Property Tax Considerations in Succession and Estate Plans

AUTHOR: MARGARET S. NG

PUBLISHED: 10/18/16

In California, property owners can pass certain real property to their children without increasing property taxes. However, few people incorporate property tax considerations into their succession planning. In this article, we discuss the potential techniques as well as pitfalls to consider when transferring California real property in succession planning.

BACKGROUND ON PROPOSITION 13

Proposition 13 (“Prop 13”) was passed in California in 1978 and freezes the assessed (or taxable) value of California real property at the fair market value of the property as of the purchase date (or in the case of property that was purchased prior to 1978, the fair market value of the property as of March 1, 1975). However, Prop 13 permits county assessors to reassess the value of any portion of real property on which new construction is completed. County assessors are also permitted under Prop 13 to increase the assessed values of real property to an inflation factor not to exceed 2% each year.

Efficient Use of Parent-Child Exclusion from Reassessment

Consider which real property is your principal residence. Transfers of principal residences from parents to children are exempt from reassessments under Prop 13. There are many factors in establishing which home is your principal residence. However, if you are fortunate enough to own more than one residence in California, you should consider which home would best qualify as your principal residence and when such transfer should be made to your children. Note that there is no limit on the number of times the principal residence exclusion may be applied; however, a property owner can only have one principal residence at any given time.

Consider appreciation of real property when electing to apply the $1 million parent-child exclusion. In addition to exempt transfers of principal residences, transfers of additional real property up to $1 million in assessed value (“$1 Million Exclusion”) from parents to children are also excluded from reassessment. The $1 Million Exclusion on transfers of additional real property is based on the assessed value at the time of transfer, not the fair market value, of the transferred property. If a property owner owns more than one property which is not a principal residence, it is important to consider which real property(ies) would benefit the most from the application of the $1 Million Exclusion. Generally, the property(ies) that have appreciated in value the most since acquisition would benefit the most from the application of the $1 Million Exclusion.

Acquiring & Holding Real Property in LLCs ( & other Legal Entities)

Holding investment or commercial real property in a limited liability company (“LLC”) or other legal entity affords liability protection for the property owner. However, parent-to-child transfers of real property held in legal entities are not excluded from reassessment.  Consider holding the real property in the LLC until an imminent transfer of the real property to your children is certain. Instead of transferring your ownership interest in the LLC or legal entity to your children, consider first conveying the property to your individual name and then transferring the property to your children, thereby allowing you to take advantage of the parent-child exclusion from reassessment.  It is not always predictable when a transfer is imminent, such as in the case of an unexpected death of the property owner. Caution should be taken to ensure the sequence and the manner in which the transfers take place, so as not to trigger a reassessment.

Consider the manner in which real property is acquired by a legal entity. If you intend to acquire and own real property in an LLC or other legal entity, it may be beneficial to have the legal entity take title to the property directly from the seller upon the purchase of the property. By having the LLC take title directly, a subsequent transfer of the LLC interests to two (2) or more children (or other transferee(s)) may not trigger a reassessment so long as no one transferee obtains more than a fifty percent (50%) ownership interest of the LLC. For instance, if you acquire real property directly through your wholly-owned LLC and eventually transfer one hundred percent (100%) of the LLC interests to two (2) children, so long as neither of them receives more than fifty percent (50%) of the LLC interests, the property should, generally, not be reassessed under the current law.

Conversion and Mergers of Legal Entities Holding Real Property

Plan conversions or mergers of legal entities with property taxes in mind. Oftentimes property owners desire to convert older general partnerships to limited partnerships or limited liability companies. Typically, the conversion requires filing certain forms with the Secretary of State. Unknowingly, property owners will record a deed transferring the real property to the newly converted entity. The transfer of any real property from the old entity to the new entity should be avoided. Recording transfer deeds from the old legal entity to the newly converted legal entity could subject the real property to “change in ownership” rules that may not previously apply.

To illustrate this point, think of a real property that was acquired by a general partnership before 1975 and the partnership was subsequently converted to an LLC. At the request of a lender or a title company, the property owner records a deed transferring the property from the old general partnership to the converted LLC. This transfer is intended only to affirm title in the new entity’s name; however, for property tax purposes, the recording of such transfer could subject the LLC to “change in ownership” rules that did not apply to a pre-1975 general partnership, which could ultimately result in a reassessment of the property that could have been avoided.

Trust & Wills

Consider how real property is allocated in your trust document or will. Oftentimes parents, intending to be equitable, will direct assets to be distributed equally among their children. Their trust documents or last wills may not provide the trustee or executor sufficient flexibility to allocate one real property to one child while leaving assets of equal value to another child. Without the appropriate language giving a trustee or executor sufficient discretion in the trust document or will, a non-pro rata distribution of real property could be deemed a sibling-to-sibling transfer and partially disqualify the transferred real property from any applicable parent-child reassessment exclusion. It is important that the trust document or the last will contain appropriate language to give the trustee or executor flexibility to make non-prorata distributions in order to optimize any applicable parent-child exclusion for transfers of real property. 

Conclusion

Real property can be held and transferred in various ways. Prop 13 affords protections from reassessment for California real property owners. With careful planning at each stage of property ownership and succession planning, Prop 13 protections can be extended to future generations. While there has been some support to overhaul the current property tax framework in California to a split roll system, in which non-residential and residential properties are treated differently, the proposal has not yet gained sufficient traction.  It remains to be seen whether a split-roll proposal will pass in legislative or referendum form.  In the meantime, thought and consideration given to property taxes in succession planning may prove extremely beneficial for the next generation.

  It is important that the trust document or the last will contain appropriate language to give the trustee or executor flexibility to make non-prorata distributions in order to optimize any applicable parent-child exclusion for transfers of real property.  

Disclaimer

This article is intended to convey general information only and not to provide legal advice or opinions.  The contents of this article, should not be construed as, and should not be relied upon for, legal or tax advice in any particular circumstance or fact situation.  The information presented in this article at the time of print or online publication may not reflect the most current legal developments.   An attorney should be contacted for advice on specific legal issues.

ABOUT AUTHOR:

Margaret S. Ng specializes in corporate transaction, taxation and estate planning matters. She advises clients in a variety of business transactions, including corporate restructures, mergers and acquisitions, debt and equity offerings and real estate transactions. She has represented individuals, partnerships, small and mid-size businesses, and national companies from a variety of industries including manufacturing, real estate, agriculture, technology, medical device, professional services, retail and food service..


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