi-family portfolio and their home (assessed at $500,000 and date of death fair market value of $1,490,000) to their two children. Under the new Proposition 19 rules, the multi-family portfolio will be 100% reassessed. The primary residence will not be reassessed because their daughter moved into the deceased parents’ home with her family within one year of the second to die of her parents’ date of death and filed a homestead exemption.

II. PROPORTIONATE INTEREST RULE

California Revenue and Taxation Code § 62(a)(1) and (2) proportionate interest rule could be the most important property tax rule relating to avoiding unwanted changes in ownership. It states:

62 Change in ownership shall not include:

(a) (1) Any transfer between co-owners that results in a change in the method of holding title to the real property transferred without changing the proportional interests of the co-owners in that real property, such as a partition of a tenancy in common.

(2) Any transfer between an individual or individuals and a legal entity or between legal entities, such as a co-tenancy to a partnership, a partnership to a corporation, or a trust to a co-tenancy, that results solely in a change in the method of holding title to the real property and in which proportional ownership interests of the transferors and transferees, whether represented by stock, partnership interest, or otherwise, in each and every piece of real property transferred, remain the same after the transfer. The provisions of this paragraph shall not apply to transfers also excluded from change in ownership under the provisions of subdivision (b) of Section 64.iii

Transfers between different legal entities and to and from legal entities are exempt so long as the proportionate interests of the grantor individual underlying owners are retained in both capital and profits.

Examples:

Larry transfers his shopping center in which he owns a 100% fee simple interest to his single member LLC = No change in ownership.

Larry transfers his shopping center in which he owns a 100% fee simple interest to a LLC owned 99.9% by Larry and 0.1% by Larry Jr. (Larry’s son) = 100% change in ownership as the transfer to the LLC was not proportional to the previous underlying ownership.

III. MORE THAN A 50% CHANGE IN AN ENTITY’S UNDERLYING OWNERSHIP

= 100% REASSESSMENT, LESS THAN 50% = NO CHANGE IN OWNERSHIP

Under the original Proposition 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 real property. This loophole was plugged with California Revenue and Taxation Code § 64(c)(1) change in control/ cumulative rule. This rule is the second part of understanding entity transfers:

A “change in control” occurs when a single person or entity obtains: (i) direct or indirect ownership or control of more than 50% of a corporation’s voting stock, or (ii) direct or indirect ownership of more than 50% of the total interest in capital and profits in any partnership or LLC.iv

A reassessment of all real property owned by the entity will occur once the 50% threshold is passed. It is the responsibility of the property owner to file Form BOE 100B with the Board of Equalization in Sacramento within 90 days of the change. The statute of limitations is unlimited if Form BOE 100-B is not filed.

Today some 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.

Example:

George purchases an apartment building in the name of George’s LLC. George later transfers 50% of George’s LLC to his new business partner, Fernando. George timely files Form BOE-100-B with Sacramento. Result: no change in ownership because not more than 50% of the membership interest in George’s LLC was assigned.

IV. FAMILY LIMITED PARTNERSHIPS

Family limited partnerships are a very popular tool in California for families with commercial real estate portfolios that desire a business management and organizational structure. These entities come with the added benefit of discounting a taxable estate for estate tax liability due to the fractionalized ownership of the entity. Prior to Proposition 19, if parents contributed property to a family limited partnership and then transferred more than 50% to the children, reappraisal would occur because the old Proposition 58 parent/ child transfer exclusions did not apply to interests held in entities. However, if Proposition 19 is eventually repealed and the old Proposition 58 rules return, 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.

Example:

Papa money bags wants to teach his children the family business of developing and owning industrial warehouses and avoid conflicts between his children once he and his wife pass away. Coincidently, he also likes the point that upon his death he hopes that his 706 estate tax return will reflect a 30% to 40% discount on the value of his warehouse portfolio for lack of marketability and lack of control.v He transfers the warehouses to his new family limited partnership in which he owns a 100% interest. Four months later, to avoid the step transaction doctrine discussed in the next example (there is no specific law on the four months, it is just widely accepted by practitioners as an appropriate waiting period)) he assigns a 1% limited partnership interest to each of his three children. Result: no change in ownership because not more than 50% of the limited partnership’s ownership changed.

