Critical considerations now that Proposition 19 has passed
On November 3 2020, California’s electorate passed Proposition 19, a constitutional amendment that substantially restricts property tax benefits for real property inherited by children from parents, while also substantially expanding base-year value transfers of property tax value by persons over 55 and victims of wildfire and natural disasters. This article examines several key considerations now that Proposition 19 has passed.
Other law allowing for reassessment of property for property tax purposes remains in place for now. This includes the ability to avoid reassessment of partnership or LLC real properties until a cumulative change of more than 50% ownership of the entity results or in certain circumstances, when one person acquires majority ownership of the entity. These exemptions are still available as a means to avoid real property reassessment if properly structured and utilized.
a. Principal Residences
Under current law, parents can transfer a principal residence of unlimited value to their children without triggering a reassessment (the “principal residence exclusion”). Proposition 19 imposes new qualifications on this exclusion by:
(1) requiring the child to use the property as the child’s own principal residence, and
(2) limiting the exclusion to just the first $1 million of fair market value.
For example, assume parents own a home with a fair market value of $2 million, but because of Proposition 13, it has an adjusted base-year value of just $500,000.
Under current law, parents can transfer the entire home to their children without triggering a reassessment, and their children would inherit the $500,000 adjusted base-year value. In contrast, with the passage of Proposition 19, then using the same example, only the first $1 million of value would be excluded, and the new adjusted base year value of the property would be $1 million. (See below discussion to understand how the new taxable value is calculated.)
1) Home must be used as a home
As noted, with the passage of Proposition 19, the transferee children are required to use the property as their own principal residence and are required to claim the homeowners’ exemption at the time of the transfer, or no later than one year after the date of transfer. In general, the one-year filing period is beneficial considering that the transferee children may need such time to make their own transfer of a principal residence to their respective children, or to qualify for the IRC §121 election, or simply to move.
For transfers that vest immediately upon the death of a parent (e.g., for properties held in a trust), it is unclear whether the clock for filing the homeowners’ exemption claim starts to run upon the date of death or upon the recording of a deed. Until this ambiguity is clarified, you should assume that the former date controls.
Children can file the homeowners’ exemption claim at the time of transfer on the preliminary change of ownership report by responding “yes” when asked whether the property is “intended as my principal residence” and providing the date of intended occupancy. As a protective measure, even if the children may not immediately use the property as the principal residence but plan to file the claim within the one-year period, it is wise to say ‘yes’ on the form, regardless and to provide an occupancy date not later than one year following execution of the transfer deed.
In some cases, parents gift their principal residence to multiple children, which presents no issue under current law since there’s no requirement that the children reside in the property. Under Proposition 19, it is not clear whether such transfer would continue to qualify for the parent-child exclusion, since in most cases, only one child would use the property as their own principal residence. Further guidance from the Legislature or assessor analysis is needed to clarify this issue.
2) Under the new law, the “Lebowski Loophole” is eradicated
Proposition 19 was inspired by an incident now called the “Lebowski Loophole,” . That reference is to a Los Angeles Times investigation disclosing that actor Jeff Bridges and his siblings inherited a beachfront Malibu home from their parents that they thereafter rented out for $15,995 per month, though the property tax bill was less than half that. Proposition 19 closes the perceived loophole by obligating children to use the property as their own principal residence, thereby preventing any leasing activity.
However, Proposition 19 does not specify what happens if or when the property converts to other uses in the future. What then, are the consequences if the transfer initially qualifies for the principal residence exclusion, but is thereafter converted to other uses (e.g., second home, third-party rentals, etc.)? Unfortunately, Proposition 19 contains no guidance, though a similarly proposed but failed constitutional amendment from this past legislative session would have required the property to be reassessed at its fair market value as of the date of the transfer from the parent – not on the date of conversion of use.
3) Defining “taxable value” and “assessed value”
Proposition 19 requires assessors to calculate the new “taxable value” using the following formula:
New taxable value = “taxable value” + $0 [if the “assessed value” upon the transfer is less than the “taxable value” plus $1 million]; or “taxable value” + [the “assessed value” upon the transfer minus the “taxable value” and minus $1 million (if the “assessed value” upon the transfer is equal to or more than “taxable value” plus $1 million)].
Even for seasoned tax professionals, the formula requires careful analysis. In this context, “taxable value” means the present year adjusted base-year value. In other words, the “taxable value” is simply the property tax value that is stated on the owner’s most recent property tax bill. In the example used above, the taxable value is $500,000.
Additionally, in this context, “assessed value” means “full cash value” – that is, “the appraised value of real property when purchased, newly constructed, or a change of ownership has occurred.” This is frequently measured by fair market value and/or purchase price.1 In other words, “assessed value,” as used in Proposition 19, is fair market value. Again, using the example from above, the assessed value would be $2 million, which is also the fair market value.
The new taxable value, based on this example, would be $1 million (i.e., [$500,000 taxable value] + [$2,000,000 assessed value, minus $500,000 taxable value, and minus $1 million]).
4) Significant questions
As previously noted, Proposition 19 requires assessors to determine the fair market value for each property transferred under the principal residence exclusion, a process that will likely be time-consuming and may produce flawed or imperfect results. As a protective measure, if there is any question that a parent-child transfer has the potential to result in increased property taxes, the transferee child would is advised to obtain a qualified appraisal and be prepared to submit the appraisal to the assessor with the parent-child exclusion application.
