In the November 2020 election, California voters narrowly approved Proposition 19 (The Home Protection for Seniors, Severely Disabled, Families, and Victims of Wildfire and Natural Disasters Act), which amends the California constitution.  Proposition 19 significantly modifies existing property tax laws under Proposition 13 (which caps real property taxes to 2% per year unless sold or transferred) and Proposition 58 (allows transfer of primary residence to owner’s child at owner’s assessed value and up to an additional $1 million of assessed value of other real property).

Beginning on February 16, 2021, Proposition 19 will significantly impact transfers of California real property; particularly those between parent and child.[1]  As such, California property owners need to understand the impact of Proposition 19 and its effects on existing and future real property transfers.

Proposition 13

In 1978, California voters passed Proposition 13 which taxes California real property based on its adjusted base year value (“assessed value”[2]) rather than its fair market value.  Real property’s assessed value is generally the property’s purchase price and cost of improvements or additions, plus an increase of no more than 2% per year unless and until there is a change in ownership.

Generally, California real estate, on average, has appreciated in value at a rate higher than 2% per year.  As such,  the longer a piece of real property is held, the greater the difference between the property’s assessed value and its fair market value, and thus, the greater the difference between the amount of property tax paid as compared to an owner of a newly purchased real property of equivalent value.  Simply put, many California property owners are currently paying property taxes based on an assessed value significantly lower than the property’s fair market value.

Proposition 58

In 1986, California voters passed Proposition 58 (commonly referred to as the “parent-child exclusion”) which provides that real property can be transferred between a parent and child[3] without a reassessment for property tax purposes where:

• The property transferred is the parent’s primary residence, regardless of its value; and
• $1 million of assessed value of ‘other property’ (i.e., second homes, vacation property, commercial real estate, etc.).

Proposition 19

Proposition 19 severely limits the use of the parent-child exclusion for California property owners wishing to transfer their primary residence or other real estate to their children.  Proposition 19 modifies existing law in two ways:

Transfers of a Primary Residence Between Parent and Child May Be Subject to Reassessment.  Under Proposition 19,  the ability for a parent to transfer their primary residence to their child without reassessment will no longer apply unless two (2) conditions are met:

• The child is required to use the residence as his or her own primary residence within one-year of transfer.[4]  If the child does not move into the residence, the property will be fully reassessed at its current fair market value and property taxes will increase correspondingly. If the plan is for all children to inherit the primary residence, all of the children would have to live in the primary residence at least one year prior to transfer;
• Even where the child uses the parent’s residence as his or her primary residence, there will be a partial reassessment if the residence has a fair market value in excess of its assessed value, plus $1 million.[5]  In this situation, the child will take the property with an assessed value equal to the fair market value of the property, minus $1,000,000. The formula for calculating the new assessed value is expressed as follows:

Assessed Value = Fair Market Value – $1 million – Existing Assessed Value

If the fair market value of the real property under this scenario does not exceed the parent’s assessed value by more than $1,000,000, there will be no reassessment for purposes of an increase in property taxes.

Non-Primary Residences Will Be Reassessed.  Proposition 19 also eliminates the $1 million parent-child exclusion from property tax reassessment on transfers of other property not used as a child’s principal residence.[6]  Proposition 19 essentially limits the parent-child exclusion to transfers of a parent’s primary residence, subject to conditions.

To illustrate the changes made by Proposition 19 to the parent-child exclusion, consider the following example:

Parent wishes to transfer two properties to her child:  Parent’s primary residence and vacation with the following values:

Assessed Value                       Fair Market Value

Primary Residence                              $2 million                                $4 million

Vacation Home                                   $300,000                                 $1 million

Current Law (Pre-Proposition 19).  Under existing law, if parent gifts her primary residence to child, the assessed value remains at $2 million and child will continue to pay the same annual property taxes ($22,000) as parent.  In addition, parent can also gift her vacation home to child and the home’s assessed value will also remain at $300,000,and the annual tax will remain $5,500.

After the effective date of Proposition 19.  Using the same facts as above and assuming child uses the parent’s residence as child’s primary residence, only the first $1 million of increased value in the residence will be exempt from reassessment.  This results in a new property tax bill for $33,000.  Further, since Proposition 19 eliminates the exemption for non-principal residence transfers, the vacation home is reassessed at its fair market value of $1 million, resulting in a property tax bill of $11,000.  After February 16, 2021, the total net increase to child’s annual property tax bill for both properties will be $16,500 over the parent-child exclusion prior to the enactment of Proposition 19.