V. STEP TRANSACTION DOCTRINE

Example:

In Shuwa Investment Corp. v. County of Los Angeles the California Court of Appeal affirmed the step transaction doctrine rule. The step-transaction doctrine is applied when a series of transfers are made merely to avoid a change in ownership reassessment. In such cases the “substance of the transaction rather than the form” will determine if a change in ownership has actually occurred.vi Japanese investment firm Shuwa Investment Corp. purchased the ARCO Plaza on Bunker Hill in downtown Los Angeles in 1986 from the Flower Street limited partnership. Flower Street was half owned by ARCO and half owned by Bank of America. “The proposed structure was a three-step transaction in which 1.) ARCO would sell its partnership interest in Flower Street to Shuwa, 2.) Bank of America and Shuwa would liquidate Flower Street and receive their respective 50% undivided interests in ARCO Plaza, and 3.) Bank of America would sell its 50% undivided interest in the ARCO Plaza to Shuwa.”vii “The parties sought a formal opinion from the State Board of Equalization regarding the tax consequences of the transaction to confirm there would be a change in ownership for property tax purposes of 50% of the property. Tax counsel for the State Board of Equalization issued an advisory opinion which concluded that, assuming the steps were necessitated by bona fide business purposes, independent of a desire to avoid property tax, the transaction would result in only a 50% change in ownership for reassessment purposes.”viii The County reassessed the property 100% because the three transfers were steps in a larger transaction, that Shuwa owned 100% of ARCO Plaza when it owned no interest in the property the day before, and that Shuwa’s complaint was barred by the step transaction, business purpose and substance over form doctrines. So much for the State Board of Equalization opinion!

In Penner v. County of Santa Barbara, a family limited partnership was created by a mother who initially owned a 100% fee simple interest in real property in Santa Barbara. She transferred the property to a limited partnership entity in which her children were limited partners. Proposition 58 never applied to entities. Since the children did not obtain the gift of the real property directly from the mother, the old Proposition 58 parent-child exemption did not apply. As such the transfer was disproportionate and not excludable under California Revenue and Taxation Code § 62(a)(2). The mother argued in court that the result would have been the same if multiple steps had been taken by first transferring the property from herself to her children and her as tenants in common, followed by all of them transferring it into the family limited partnership under the proportionate interest rule. Therefore, the transaction should be treated as a single transaction under the step transaction doctrine or so she hoped. The Court of Appeal acknowledged that if the multiple steps had been taken, the parent-child exclusion and then the proportional ownership interest transfer exclusion under California Revenue and Taxation Code § 62(a)(2) would have applied. The step transaction doctrine allows the assessor to ignore certain steps that are taken, but does not allow a taxpayer to invent steps that never existed.ix

VI. MICHAEL DELL

Example:

The most well-known and colorful example of California Revenue and Taxation Code § 64(c)(1)’s change of control rule involves Michael Dell’s (chairman and CEO of Dell Technologies) 2006 purchase of the Fairmont Miramar Hotel and Bungalows in Santa Monica for $210,000,000. No deed ever recorded transferring a fee simple interest to Michael Dell as he did not purchase the real property. Michael Dell’s private equity fund, MSD Capital, purchased the membership interest of the previous owner, Maritz, Wolff & Co.’s (a Los Angeles-based investment firm) fund Hotel Equity Fund VII, L.P.’s single purpose entity, Ocean Avenue LLC. Maritz, Wolff & Co. purchased the property in September 1999 for $90,600,000. MSD Capital purchased 42.5% of the membership interests. Michael Dell’s wife, Susan Lynn Lieberman, had a separate property trust that purchased 49% of the membership interest. A third LLC, Miramar Hotel Investor, LLC, comprised of independent investors and Michael Dell purchased 8.5% of the membership interest. Ocean Avenue LLC is still the owner of the hotel. The Assessor at the time, John Noguez, did not like the taste of that so he reassessed the property anyways, despite the fact that neither Michael Dell or Susan Dell individually acquired over 50% of the Ocean Avenue LLC capital and profits. In Ocean Avenue LLC v. County of Los Angeles, the California Court of Appeal affirmed the Superior Court ruling that even though 100% of an entity was sold, a change in ownership did not occur because no one person obtained more than 50% the underlying entity’s membership interests. The Los Angeles County Assessor seemed to have over looked California State Board of Equalization Property Tax Rule 462.180, Example 7, that says a married couple’s interests are not attributed to each other when calculating the 50% threshold. Later John Noguez was arrested for taking bribes from wealthy westside homeowners to pay lower property taxes.

