Recent Changes to California Property Tax Law: Planning Opportunities with Principal Residences
The passage of Proposition 19 by California voters in November 2020 made significant changes to the property tax reassessment exemption for transfers between parents and children. (Read our November 2020 alert here.) Prior to the passage of Proposition 19, the transfer of a principal residence between a parent and a child could be entirely excluded from property tax reassessment, regardless of the market value of the property or whether the child subsequently used the property as a primary residence or for some other purpose. Under the previous exemption, children not only benefited from the existing taxable value of the property, but could also pass on some or all of this benefit to their own children. Prior to Proposition 19, it was advantageous for property tax purposes to own a principal residence directly through an inter vivos trust so that the parent-child exemption could be used to fully exempt the residence from property tax reassessment.
Proposition 19 repealed the existing parent-child exemption and replaced it with a much more limited one. Effective for transfers made on or after February 16, 2021, the parent-child exemption is limited to transfers of a principal residence that at least one of the transferee children will use as a principal residence, as well as certain farm property. In addition, even if a transfer qualifies for the exemption and the property will continue to be used as a principal residence by a child, a principal residence whose fair market value exceeds the current taxable value of the residence on the date of the transfer , plus $1 million (adjusted for inflation), will trigger a partial property tax reassessment. Given these limitations, the new parent-child exemption will likely not be available in most cases where children inherit a principal residence.
To preserve the taxable value of the principal residence when it is transferred to children (usually upon death), you should consider forming a limited liability company owned by your living trust to be the direct purchaser of the residence. For California real estate where a business entity, such as an LLC, is the original purchaser, a transfer of some or all of the LLC’s interest will generally not result in a “change of ownership” triggering a reappraisal unless the transfer does not result in a person obtaining, directly or indirectly, more than 50% of the interests in the entity (so-called “change of control” rule). In the case of an LLC or a partnership, control is measured in economic terms by the ownership of more than 50% of the total capital of the company and more than 50% of the total profits of the company; the effective control of management decisions by a manager, the general partner or other partners or associates is not relevant. For purposes of applying the “change of control” rule, there is no allocation of ownership between family members or other related persons. With respect to trust owners, an interest held by a revocable trust is treated as being held for property tax purposes by the settlor(s) of the trust who have the power to revoke the trust, and an interest held by an irrevocable trust is treated as belonging to the current beneficiary(ies) of the trust.
Where an LLC is the original purchaser of a California residence (or other real estate), ownership is not reassessed upon the death of the first spouse even though the surviving spouse will become 100% owner of the LLC because the inter-spouse exclusion applies and overrides the change of control rule. When the surviving spouse dies and the interest in the LLC passes to two or more children, as long as no child owns more than 50% of the LLC (whether directly or through an irrevocable trust for the benefit of the child), there would be no revaluation of the property. This same planning works if ownership passes to non-child beneficiaries, as long as no beneficiary has more than a 50% interest in the LLC.
However, this same planning will not work if you first buy the residence in your name or through your living trust, then bring the property to an LLC that you own 100%. In this scenario, in addition to the change of control rule described above, ownership will also reassess when more than 50% of the LLC’s interest has been transferred, cumulatively (excluding transfers to spouses) . For a residence or other property contributed to an LLC, the transfer of the LLC’s interest on the death of the second spouse would trigger a reassessment (even if no beneficiary receives more than 50% of the LLC upon transfer), as would transfers during your lifetime of more than 50% of LLC interests. This 50% cumulative transfer rule does not apply where the LLC or other legal entity is the original purchaser of the property.
As with any planning, there are other factors you need to consider when deciding whether or not to acquire a primary residence through an LLC. For example, because a residence is non-income producing, the lender may require the owners of the LLC to guarantee any mortgage debt, which is generally undesirable because it causes non-recourse financing secured by the residence becomes a recourse for the owners of the LLC. Some banks may also charge a higher interest rate on the mortgage if the residence is purchased through an LLC. New federal requirements for reporting the beneficial ownership of entities, including LLCs, may also soon apply. (Read our article “New Beneficial Ownership Reporting Requirements for LLCs and Other Entities” here.) But depending on your situation and overall goals, acquiring your residence through an LLC can be a powerful way to generate significant, long-term property tax savings when the residence passes to your children. .