California Proposition 19’s Impact on Estate Planning and Gifting of Real Property
California Proposition 19, a constitutional amendment for property tax transfers and exemptions, was approved by voters during the November 2020 election. This is the most dramatic change to property tax protections since Proposition 13 was passed in 1978. Property owners need to understand the property tax consequences of Proposition 19 and how it will impact families across California.
Proposition 19 primarily concerns two groups of California property owners. Proposition 19 provides a property tax break for homeowners age 55 or older, disabled persons, or victims of wildfire or natural disaster. These persons may transfer their primary residence’s taxable value[1] to a replacement residence of equal or lesser value, if they relocate anywhere within California.
If the replacement primary residence is worth more than the original residence, the taxable value of the replacement property is increased by the difference between the full cash value of the new primary residence and the original primary residence. The ability to transfer the taxable value of a primary residence may be utilized up to three times.
This tax advantage comes at the expense of the second group of taxpayers, the children (or qualified grandchildren) who receive California real property by gift or bequest. Generally, a property’s taxable value is reassessed based on the property’s fair market value at the time of transfer. However, the pre-Prop-19 rules allow for the transfer of real property between parents and children (or qualified grandchildren) without a reassessment in property tax. This exemption allows parents to transfer a primary residence of unlimited taxable value, plus up to $1 million in taxable value for all other real estate, while their children keep the low taxable value enjoyed by the parents. The benefit applies whether the transfer of real property is made during the parent’s lifetime or at a parent’s death. The recipient may use the property as they wish, either as a vacation property, rental property, or as their residence.
This generous tax break for gifted or inherited real property is severely limited under Proposition 19. Prop 19 requires the child who receives a primary residence to use the home as his or her primary residence within one year of receiving it, in order to claim the reassessment exemption. The new owner must claim the homeowner’s exemption (or the disabled veteran’s homeowner exemption) within one year of the transfer.
Transferred homes that are not used as principal residences will be reassessed at fair market value for purposes of calculating annual property tax. Prop 19 also eliminates the additional $1 million in other real estate that is allowed to be transferred without reassessment.
Even if a transfer qualifies for the primary residence exemption for the parent-child transfer, there will be a partial reassessment if the principal residence has a fair market value in excess of its taxable value plus $1 million. For those properties, the formula for calculating the new taxable value is: Existing Taxable Value + (Fair Market Value – $1 million – Existing Taxable Value). For example, if at the time of transfer the principal residence has an existing taxable value of $500,000 and a fair market value of $1,750,000, the taxable value of the residence for the new owner will be $750,000. Beginning February 16, 2023, the $1 million amount is adjusted each year at a rate equal to the change in the California House Price Index.
Prop 19 also 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.
In addition, Proposition 19’s exemptions from property tax reassessment apply to transfers between grandparents and qualified grandchildren (where the grandchildren’s parents are deceased), and “upstream” transfers from children to parents. But because transfers from parents to children are more common, this article focuses on parent-child transfers.
To keep the low property tax basis for the next generation, parents with vacation homes or rental properties may want to transfer the properties to their child(ren) before February 16, 2021, the date Proposition 19 takes effect.
However, the parents must keep in mind that any real property transferred during the parents’ lifetimes will have their carryover income tax basis. If the property has appreciated since purchase, the transfer may result in a large capital gains tax when the children later sell the property. The gifted property will not receive a step-up in income tax basis to fair market value, which the children would have received had they inherited the property. Depending on the size of the parents’ estate and the property value, the desire to minimize income tax may outweigh the property tax savings, especially if the property will be sold after the parents’ deaths.
If the parent/donor wishes to continue to use the property after it is transferred, they will have to pay rent to the new owners, which could result in taxable income to the new owners. If rental property is transferred, the rental income now belongs to the new owner. Moreover, when multiple owners co-own the property, they should have a written agreement for managing the property to minimize conflict.
The decisions about gifting real property are further affected by the donee’s plans to live at the property, to keep and rent out the property, or to sell the property. Potential donors also need to evaluate the overall size of their estate, the value of the assets they are planning to transfer, any gift tax liability, and the need for filing a gift tax return to report the gift. Family dynamics, risk of family disputes, and sibling and in-law relationships should also be considered.
With Proposition 19’s approaching effective date, there is a limited window for transfer tax planning options. Clients are encouraged to consult with the estate planning team at Wendel Rosen to implement a plan based on each client’s estate planning goals and to make best use of the available property tax, plus gift and estate tax opportunities.
[1] Taxable value is defined as the property’s base year value, plus the annual increase authorized under California’s Proposition 13. The taxable value is used by the County Assessor’s Office to calculate the amount of property tax due each year.