PROPOSITION 19 AND YOUR ESTATE PLAN

The changes to the parent-child exclusion made by Proposition 19 may affect many existing estate plans. For example, consider the Qualified Personal Residence Trust (“QPRT”). In a QPRT arrangement, the grantor (usually a parent) transfers their residence to a trust while the grantor still occupies the residence for a fixed term of years.   The grantor continues to live and use the residence as their primary residence until the end of the fixed term, at which point, the residence transfers to someone else (typically the grantor’s child).  Most parents that establish QPRTs want to continue living in the residence after the fixed term ends.  If they wish to do so, the parent must pay rent to the QPRT or to their child, depending on who owns the residence at the end of the fixed term.

Under current law, when a child becomes the owner of the residence in a QPRT, the transfer would qualify for the parent-child exclusion.  However, under Proposition 19, the child would need to use the residence as their primary residence or trigger reassessment.  The residence could not be rented back to the parent, and if there are siblings with an interest in the residence at the end of the fixed term, they would all need to move into the residence together and share a household to qualify for the exclusion.  Additionally, where a QPRT’s fixed term ends on or after February 16, 2021, the value of the residence in the QPRT may be reassessed to its current fair market value.  For this reason, it is advisable to consult with an experienced estate planning attorney to review one’s estate plan and make any adjustments prior to February 16, 2021.

PLANNING OPPORTUNITIES: THERE’S STILL TIME

For those considering a transfer of California real property to their children, while benefitting from existing law, it is imperative any planned transfers occur before Proposition 19’s effective date of  February 16, 2021[9].   Those who should consider pre-Proposition 19 planning include:

• Individuals with highly appreciated real property such as residential rental and commercial real estate;
• Individuals who plan on leaving their children their principal residence and/or other real property (i.e., vacation homes and second homes); and
• Parents with children who currently reside together and who intend to remain in the residence after the parents’ death, or children who plan to move into their parents’ primary residence at parents’ death need to consider how Proposition 19’s limitations will affect any potential reassessment and resulting annual property tax payments.

GETTING AROUND PROPOSITION 19?

There are options for avoiding the harsh results of Proposition 19.  Below are a few ideas for illustrative purposes:

Outright Transfer by Gift.  Gifting properties outright February 16, 2021 can preserve the transferred property’s assessed value for property tax reassessment purposes.  However, this option has several drawbacks.  First, an outright gift of real property means giving up ownership and making the property vulnerable to creditors.  Second, the person receiving the real property will take the property with the donor’s income tax or cost basis (transferred basis).   This means that any appreciation of the gifted property since its original purchase will be subject to capital gains tax when the property is sold.  Also, the gifted property will not receive a step-up in income tax basis to its full fair market value, which the child would have received had he or she inherited the property. Without this step-up in basis, the child/children could incur substantial capital gain tax in the event they sell the property post-transfer. As you can see, there are various issues/problems with an outright gift of real property.

Transfer of Property by Trust.  Although a revocable trust will not prevent reassessment under Proposition 19, a well drafted non-grantor irrevocable trust may be used to prevent reassessment.  However, it is important an experienced estate planning attorney experienced in drafting irrevocable trusts is consulted for this purpose.

CONCLUSION

Without proper planning, Proposition 19 may have serious unwanted financial consequences regarding transfers of real property between parents and their children.  There are many issues to consider and time is limited before Proposition 19’s effective date of February 16, 2021.  Please contact us as soon as possible if you require strategies to mitigate the effects of Proposition 19.

[1] Proposition 19’s exemptions from property tax reassessment also apply to transfers between grandparents and qualified grandchildren (where the grandchildren’s parents are deceased), and “upstream” transfers from children to parents.  This article focuses on transfers from parent to child.

[2] Although Proposition 19, uses the term “taxable value” to refer to assessed value, for purposes of this article, the term assessed value will mean taxable value.

[3] A later proposition extended this benefit to qualifying grandchildren.

[4] The new owner must claim the homeowner’s exemption (or the disabled veteran’s homeowner exemption) within one year of the transfer.

[5] The $1 million limit will be adjusted every other year beginning on February 16, 2023, based on the House Price Index for California in the prior calendar year.

[6] Note, under Proposition 19, if the real property transferred from parent to child transfer is of a family farm, the child will receive the parent’s assessed value for the family farm, provided the farm continues to be used as a farm.  Family farms are defined as real property used for pasture, grazing, or agriculture.

[7] Assuming a 1.1% increase for calculating the property tax bill on the assessed value.

[8] Assuming a 1.1% increase for calculating the property tax bill on the assessed value.

[9] Note that although Proposition becomes effective on February 16, 2021, February 15, 2021 is President’s Day is a legal holiday and County Recorders’ offices will be closed.  As such, it is advisable if to record any deeds  by February 11^th.