Succession Planning Part 4: Succession, California Style, or How Prop 13 Affects Everything

When people work on their succession planning, estate taxes loom large in their minds.  We all worry that paying the estate tax will break the business and try to plan accordingly.  This may be the least of our problems, at least in California.  An estate tax is a one-time deal; but a change in property taxation will come back every year to bite you all over again.

Proposition 13 established a property tax rules that are unique to California, and these rules, and their modification under Proposition 58 will affect us in ways that most of us have never factored into our plans.

First, let’s review the provisions of Props 13 and 58 and how they work for you.  Then we’ll go through some examples of how they don’t work for you in a succession scenario if you don’t prepare.

Proposition 13 limits ad valorem property tax rates at 1% of the property’s value at the time of acquisition, with an annual increase cap of up to 2% per year thereafter.  The property is only reassessed for tax purposes when it changes ownership, when the tax becomes reset to 1% of the newly assessed market value of the property.  Reassessment can also take place after completion of a development project like building or remodeling a house.

Briefly, once you buy your property, your property tax will only increase by 2 percent per year thereafter.

Proposition 58 (*) amended this scheme for certain property transfer arrangements.  The following situations are excluded from reassessment when property is transferred:

• Transfers between spouses
• Transfers to Revocable Living Trusts
• Transfers of a Residence Between Parents and Children
• Certain Transfers of Non-residence Between Parents and Children (limited to $1 million dollars in assessed value per parent)

Proposition 193 (**) did the same thing for grandparent/grandchild property transfers if the following conditions are met:

• Both parents of the grandchild are deceased.
• The real estate in question is a principal residence.
• The exemption also applies to the first $1 million of other property.
• Grandchildren are not be eligible to receive the exemption if they have already benefited from a purchase or transfer that was similarly exempt from reappraisal.

Please note that both lists above have different requirements for transfers of a residence versus transfers of investment property.  Many of us have our houses on our forestland.  This means we need to define which portion of the property is dedicated to the residence and which portion is the investment property.

Please also note that transfers from sibling to sibling are NOT excluded from reassessment.  This means the succession planner needs to put some effort before the transfer into ensuring that siblings will not be put in a situation where they must buy each other out.

Why is this such a big deal?

Let’s look at an example.  Bill Jones and his wife, Mary, bought property in 1980 and built a house on the property.  They completed the work in 1982.  The tax appraiser assessed the house and property at $200,000, giving them a base property tax of $2,000 per year.  They raised a family with two children, John and Cathy, and 25 years later, in 2007, they die in a car crash, leaving everything to the children equally.

We have a nice, neat parent-to-child transfer at this point.  If the property remains in the keeping of both children, the annual property tax would be in the vicinity of $3,300 dollars per year, an affordable amount.

As the estate is settled, it turns out that Cathy has no interest in keeping her share of the family property and she agrees to sell her portion to John, who is eager to continue the family business.  This is a sibling-to-sibling transfer and it is NOT excluded from reassessment.  The property has increased in value significantly over 25 years and is now appraised at $2.5 million dollars.  The annual property tax, after reassessment, is now a whopping $25,000 per year.  John now has this additional annual tax burden on top of paying off his sister, which will put a significant strain on the business’s finances.

Think about your own land – could your heirs manage to pay this sort of property taxes if you don’t arrange to pass title on correctly?  Remember, many of us only see income from our property every ten years.

What are you to do in your planning process to prevent or minimize this problem?

1.  Know your heirs and their desires.  If you know one or more of your heirs are not interested in your land, arrange your estate such that they inherit other forms of property.  Give your land to the heir who wants it and can successfully manage it.

2.  Transfer title to your land to another form of business entity, like a trust, a partnership or a corporation.  There are advantages and disadvantages to each of these business entities.  Today, we will focus on just the property tax aspect and leave the other factors for future articles.

Sole Proprietorship – When the original owner retires or dies, this will trigger a change of ownership and a reassessment if Prop 58 or Prop 193 rules cannot be applied.

Joint Ownership/Tenancy and Partnerships – Reassessment will be triggered when over 50% of the original ownership changes unless Prop 58 or Prop 193 rules can be applied.  For Limited Partnerships, a change of who comprises 50% or more of the general partners will trigger a reassessment.

Trust – Revocable Living Trusts are a common way of setting up estates to facilitate the transfer to the heirs.  The selling point that most people are aware of is the avoidance of probate and the privacy of the execution of the trust.  There is another factor that is particularly pertinent to real estate transfers – the grantors of the trust can deed the property to a revocable living trust without triggering a reassessment and thereafter, the trust is the owner of the property.  The people behind the trust, the grantors, the trustees and the beneficiaries, do not own the property outright after the property has been transferred into the trust.  There are many kinds of trusts and a tremendous amount of flexibility in how they are constructed.  The best way to shelter your property from reassessment may be to place it in a trust and never take it out again.  We strongly recommend that your trust gets reviewed by a competent trust/estate lawyer to make sure you know and understand any circumstances that will trigger a reassessment of your property after it is in the trust, as well as ensuring that the future beneficiaries of the trust retain enough flexibility to meet their personal goals as well as those of the family as a whole.

Corporation – Corporations are created to shield the owners of a business from having their personal assets taken from them in a business liability suit and to provide a mechanism for several people to have ownership shares in the company.  Corporations can own real estate.  They also require a lot of formal documentation and have regular reporting requirements to the state.  California law requires a minimum of $800 per year in corporate tax regardless of whether or not the corporation earned any income that year, making them an expensive option as well.

Limited Liability Company – This entity is a hybrid composed of attributes found in partnerships and corporations.  It does not require as much reporting or as strict a structure as a corporation, but it can be formatted in a wide array of structures to meet the needs of the members and the business.  The LLC is also subject to the $800 minimum tax per year that a corporation faces.

As always, be sure to have your succession plans and estate arrangements reviewed by an estate lawyer and be prepared to revisit it regularly.  Even if your family circumstances don’t change, the legal and tax environment surrounding you can, and you don’t want to have your property organized under obsolete laws.  And be sure to ask whether your arrangements will trigger a property reassessment.

(*) Details on Proposition 58 provisions and transfer filing requirements can be found at:

https://www.sccassessor.org/index.php/tax-savings/transferring-your-assessed-value/parent-to-child

(**) Details on Proposition 193 can be found at: http://ballotpedia.org/California_Proposition_193,_Tax_Implications_of_Grandparent-Grandchild_Property_Transfers_(1996)