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Approved in 1975 by voters, Proposition 13 limits the property tax rate to one percent (1%) of assessed value and changes the method of assessing property value. Prior to Proposition 13, annual assessments were conducted based on current fair market value. Limited by staffing and resources, county assessors would conduct physical reappraisals every three to five years and applied estimated increases based on local trending factors between physical reappraisals. Proposition 13 changed the method of property taxation from current market value system to acquisition value system. Under acquisition value system, property values were rolled back to the market value in 1975 (base year value). The base year value is then adjusted annually to reflect inflation but may not exceed two percent (2%). Property tax is assessed based on the adjusted base year value or is determined based on the current fair market value when there is a change of ownership or completion of new constructions.
Change of ownership is not limited to purchases and sales, and payments and considerations are not required. Transfers that constitute changes of ownership include gift, inheritance, admissions or departures of owner(s), property settlement, transfers of present interest and beneficial use of a property, and long-term lease agreements. County assessors discover changes in ownership by various means including taxpayer self-reporting, inspections filed with county, review of building permits, and news media. A new base year value will be established when there is a change of ownership. If a partial of ownership changes, only that portion is subject to reassessment.
Certain transfers are automatically excluded from reassessment or could be excluded if a claim is filed.
Examples of automatic exclusions, including but not limited to:
- Transfers of real property between spouses, including in and out of a trust for benefit of a spouse.
- Transfers of real property between registered domestic partners after January 1, 2006, including in and out of a trust for benefit of a registered domestic partner.
- Transfers of real property for the purpose of changing the method of holding the title without changing the proportional interest of owners in the real property (for example, partition of tenant in common).
- Transfers between individuals and/or legal entities or between legal entities result in only changing the method of holding title to the property without changing the ownership interest (represented by partnership interest or stock) in each and every real property transferred.
- Transfers to a joint tenancy and the original transferor remains as a joint tenant.
Examples of transfers that require to file a claim in order to avoid reassessment:
- Transfers of principal residence between parents and children (there is no limit in base value).
- Transfers of up to $1 million in base value of real property between parents and children.
- Transfers of up to $1 million in base value of principal residence from grandparents to grandchildren (not vice versa), provided that
- The transfer takes place on or after March 26, 1996,
- The grandchild(ren)'s parent (grandparent's child) deceases on or before the date of transfer, and
- Transfers of principal residence between two cotenants upon a death of one of the cotenants, provided that
- together, the two cotenants own 100% of the property,
- both cotenants hold the title at least one year immediately preceding the death,
- the property is the principal residence to both cotenants, and
- the surviving cotenant obtains 100% ownership interest.
- Purchase of a replacement principal residence by a taxpayer 55 or older, and the replacement is at equal or less value than the original residence.
- Transfers of real property between registered domestic partners between January 1, 2001 and January 1, 2006.
Generally, transfers of ownership in legal entities (partnership interest, stock, or membership interest) are not a change in ownership of real properties owned by the entity unless the transfer results in 1) change of control, or 2) cumulative transfers more than 50% by original co-owner(s).
Control exists when one has direct or indirect ownership more than 50% of voting stock or partnership capital and profit interest. When a transfer results in ownership change more than 50%, each and every real property owned by the entity is reassessed.
Starting March 1, 1975, if real properties or legal entity interest transferred to an entity and the owners retain the same proportional interest in the new entity, the transfer is not considered change in ownership of the real property and the real property is not subject to reassessment. However, when subsequent transfers by original co-owners cumulatively exceeds 50%, the real properties that original co-owners transferred (previously excluded for reassessment) will be reassessed. (Properties purchased by the entity are not reassessed.)
With the various exclusions and exemptions, there are many planning opportunities. However, one should be aware that step transaction doctrine is applied if a series of transactions are determined to be used to circumvent the change of ownership law. When the doctrine is applied, the result of the first and last transfers are reviewed in determining change of ownership, and all the interim steps are disregarded. Whether step transaction doctrine should be applied depending on facts and circumstances, including not limited to, timing of transfers, existence of business and the business purposes. Failure to pass any of the three tests may result in application of the step transaction doctrine:
- End result test - are the steps or transfers designed for purposes of reaching the end result?
- Interdependence test - are the steps or transfers interdependent that if one step would result in change of ownership without completing others?
- Binding commitment test - is there an agreement that all parties involved are obligated to complete all steps?
Because the exclusion for parent-child and grandparent-grandchild transfers applies only to real property and not ownership interest in business entities, the step transaction doctrine allows steps taken to transfer the property out of the legal entity to individual for the purposes of qualifying for the exclusion.
An example of a commonly used structure:
Step 1: Husband (H) and Wife (W), co-owners of a real property, transfer the property to a family limited partnership (FLP) and each receives 50% interest in the FLP. This is not a change of ownership because it only changes the holding method of the title to the property. H and W are now "original co-owners".
Step 2: H and W gift one-half of their respective partnership interest to their son (S). After the transfer, H and W each owns 25% and S owns 50% interest in the FLP. Because the total of H's and W's transfers (cumulative transfers by original co-owners) is not more than 50%, this does not constitute change of ownership. In addition, S receives no more than 50% interest in FLP; there is no change in control, and it is not considered a change of ownership.
Step 3: The FLP liquidates and transfers the real property to partners in proportion to their interest in the FLP. H, W and S hold the property as tenants in common (TIC) with identical ownership carried from FLP. This does not constitute change of ownership; it is a change of the method holding the title to the property.
Step 4: H and W each transfers one-half of their respective TIC interest to S. Because this is a transfer between parent and child, the $1 million exclusion applies. Together, H and W are able to transfer up to $2 million of assessed value to S. After the transfer, H and W each has 12.5% interest in the property, and S has 75% interest in the property.
Step 5: H, W and S transfer their interests in the property and form a second FLP. This does not constitute a change in ownership; it is just a change of method holding the title to the property.
Step 6: H and W transfer their remaining interest to S. The total transfer is 25%. There is no change in control, and, therefore, not a change in ownership.
It is also important to know that the $1 million exclusion is not as straightforward as it appears. As mentioned earlier, there is a $1 million exclusion for parent-child transfers of real properties other than principal residence, and it is also available for grandparent-grandchild for any real properties. However, one should be aware:
- The $1 million exclusion is available to each eligible transferor. If there are multiple properties or children/grandchildren, the $1 million is allocated.
- If a grandchild never receives a transfer of principal residence from his/her deceased parent under the parent-child exclusion, the grandparent may transfer his/her principal residence to the grandchild under the grandparent-grandchild exclusion and the transfer value is not subject to limit.
- The $1 million exclusion for grandparent/grandchild transfer is available only if the parent (grandparent's child) is deceased and to the extent that the deceased parent's $1 million has not been used.
- The $1 million limit is not allowed to exclude values of properties that were previously excluded from reassessment unless the transferor was an original transferor.
- Transfers that would qualify but not claimed are not counted toward the $1 million limit.
- Transfers of properties outside California are not counted toward the $1 million limit.
If you have real properties that have been in your family or business for generations, the appreciation in value is probably astronomic by now. With careful planning and structuring, you may be able to preserve some of the base year value and minimize property tax reassessment upon transferring the properties to next generations. Due to the complexity, it is important to allow enough time for planning and to carry out the plans.