What’s the Deal with Prop 19?
What is Prop 19?
As most estate planners can attest, California Proposition 19, or Prop 19, caused a whirlwind of calls and emails from worried property owners in the beginning of the year. Prop 19 passed in the November 2020 general election.
Prop 19 did two things: (1) allowed for older and/or disabled homeowners to transfer their property tax basis to a new property within the state; and (2) substantially changed the rules for intergenerational property transfers. Along with Prop 19 came controversy, almost exclusively reserved for the second part of Prop 19, intergenerational transfers.
How Did Prop 19 Change Intergenerational Transfers?
Prior to Prop 19, under Prop 58, parents could transfer their primary residence to their children and exclude the transfer from a property tax reassessment.[1] Parents could also transfer additional properties to the children and exclude them from reassessment, with caps on the value of the excluded transfers.[2] Any transfers that occurred prior to Prop 19, effective February 16, 2021,[3] fall under the Prop 58 rules.
Prop 19 drastically changed the rules for transfers from parents to children. Parents can no longer exclude from reassessment transfers of property other than the parents’ primary residence.[4] The only parent-child transfers that are eligible for the exclusion from reassessment is the transfer of the parents’ primary residence or family farm, with strict limitations. To qualify for the exclusion, the property must transfer to a child or children, a child must also make the home their primary residence, and the exclusion is limited to the assessed value of the family home plus $1,000,000.[5] Given many families in California own more than one property, Prop 19 threw a wrench into their estate planning with regards to minimizing property tax reassessments upon transfers to next generations.
To illustrate the impact of Prop 19, consider the following example: Parent owns two properties: her primary residence and a vacation home. She and her deceased spouse bought the properties over 30 years ago. Each property cost $300,000 (“factored base year value”) and she plans on leaving the properties to her two children upon her death. On parent’s death, the primary residence’s fair market value is $1,500,000 and the vacation home’s fair market value is $1,200,000.
Since Prop 19 no longer has an exclusion for the vacation home, the children will receive the vacation home, but the property will be fully reassessed. For the primary residence, we need to do some math to determine the “combined base year value” for property tax purposes:
Calculate the sum of factored base year value plus $1,000,000:
$300,000 + $1,000,000 = $1,300,000
Calculate the difference between fair market value and factored base year value plus $1,000,000:
$1,500,000 – $1,300,000 = $200,000
Add the difference to factored base year value.
$200,000 + $300,000 = $500,000
New combined base year value: $500,000
The children will receive parent’s residence but will now pay property taxes based on the new combined base year value of $500,000. The additional property taxes paid by the children will total thousands of dollars per year more under Prop 19.
Given the impact of Prop 19, many are looking for planning options to transfer property to their children while mitigating the property tax reassessments.
Are Legal Entities an Option to Avoid the Impact of Prop 19?
The short answer is yes, using legal entities in a Post Prop 19 world, continues to be a viable option to transfer at least some of the property to others. Legal entities is primarily a technique used for investment properties. Using legal entities for a primary residence may have adverse tax consequences that should be analyzed.
Separate property tax rules pertain to transfers of any interest in real property to a corporation, partnership, limited liability company, or other legal entity.[6] The rules are intricate and can be complicated; legal guidance is strongly recommended to ensure rules are not triggered inadvertently. In sum for planning purposes: one can transfer up to 50% of the legal entity that owns real property without triggering a property tax reassessment. This assumes no owner of the entity gains a controlling interest. Provided the transfer avoids a change in control in the entity, the transfer also avoids the change in ownership for property tax purposes.
Consider this illustration of the technique: Parents own two rental properties. Both properties are titled in the parents’ revocable trust. Parents establish new limited liability companies (LLCs), one for each property. The parents also contribute each property to the respective LLC. Parents then gift 50% of each LLC to their only child. After the gift, parents own 50% of each LLC and the child owns 50% of each LLC. A few years later, parents and child decide to dissolve the LLCs. After dissolution, parents own 50% of each property and child owns the other 50%. If parents do no other planning, upon their deaths, when child inherits the other 50% of the properties, the property tax reassessment will be limited to the 50% that the parents owned upon their deaths. By using the legal entity rules, the family was able to mitigate the property tax reassessment to 50% of the properties’ value.
Conclusion
Prop 19 has substantially changed the game with respect to planning for intergenerational property transfers in California. Mitigating the impact of Prop 19 for families has become a key planning objective that requires careful understanding of the property tax rules. Guidance from qualified attorneys is strongly recommended, especially if employing the use of legal entities in the plan.
Given the strong backlash that Prop 19 has received, there is a chance Prop 19 may not stick around for long. Maybe a new initiative will be put forth soon in front of the California voters to change the property tax rules once again. Stay tuned.
[1] Revenue & Taxation Code §63.1
[2] Id.
[3] State Board of Equalization, Letters to Assessors, No. 2020/061, December 11, 2020, p. 1.
[4] State Board of Equalization, Letters to Assessors, No. 2021/008, February 16, 2021, p. 3.
[5] See California Code of Regulations, Title 18, Section 462.520 (Proposed).
[6] See State Board of Equalization, Property Tax Rule 462.180