Dear Clients,
We previously sent out an email to clients regarding the impacts of Proposition 19, passed by the voters on November 3, 2020 by a bare majority. We are sending this follow up report by email and regular mail in an effort to discuss these impacts with you in further detail, and to assure that our clients are fully aware of them and are aware of their options.
Proposition 19, again, was advertised as a measure to assist seniors and wildfire victims in transferring their property tax base to a new home. While it did do that (on a limited basis), it also removed many of the protections enjoyed by families in transferring real property to their children and grandchildren. These new rules become effective in just two months, on February 16, 2021, so the opportunity to plan is extremely limited. Current estate plans where parents leave their home or rental properties to their children (after death) are all affected by these new rules.
Old Rules
Under the old rules under Proposition 13 and Proposition 58, parents had a much broader ability to transfer property to their children and grandchildren. There were two “classes“ of property.
First, for a property used by the parents as the “residence“, this property could be transferred to children without any reassessment at all. The value of the property was not a factor. The children could take the property and keep it (even rent it), and pay property taxes at the parents’ old low tax base.
For “non-residential“ properties, (rental homes, apartments, investment property), each parent had a $1 million exemption that they could apply against their own tax base (their assessed value, not the fair market value), and these properties would only be reassessed above that exemption. For example, if the parents bought an apartment in 1972 and had a low tax base of $1.5 million, together they could transfer the entire apartment to their children under a properly structured trust without a tax reassessment. To the same extent, transfers to grandchildren also benefited from these rules, provided that the child (who was the parent of that grandchild) was pre-deceased.
New Rules
Under Proposition 19, all of the old rules change, effective for any transfers occurring on or after February 16, 2021.
For residential property, transfers to children will be fully reassessed at fair market value unless the child actually uses the home as his or her personal residence. Even if that is true, the child only gets a $1 million exemption. If the fair market value of the property has risen more than $1 million above each parent’s tax base, the assessment is increased by the excess amount.
For non-residential property (rentals, apartments, commercial property), transfers to children after February 16, 2021 will cause the properties to be fully reassessed at its fair market value. All prior exemptions are eliminated. These rules also apply to transfers to grandchildren.
These new rules will have a severe impact on parents who had planned to pass their properties to their children, where the children planned to keep the properties. Now, there may be a huge property tax increase that factors in. As a result, many parents are now asking, “Can or should I transfer these properties to my children now, before February 16, 2021, to save on property taxes while we are still under the old rules“?
The answer is not as clear and simple as we would like, and requires careful study by each family considering their own unique circumstances. A variety of factors are involved which we will highlight below. The bottom line is that decisions should not be driven just by what is in this letter. They can only be made after a complete evaluation of the tax consequences by your CPA or financial advisor, followed by a discussion of how these options will affect your family and estate plan.
Tax considerations for early gifting
While transferring property to children now may be made without reassessment and save on future property taxes, you and your CPA must assess whether there is a hidden capital gains “tax penalty“ due to this early gift.
All of your properties have a tax “basis“ for capital gains purposes. This is, essentially, the value of your property at the time of its acquisition. Under present law, that tax basis governs what you must pay in capital gains taxes if you sell the property. Thus, if you acquire a rental home for $400,000, and it is now worth $1.5 million, you would have to pay capital gains taxes on $1.1 million if you sold the property.
Under present law, your tax basis is readjusted, or “stepped up “each time that the property is transferred pursuant to a transfer at death. Thus, if you passed away, and transferred the property to your children, they would receive a “stepped up“ basis in the property at $1.5 million. If they sold the property later, their capital gains taxes would be measured from that value and minimized.
Suppose you only pay $4500 per year in property taxes on that property. Do you want to transfer that property to your children now, before February 16, 2021, so they will pay the old property tax rate and will not be reassessed at $1.5 million if you transferred the property later at death. This may save the children $10,500 per year in annual property taxes. So why not do it now?
The danger is that by gifting the property to the children during your life, prior to February 16, 2021, while you are saving the children the higher property tax each year, the current law says that they get no “stepped up“ basis, and that they take on your old tax basis. Therefore, they may save $10,500 per year in property taxes, but if they ever sell the property, their capital gains taxes would be measured from your old $400,000 tax basis. For a $1.5 million sale, instead of a zero capital gains tax, they may be looking at a tax exceeding $300,000.
These are among the many factors that play into a decision to transfer property to your children before implementation of proposition 19. What is your present tax basis? Will the children ever sell the property (they may hold onto it forever)? How does your CPA calculate potential capital gains taxes if the property is sold by your children? If the property is to be used as your children’s residence, will they have other capital gains exemptions that they can personally apply to reduce the taxes? Is there a mortgage on the property that can be accelerated by your lender if you transfer to children? Do you want to give up control and ownership of the property, or leave it to the control of your children? Are you willing to file all of the necessary gift tax returns and to get necessary appraisals needed for a transfer? Will voters, once they realize what they have done, pass another initiative reversing Proposition 19 in the future?
It starts with a discussion with your CPA or financial advisor to weigh the tax consequences of these decisions. We can then work with you in making a decision, and can implement these decisions with proper transfer documents.
However, we expect that there will be a crash of activity as of the effective date of Proposition 19, February 16, 2021, draws closer. Deeds and recordings must be completed by that time, as county recorders and facilities are already overwhelmed and hampered by the Covid crisis. Therefore, your earliest attention to these issues is strongly advised. Your patience is appreciated as we do our best to work with you and your CPA or financial advisor in implementing your decisions in a timely manner.