Watch out for the “taint”. If a previous 62(a)(2) (transfer solely a change in the method of holding title and the proportional interests remained the same) exclusion was previously used, there is a change in ownership when more than 50% of the original owner’s interests are cumulatively transferred. If you did not buy the property in an entity and subsequently transferred

the property to an entity using the proportional interest rule, your property is tainted. Had Michael Dell’s sellers purchased the Fairmont Miramar in their names as individuals and later transferred it to Ocean Avenue LLC, Michael Dell’s strategy would not have worked.

Example:

Taking the Michael Dell example, in some circumstances, a parent may be able to transfer real property to her children post Proposition 19. Let’s assume there is no taint, Betty purchased a strip mall in the name of her single member limited liability company long ago. Now Betty, horrified by the reality of Proposition 19, decides to gift her three children half of the membership interest in the LLC that owns the parcel. After the assignments are executed, each child owns a one sixth membership interest in the LLC. Once Betty passes away, since no child obtained over 50% of the membership interest in the LLC, none are in control and there will be no reassessment. The problem with this example is that the kids only get a step-up in cost basis on one half of the property on Betty’s date of death for capital gains tax purposes. The previously inter vivos gifted one half portion receives no step-up in basis on death and thus the children will not be able to take depreciation on half of the property following death.

VII. LIFE ESTATES

A life estate is when a property owner grants someone the right of use, occupancy and control of a property during their lifetime. It is the same thing as ownership except it has an expiration date, the date of the grantor’s death. California Revenue and Taxation Code § 62(e) states:

Any transfer by an instrument whose terms reserve to the transferor an estate for years or an estate for life [is not included in a change in ownership]. However, the termination of such an estate for years or estate for life shall constitute a change in ownership, except as provided in subdivision (d) and in Section 63.x

The exception only applies when the original property owner grants themself (the transferor or their spouse) the right of use, occupancy and control during their lifetime and grants someone else the remainder interest. As such, retained life estates are exempt from reassessment.

Example:

If the parents want to give their home to their kids now and but still want their kids to get a step-up in basis on death, they can transfer the remainder interest in the home to their kids, retain a life estate, still live in the home (or not) 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 under Proposition 19. Gift tax may be due for the initial gift of the remainder interest in the home but perhaps it is better to make that gift at a present remainder value that would be lower than the later appreciated fee simple value at the time of death for estate tax planning purposes.

VIII. TRANSFERS TO AND FROM TRUSTS

Any transfer to or from a revocable/ living/ family trust is exempt from reassessment.xi

Generally, transfers to irrevocable trusts are often exempt. California Revenue and Taxation Code § 61(h) states:

Except as otherwise provided in Section 62, change in ownership, as defined in Section 60, includes, but is not limited to:

(h) Any interests in real property that vest in persons other than the trustor (or, pursuant to Section 63, his or her spouse) when a revocable trust becomes irrevocable.xii

Grantor retained annuity trusts, intentionally defective grantor trusts and charitable remainder trusts are exempted from revaluation provided the trustor-trustee must retain the present right to the income and not another beneficiary. Charitable lead trusts are generally not exempt because under Proposition 19 you can’t transfer commercial real estate to your decedents without a change in ownership.

Bypass trusts and qualified terminable interest trusts are exempt because the surviving spouse is a present income beneficiary. Survivor’s trusts are exempt becuase the surviving spouse has a general power of appointment and the trust is revocable.

California State Board of Equalization Property Tax Rule 462.160 (b)(1)(A) states:

The transfer of real property by the trustor to a trust in which the trustor-transferor is the sole present beneficiary of the trust [is not a change in ownership]. However, a change in ownership of trust property does occur to the extent that persons other than the trustor-transferor are or become present beneficiaries of the trust unless otherwise excluded from change in ownership.xiii

Example:

Armen transfers a parcel in the desert used for mining to an irrevocable trust for the benefit of his children. Result = 100% change in ownership because the present beneficiary is not Armen.

