Estate-planning is often focused on reducing or eliminating estate tax at death. As the estate-tax exemption has increased in recent years — currently $5.45 million and counting — there is a shift to planning for income and property taxes. For individuals with significant real property holdings, allowing their heirs to retain low assessed property-tax value is an important objective.
CALIFORNIA PROPERTY TAX
Property-tax increases are limited to 2 percent annually, until reassessment. Property is reassessed, or reset to its fair-market value, when it is transferred, either during lifetime or at death. Minimizing property-tax reassessment at death is important if the heirs intend to retain the real property.
If the heirs plan on selling the property, then planning to minimize property-tax reassessment is less important. Also, if a property has been purchased recently and has an assessed value relatively close to fair-market value, it may be less important to preserve the property-tax assessed value.
Keep in mind these basics concepts of California property-tax law:
Transfers of property to spouses qualify for exclusion from reassessment regardless of the amount or type of property transferred.
Parents can transfer interests in real property to their children without a reassessment for their primary residence, and up to $1 million per parent of assessed value — not fair-market value — of other real property.
The parent-child exclusion applies for both lifetime and testamentary transfers. Transfers to trusts for the sole benefit of children qualify for the parent-child exclusion. If grandchildren or other relatives are the beneficiaries of those trusts, the parent-child exclusion cannot be used.
Transfers of interests in legal entities do not qualify for the parent-child exclusion, but are not subject to reassessment, until more than 50 percent of the ownership of that legal entity is cumulatively transferred. At that point, the entire real property interest owned by the legal entity is reassessed.
WAYS TO STRUCTURE OWNERSHIP
Here are some of the options for the structuring the ownership of real property and their effect on property tax:
Real property can be simply owned outside of a legal entity. This structure allows the use of $1 million of parent-child exclusion from reassessment for transfers during life and at death but once each parent’s parent-child exclusion is exhausted, the remaining interests are reassessed. If there is no need for maintaining a legal entity, but the property is owned with other owners, there might still a need for organized control.
In that case, a tenants-in-common agreement is recommended. One considerable downside is the lack of liability protection, exposing the owner to any liabilities related to the real property.
Another option is to own the property in an entity and to accept that there will be a reassessment of real property when a transfer of greater than 50 percent in the entity occurs. There could be business reasons why the property must be held in an entity and the owner is willing to accept reassessment as a cost of retaining those benefits. If the reassessment event can be planned for in the business model, the successor owners may be able to weather the increase in property tax without interruption to the business.
Transferring interests in entities or real property before death can minimize or eliminate reassessment. The owner could transfer interests in the real property, outside of a legal entity, to his or her chosen beneficiaries. Assuming that these are the children of the owner, such transfers will utilize the owner’s $1 million parent-child exclusion and retain the original property tax basis in the property. The gifts could be made to trusts for the children’s benefit with the owner serving as trustee, thereby retaining a degree of control over the real property.
Once the owner has transferred more than 50 percent of the real property (so that the owner now owns less than 50 percent), all interests in the property are contributed to a legal entity. At the owner’s death, the remaining interest in the legal entity can then be transferred to the children, without reassessment, and without the use of any further parent-child exclusion, allowing that exclusion to be used on other properties that are not held inside of legal entities.
There are other versions of this structure that involve more aggressive transfers which meld the rules regarding parent-child exclusion and legal entities. The State Board of Equalization has grumbled that these alternate structures violate the step-transaction doctrine and the BOE is inclined to challenge their validity so caution should be used in going outside the more tried and true techniques.
As you can see, how one structures real property ownership determines how reassessment will apply at death. There are ways to plan and control this reassessment, and real property owners should pay close attention to ensure that their heirs are protected from any unnecessary property-tax reassessments.
Daniel Vermillion (firstname.lastname@example.org) is a senior associate in the Family Wealth Group at Farella Braun + Martel LLP, a law firm with offices in San Francisco and St. Helena.