Settlement Agreements: Avoiding a Real Property Tax Reassessment

In California, the major assets of a trust are often real property. More commonly than not, children do not wish to jointly own property with their siblings, which can lead to litigation. However, if the disputes can be settled, practitioners drafting a settlement agreement involving real property must consider tax implications involving the transfer of real property. In this context, the attorney must be aware of the potential for reassessment and liability of the trustee stemming therefrom.

I. Property Tax Reassessment

In California, the property tax basis is determined by the purchase price, plus improvements and annual increases.¹ In 1978, California adopted Proposition 13, which states that taxes on real property shall not exceed 1% of the full cash value of such property.² Under Proposition 13, properties are reassessed only upon a change in ownership. A “change in ownership” occurs when any portion of the real property changes hands, which includes a sale, a gift, or a death.³ In the trust context, while alive, a trustor is the owner of the real property.

However, upon the death of the trustor, at the point the revocable trust becomes irrevocable, the interest in the real property, which vests in persons other than the trustor, can trigger a reassessment.⁴ A reassessment event results in a reappraisal of the real property as of the date of the change in ownership and establishes a new base year value.⁵ As such, depending on the date the “change of ownership” occurs, similar properties can have substantially different assessed values.

In 1986, California amended Proposition 13 to permit exclusions of transfers of real property between parent(s) and child(ren) from being reassessed.⁶ If a claim for reassessment exclusion is filed, the transfer of principal residence is exempted regardless of the current value of the real property. Additionally, a parent can transfer to his children property with an assessed value of $1,000,000 of real property without reassessment even though the aggregate fair market value may be substantially more than $1,000,000.⁷ A principal residence is defined as “a dwelling that is eligible for a homeowners’ exemption … as a result of the transferor’s ownership and occupation of the dwelling.”⁸ Basically, the principal residence is the real property that the trustor owned and used as his residence and has filed a homeowner’s exemption.⁹

As of 2016, Alameda County and Contra Costa County collected an average of $6,402 and $5,898 in property taxes, respectively.¹⁰ If the current value of the real property is more than the previously assessed value of the real property, when change of ownership occurs, the property taxes will increase.

II. Settlement Agreements & Non-Pro Rata Distribution

Non-pro rata distributions have an increased risk of reassessment, if not executed properly. A pro rata distribution is one where each beneficiary takes the same interest in each asset of the trust.¹¹ Conversely, a non-pro rata distribution occurs when each child receives an equal proportion of the entire estate, but not necessarily an equal share of each asset.¹² Due to the nature of litigation, settlement negotiations of trust litigation often result in one of the children’s interest in the principal residence being satisfied using the other assets of the trust or being bought out, resulting in a non-pro rata distribution.

For the former option, the trustee may distribute the principal residence to one child and distribute the other real property and/or other assets to the other child of equal value.¹³ In order to qualify for the parent-child transfer, the other assets in the trust must be sufficient to equal the child’s interest in the principal residence.¹⁴ If the value of the property exceeds the value of the remaining assets in the estate, all or part of the principal residence may still be subject to the reassessment. Any excess interest in the real property is considered to be coming from the sibling.¹⁵ The portion of the property resulting from the sibling-to-sibling transfer may be subject to reassessment.

With continuing increases in property values in California, the principal residence makes up the majority of the trust value, so a buyout may be the only option. In this context, to avoid reassessment in a buyout scenario, the trustee may secure a loan against the principal residence from a third party lender, which is distributed to the other child.¹⁶ Then, the encumbered real property is conveyed to the children who are to obtain ownership.¹⁷ It is critical that the loan not be obtained by any of the beneficiaries of the real property. This type of loan is considered payment for the interest in the real property and disqualifies the property from the parent-child exclusion.

III. Reducing the Trustee’s Liability

Practitioners must consider whether the trustee is authorized to make such a settlement and what steps to take to protect the trustee from future liability. The trustee has the duty to administer the trust according terms of the trust, and if not inconsistent, trust law.¹⁸ Courts also recognize that the trustee has implied powers, which allow the trustee to perform acts that are proper for making the trust effectual.¹⁹

Because the Probate Code permits the trustee to make non-pro rata distributions pursuant to any written agreement²⁰ and to encumber or mortgage trust property,²¹ unless expressly prohibited by the trust, the trustee may perform the above-described actions. Any deviation from the terms of the trust may be considered a breach of trust.²²

In the abundance of caution, prior to taking action, the trustee should seek the court’s approval of the settlement agreement. Although a trustee can obtain written consent of all beneficiaries of the trust,²³ court approval provides the best protection. The court’s approval is based on whether it is for the best interest of the trust and its beneficiaries.²⁴ Absent fraud, conspiracy or material misrepresentation in its procurement, a final court order releases the trustee in connection with the action approved.²⁵

Moreover, the Board of Equalization has opined that a court order supersedes the will or trust and the above-described transfers will qualify for the parent-child exclusion under Section 63.1.²⁶ This is not applicable to intestate succession.

V. Conclusion

Although this process is time consuming and delays distribution to the beneficiaries, it is beneficial in matters of high import like the proper transfer of real property. Because the estate tax exclusion amount increased to $5,450,000 in 2016, preserving the current assessed property tax value of real property may be the only tax consideration in executing the settlement agreement. Unlike the estate tax, which is a one-time payment, property tax is an annual payment for which any misstep could have implications for generations to come.

[1] See Revenue and Taxation Code § 51
[2] Article XIII A of the California Constitution
[3] See Revenue and Taxation Code § 60
[4] Id.
[5] Title 18, section 462.001 of the California Code of Regulations
[6] Revenue and Taxation Code § 63.1.
[7] Revenue and Taxation Code § 63.1, subd, (b)(2).
[8] Revenue and Taxation Code § 63.1, subd, (b)(1).
[9] Revenue and Taxation Code § 218
[10] Id.
[11] Probate Code § 16246.
[12] Id.
[13] State Board letter to County Assessors dated February 29, 2008.
[14] Id.
[15] Id.
[16] Id.
[17] Id.
[18] Probate Code § 16000
[19] Wood v. American Nat. Bank (1932) 125 Cal.App. 2d 248.
[20] Probate Code § 16246.
[21] Probate Code § 16228.
[22] Estate of Gilmaker (1964) 226 Cal. App. 2d 658, 663.
[23] Probate Code § 16463.
[24] Weil and Brown, California Practice Guide: Probate, 14:284 (The Rutter Group 2016)
[25] Probate Code § 7250
[26] State Board letter to County Assessors dated March 27, 2013.