Example:

“Husband and Wife, partners in HW Partnership who are not original co-owners, transfer 70% of their partnership interests to HW Irrevocable Trust and name their four children as the present beneficiaries of the trust with equal shares. Husband and Wife do not retain the reversion. Under Revenue and Taxation Code § 64 (a) the transfer of the partnership interests to HW Irrevocable Trust is excluded from change in ownership because no person or entity obtains a majority ownership interest in the HW Partnership.”xiv

Under California State Board of Equalization Property Tax Rule 462.160 (b)(1)(A) (the sprinkle and spray powers rule) states “Where a trustee of an irrevocable trust has total discretion (“sprinkle power”) to distribute trust income or property to a number of potential beneficiaries, the property is subject to change in ownership, because the trustee could potentially distribute it to a non-excludable beneficiary, unless all of the potential beneficiaries have an available exclusion from change in ownership.”xv If a trustee has the discretion to distribute income and principal to

VIII. TRANSFERS TO AND FROM TRUSTS

Any transfer to or from a revocable/ living/ family trust is exempt from reassessment.xi

Generally, transfers to irrevocable trusts are often exempt. California Revenue and Taxation Code § 61(h) states:

Except as otherwise provided in Section 62, change in ownership, as defined in Section 60, includes, but is not limited to:

(h) Any interests in real property that vest in persons other than the trustor (or, pursuant to Section 63, his or her spouse) when a revocable trust becomes irrevocable.xii

California State Board of Equalization Property Tax Rule 462.160 (b)(1)(A) states:

Example:

Armen transfers a parcel in the desert used for mining to an irrevocable trust for the benefit of his children. Result = 100% change in ownership because the present beneficiary is not Armen.

Example:

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.

Example:

Mama bear and papa bear leave their home in the forest to their eleven cubs and their beloved live-in nanny, Red, who is part of the family, equally. Oh my, that caused a change in ownership because Red was not a child and thus the Proposition 19 parent child exemption does not apply to her. This is because, like most family trusts, Mama bear’s and papa bear’s trust has sprinkle and spray powers meaning the trustee could give a portion of the home to the nanny. If the trust had specified each beneficiary’s gift where the children got the house equally (and otherwise qualified under Proposition 19) and the nanny received other non-home assets, there would not be a change in ownership.

IX. ORIGINAL JOINT TENANTS

Transfers from original joint tenants to new joint tenants or the termination of an original joint tenancy do not create a change in ownership under California Revenue and Taxation Code § 65(b) & (d).

Example:

Allan and Barbara as tenants in common transfer their farm to Allan and Barbara as joint tenants is exempt.

Allan and Barbara as joint tenants transfer their farm to Allan, Barbara, Carl and David as joint tenants is exempt.

Transfers from the new joint tenants back to the original joint tenants are also exempt. To create original joint transferor status, a transaction must occur that either changes title to joint tenancy or adds an additional person to title as one of the joint tenants.

The purchase of property as joint tenants does not create original joint transferor status. The transfer of title to owners who are not joint tenants is not exempt. The death or transfer of the last of the original joint tenant’s interest is a 100% change in ownership.

X. LEASE OF TAX-EXEMPT LAND TO A FOR PROFIT BUSINESS = CHANGE IN OWNERSHIP

California Revenue and Taxation Code § 107(b) states [taxable] “Possessory interests” means the following:

(b) Taxable improvements on tax-exempt land.

As such, real property that is exempt from paying property taxes because it is owned by a governmental entity or because the property tax is abated due to the fact that it is owned by a nonprofit organization, which is leased to a for profit business, is no longer tax exempt. See Host International, Inc. v. County of San Mateo.xvi

XI. LEASE TERMS OF 35 YEARS OR LONGER = CHANGE IN OWNERHSIP

California Revenue and Taxation Code § 62(g) states that a transfer of a lessor’s interest subject to a thirty-five year (including options) term lease is a change in ownership for property tax reassessment purposes.xvii

Example:

Uncle Bernie wants to open a whimsical Moby Dick themed marina at an alpine lake featuring expensive improvements far beyond the tiny tenant improvement allowance his forest service landlord wants to extend. In order to justify the amortization of the whimsical improvements, Uncle Bernie wants to make sure he and his children will have a right to occupy the premises for generations to come. He signs a twenty-year lease that includes three, five year options. Oops, that caused a change a in ownership because the total term of the lease could be 35 years or more.

