When dealing with a death in the family and administering assets of the deceased family member, the county-level property tax reassessment rules for transfers of California real estate are often overlooked. Generally, the taxable value on which the property tax is assessed is adjusted to market value when a transfer (e.g., bequest, gift, sale, etc.) occurs. However, there are exceptions to every rule. One exception to the market value increase adjustment is the “parent-child exclusion” under California Prop. 58.
Prop. 58 excludes the following transfers between parents and children from reassessment:
- no dollar limitation for transfers of principal residence owned directly by transferor (i.e., parent, child or certain trusts); and
- $1 million limit on taxable value immediately before transfer of real property, other than principal residence, owned directly by transferor (i.e., parent, child or certain trusts).
A similar exclusion is available for transfers between grandparent and grandchildren as well. However, transfers between siblings or other family members are not excludable from reassessment. Although not within the scope of this article, also bear in mind that if the real estate is owned by a legal entity (e.g., corporation, partnership, limited liability company, etc.), there are additional rules that govern such situations.
With these ground rules, we have provided some examples to illustrate pitfalls and how you can plan around them. P, a single parent of two children, owns a home through her Revocable Living Trust (RLT) that she purchased 30 years ago for $100,000. D and S, P’s children, are equal beneficiaries of her RLT. P dies on January 1, 2017 with the home being her only asset valued at $1 million. One year after P’s death, the home, having appreciated to $1.2 million, is ready to be distributed from the RLT to D and S and they contemplate various options to achieve the best outcome. For purposes of this example, we will assume that P’s property tax is $1,000 per year (i.e., $100,000 taxable value, multiplied by an assumed property tax rate of 1 percent).
Scenario 1 – Good result, but often difficult to achieve…
Initially, D and S both agree to convert the home to a rental property and consider having RLT distribute the property to D and S. Since this qualifies under the parent-child exclusion, D and S inherit P’s taxable value of $100,000 for property tax purposes. Furthermore, such a transfer would not be a taxable event for income tax purposes. As a result, this transaction would not cause any additional cash outlays other than the $1,000 annual property tax that carries over from P to D and S. This is the optimal outcome since both property tax reassessment and income tax events are avoided. However, after sleeping on it, S does not want to deal with the headaches of being a landlord and now wants to sell the home.
Scenario 2 – Bad result…
Although S now wants to sell the home, D still wants to keep it. So they contemplate the idea of RLT distributing the home to D and S and S subsequently selling his 1/2 interest to D for $600,000 (i.e., S’ share of the $1.2 million market value). Although D’s 1/2 interest inherited from RLT qualifies for the parent-child exclusion, the portion D purchased from S does not qualify, since this is treated as a transfer amongst siblings. As a result, the property tax bill, originally $1,000 per year, is now $6,500 per year (i.e., $600,000 market value for S’ share, multiplied by a property tax rate of 1 percent, plus D’s 1/2 share of P’s original property tax of $500). Furthermore, S is subject to income tax on the sale of his 1/2 interest in the home to D, which was sold for a $100,000 gain (i.e., $600,000 sales price minus $500,000, which represent S’ 1/2 share of the value on P’s death). Assuming a 30 percent effective income tax rate, this would be an additional $30,000 one-time cash outlay. This is not a great result because of the property tax reassessment and income tax hit on S’ share.
Scenario 3 – Another bad result…
In an effort to avoid the costs of Scenario 2, they now contemplate the idea of D buying the home directly from RLT instead. D will pay RLT $1.2 million in exchange for the home. By doing so, D is able to keep P’s $1,000 annual property tax outlay and protect the home from reassessment. However, assuming the same 30 percent effective income tax rate used in Scenario 2, RLT must now pay $60,000 of income tax on $200,000 of taxable gain (i.e., $1.2 million sales price minus the $1 million value at P’s death). Assuming D has money to buy the home, perhaps this is a better outcome than Scenario 2 if the present value of the annual property tax savings (i.e., savings of $5,500 per year until property is sold) outweighs the additional income tax cost, but certainly not the most optimal outcome as we saw in Scenario 1.
Scenario 4 – Solution…
So how can D and S achieve the Scenario 1 outcome if S still wants to sell while D wants to hold? Fortunately, RLT is able to secure a third-party lender to obtain a $600,000 loan with the home serving as collateral. By providing RLT with this liquidity, it can now grant the wishes of both D and S by distributing $600,000 of the cash to S and transferring the remaining $1.2 million home along with the $600,000 debt to D. By doing so, the home is fully excluded from property tax reassessment through the parent-child exclusion, a savings of $5,500 per year in property tax. Furthermore, RLT avoids the $30,000 to $60,000 income tax hit described in Scenarios 2 and 3 since this is not treated as a sale for income tax purposes.
Through the above rudimentary examples, you can see that the application of the parent-child exclusion can result in widely different outcomes. The key to achieving the most favorable outcome requires careful planning and proper execution, which includes navigating through many traps we did not discuss above that are often overlooked by unwary taxpayers.
Please reach out to your Squar Milner Tax Advisor at 949.222.2999, to discuss in more detail.