Additionally, beginning February 16, 2023, and every year thereafter, Proposition 19 requires that the $1 million “cap” on the principal residence exclusion be adjusted for inflation to reflect the percentage change in the House Price Index (HPI) for California for the prior calendar year. Though it’s unclear whether the $1 million cap is subject to deflation as well, consider that the HPI can be extremely volatile (it deflated by more than 40% between 2006 and 2012, but has since recovered), whereas Proposition 13’s annual increases are based on changes to the Consumer Price Index for California as the inflationary standard.
b. Elimination of the “other property exclusion”
Under current law, in addition to the principal residence exclusion, each parent can also transfer to their children up to $1 million of the adjusted base-year value of any non-principal residence property (e.g., commercial property, second home, rental property, etc.) without triggering a reassessment (the “other property exclusion”). For most property, Proposition 19 eliminates this other property exclusion entirely. Thus, other things being equal, if you were thinking about using the other property exclusion for upcoming transfers to your children, the time to complete those transfers is now.
Note: Prop 19 permits retention of the low taxable value for parent-child transfers of family farms, if the property continues to be used as a farm. Family farms are defined as real property used for pasture, grazing, or agriculture.
1) The Dell Maneuver- taking advantage of legal entities
Proposition 19 does not amend any change of ownership rules for properties owned by legal entities, which generally provide that legal entity interests can be transferred from current owners to new owners without triggering a reassessment (the rules make no distinction among parents, children, and other third parties), subject only to the change of control rule and cumulative co-ownership rules. This legal entity rule is sometimes referred to as the “Dell Maneuver,” in which Michael Dell purchased the Fairmont Miramar Hotel in Santa Monica without triggering a reassessment.
Setting aside the cumulative co-ownership rule, the change of control rule is relatively easy to bypass and thus, when structured correctly, parents may transfer 100% of their legal entity interests (e.g., common stock, and LLC membership or partnership interests) to their children without triggering reassessment, much like the principal residence and other property exclusions previously discussed.
Now that Proposition 19 has become law, individual owners would therefore have an incentive to transfer their property to a legal entity to avoid future reassessment. Additionally, in light of Proposition 19, owners should consider whether it is preferable to transfer recently acquired property into an LLC right now, without claiming any exclusion and therefore resulting in a reassessment, to protect against future reassessment. The incremental increase in property value as a result of such reassessment should be modest (depending on how recent the property was acquired), and the benefit of relaxed legal entity change of ownership rules can be significant. It should be noted that there are regular attempts to close off the Dell Maneuver legislatively, but none have succeeded to date.
Utilizing a combination of LLCS and irrevocable trusts can avoid or minimize the effects of Proposition 19 to some or even a great extent.
c. Increased portability for persons over age 55 and wildfire/natural disaster victims
Proposition 19’s other major changes expand base-year value transfers from an original to a replacement dwelling for persons over age 55 and victims of wildfires and natural disasters (i.e., “portability”). Under current law, portability is somewhat limited in that eligible claimants can only make one transfer per lifetime, only in the same county or in the 10 counties that permit intercounty transfers, and only where the purchase price of the replacement property is equal to or less than the purchase price of the original property.
Proposition 19 substantially removes each of these barriers in that eligible claimants are able to make three transfers per lifetime, in any county, and even where the purchase price of the replacement property is greater than the purchase price of the original property. In the latter case, the new taxable value would be equal to that of the replacement property, plus the difference in value between the sales price of the original property and the sales price of the replacement property.
d. When the change takes effect
Proposition 19 takes effect on February 16, 2021 (as to the parent-child exclusion changes), and April 1, 2021 (as to the revised portability changes).
While the natural response may be to utilize the parent-child exclusions before they are amended and eliminated, we need to analyze whether the loss of other potential tax savings outweigh the benefit of a transfer under current law. For example, if parents transfer highly appreciated property to their children now, rather than upon death, then the children would not benefit from step-up in basis rules, which could be more valuable if the property will be sold.
Now that Proposition 19 has passed, parents with real estate will want to consider whether to take action ahead of the effective dates in early 2021. Since the implementing provisions for Proposition 19 have not yet been prepared, we should anticipate uncertainty in the near term, while new forms, reporting mechanisms, and overall implementation issues are resolved.
About the Author
D. Steven Yahnian has been a member of the California Bar and a practicing Attorney since 1980. He has also been a California CPA since 1984. Mr. Yahnian also holds the CFP® designation.
Mr. Yahnian practices in the following areas of law through YAHNIAN LAW CORPORATION:
- Estate Planning & Administration
- Asset Protection Planning
- Tax Planning, Tax Debt Resolution and Tax Litigation
- Business & Corporate Law and Planning
- Real Property Law & Planning
As a CPA/CFP, Mr. Yahnian also has a separate accounting and tax return preparation practice called DSA ACCOUNTING.
Mr. Yahnian is a California State Bar Certified Specialist in the following
• Taxation Law and
• Estate Planning, Trust & Probate Law.
Mr. Yahnian received a B.S. degree in Accounting from USC, a J.D. from Loyola University of Los Angeles School of Law and an LL.M. in Taxation from New York University Law School. He also has a Certificate in Taxation from UCLA (with distinction). Mr. Yahnian also has an MS in Taxation* from UCLA (with Distinction).
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