Example:

Wrather Port Properties, LTD. amended an existing lease to include a sixty-six year lease term with the City of Long Beach to develop the Queen Mary, the Spruce Goose and a marina. Entering into the lease for a for profit business on formerly tax-exempt land was a taxable event per California Revenue and Taxation Code § 107(b). The Los Angeles County Assessor then attempted to levy a second change in ownership due to the long term of the lease. In Wrather Port Properties, LTD. v. County of Los Angeles the California Court of Appeals held that “the dispute in the matter before us is whether, after this initial change in ownership occurs, the automatic extension of the term of possession under a provision of the original lease constitutes a second “change in ownership” thereby triggering a revaluation of the possessory interest in the tax-exempt property” because “in fact, the assessor waited approximately two years before issuing his first valuation of the lease and, when he issued it, he recognized the lease was for a term of 66 years.”xviii The Assessor knew that the lease was going to be amended at the time of the first change in ownership. The Assessor does not get two bites at the apple…

XII. CONCLUSION

Opening up the mail and finding a notice of supplemental assessment can be an unpleasant experience. An experience that could force someone to sell an important asset that their family has cherished for generations. With today’s sky-high fair market values, having a property reassessed to fair market value very well could make the economics of continued ownership untenable. Understanding the tricky real property tax change in ownership rules to assist clients in avoiding real property changes in ownership has higher ramifications today than ever before.

*Thomas F. Caldwell, Caldwell Law, Calabasas, California.

i California Revenue and Taxation Code § 63.1
ii Assembly Constitutional Amendment No. 11 The Home Protection for Seniors, Severely Disabled, Families, and Victims of Wildfire or Natural Disasters Act (2019-2020).
iii California Revenue and Taxation Code § 62(a)(1) and (2).
iv California Revenue and Taxation Code § 64(c)(1).
v Tax Court Memorandum 2001-263.
vi Shuwa Investment Corp. v. County of Los Angeles, 1 Cal.App.4th, 1635 (1991).

vii Id.
viii fn. 5 [1 Cal. App. 4th 1642].
ix Penner v. County of Santa Barbara, 37 Cal. App. 4th 1672 (1995).
x California Revenue and Taxation Code § 62(e).
xi California Revenue and Taxation Code § 62(d).
xii California Revenue and Taxation Code § 61(h).
xiii California State Board of Equalization Property Tax Rule 462.160 (b)(1)(A).
xiv California State Board of Equalization Property Tax Rule 462.160 Example 4.
xv Id.
xvi Host International, Inc. v. County of San Mateo (1973) 35 Cal. App. 3d 286, 289.
xvii California Revenue and Taxation Code § 62(g).
xviii Wrather Port Properties, LTD. v. County of Los Angeles (1989) 209 Cal. App. 3d 517. Synopsis: Avoiding the Pain of Supplemental Property Tax Bills Properly structuring the underlying ownership when taking title and adhering to a very strategic and careful approach to any subsequent changes is pivotal to avoiding mis-steps that can lead to unwanted changes in ownership triggering supplemental property tax bills and permanent increased property tax bills. Examples drawn from actual events illustrate the proper and incorrect ways to go about changing ownership. Author’s Biography: Thomas Caldwell’s clients include national and local investors, funds, developers, operators, syndicators, lenders and tenants. His practice focuses on acquisitions, dispositions, financing, leasing, development, equity investments and syndications. He also represents high net worth families in responsible next generation wealth transfer strategies. Thomas graduated from the University of Colorado, Boulder with a Bachelor of Arts in Business Administration, majoring in finance and minoring in international business. His Juris Doctor degree was obtained from the Pepperdine University School of Law. Additionally, he graduated from Pepperdine University’s Graziadio School of Business Management with a Masters of Business Administration.