Maximizing Your Parent-Child Exclusion
Introduction – Why the Parent Child Exclusion is Important
California real estate owners pay property taxes based on the net assessed value of their property at a rate of around 1.2% per year. For example, if the net assessed value of your home is $1,000,000, your property tax bill is likely around $12,000 per year. There is often great disparity between net assessed value and fair market value as a result of the voter initiative referred to as Proposition 13. Proposition 13 “caps” the annual increase in net assessed value at 1% of the prior year’s net assessed value. To illustrate, if net assessed value of your home in 2016 is $1,000,000, the maximum net assessed value of your home in 2017 is $1,010,000. To illustrate the disparity, if the same property doubles in value during a ten year span, your fair market value will be $2,000,000, but Proposition 13 will keep your net assessed value at $1,104,622.10 or less.
According to a recent study prepared by Trulia (https://www.trulia.com/blog/trends/prop-13/), Proposition 13 saved California homeowners more than $12.5 billion in property taxes in 2015 alone. Also, more than 40% of California property owners have a net assessed value that is less than half of their current fair market value.
In general, County Assessor’s are only able to align net assessed value with fair market value when a change in ownership takes place. So long as real estate appreciates, the benefits reaped from Proposition 13 grow with every year of ownership. You, or someone you probably know, owns real estate purchased decades ago for less than $50,000. It is now worth $2m and the property tax payments are peanuts!
Under Proposition 58, a child that succeeds to real estate owned by a parent can “inherit” the net assessed value of such property. In other words, such property is excluded from reassessment irrespective of the change in ownership. However, there are limitations to Proposition 58’s benefits. This article explores those limitations.
The $1,000,000 Assessed Value Exclusion Amount (herein, the “AVEA”)
Proposition 58 allows a parent to transfer $1,000,000 of real property to his or her child without triggering a reassessment. At first glance, this AVEA seems rather puny. After all, according the California Bureau of Real Estate, the “median sold price of existing single-family homes” in Santa Barbara County was $767,000 last year. However, there are some big exceptions to the AVEA.
First, the AVEA is not used up when a child succeeds to a parent’s primary residence. The primary residence could be a castle on the Riviera – it doesn’t matter, so long as the transfer is made between parent and child, it will not have an impact on the parent’s AVEA. The child will be able to inherit the parent’s net assessed value for property tax purposes.
Second, the net assessed value (“NAV”), rather than the fair market value (“FMV”), is used to determine how much of the AVEA has been used by a given transfer. For example, if a child succeeds to a vacation home (or other non-primary residence real property) with an NAV of $100,000 but an FMV of $1,000,000, the parent will have $900,000 of the AVEA remaining.
Further, so long as husband and wife have set up their estate plan to properly utilize the AVEA of each spouse, their children may be able to “inherit” the net assessed value of one or more “non-primary residence” real properties with NAV of up to $2,000,000. Illustration:
- Dad dies and his decedent’s trust is funded with the following assets:
Family Home with FMV of $2.0m and NAV of $200k (excluded from reassessment; $0 of Dad’s AVEA used.)
Rental property with FMV of $1.25m and NAV of $500k (excluded from reassessment; $500k of Dad’s AVEA remaining)
Rental property with FMV of $1.25m and NAV of $500k (excluded from reassessment; $0 of Dad’s AVEA remaining) - Mom’s survivor’s trust is funded with the following assets:
Rental property with FMV of $2.0m and NAV of $500k (excluded from reassessment; $500k of Mom’s AVEA remaining)
Rental property with FMV of $1.5m and NAV of $500k (excluded from reassessment; $0 of Mom’s AVEA remaining)
Rental property with FMV of $1.0m and NAV of $500k (not excluded from reassessment; Rental property will be reassessed to $1.0m and property taxes will be based on that new NAV)
In this scenario, Mom and Dad have too much NAV of non-primary residence real property to completely avoid tax reassessment. They wisely delay the consequences of reassessment until the survivor’s death. They also wisely use their AVEA on Rental property that has appreciated the most. Through this planning, the increased property tax burden of their successors is limited to around $6,000 per year. However, if Mom and Dad failed to property plan, they may only be able to utilize the surviving spouse’s $1,000,000. Illustration:
- Dad dies and all of his property passes to Mom or to a Survivor’s Trust
- Mom then dies holing the following assets in her Survivor’s Trust:
Family Home with FMV of $2.0m and NAV of $200k (excluded from reassessment; $0 of AVEA used)
Rental property with FMV of $2.0m and NAV of $500k (excluded from reassessment; $500k of Mom’s AVEA remaining)
Rental property with FMV of $1.5m and NAV of $500k (excluded from reassessment; $0 of Mom’s AVEA remaining)
Rental property with FMV of $1.25m and NAV of $500k (not excluded from reassessment; rental property will be reassessed to $1.0m and property taxes will be based on that new NAV)
Rental property with FMV of $1.25m and NAV of $500k (not excluded from reassessment; rental property will be reassessed to $1.25m and property taxes will be based on that new NAV)
Rental property with FMV of $1.0m and NAV of $500k (not excluded from reassessment; rental property will be reassessed to $1.0m and property taxes will be based on that new NAV)
In this scenario, Mom and Dad squander Dad’s AVEA. As a result, the increased property tax burden of their successors is around $24,000 per year.
The Entity Limitation
Here is where things become tricky. Parents that own real property that has significantly appreciated often have the greatest need for limited liability protection, especially in a litigious state like California. Ownership of residential rental property, commercial property, and other non-primary residence properties create liability exposure. If you are worth $20m and you own a $2m apartment complex on top of the cliff in Isla Vista, you need to protect your other $18m in assets from the potential liability flowing from your ownership of the apartment complex. You can and should do this through insurance. However, there is a risk that your insurance will not cover the liability or that the liability exceeds policy limits. A limited liability company should be used in conjunction with an insurance policy in order to protect your nest egg from landowner liability.
Unfortunately, the parent-child exclusion is not available for transfers of interest in legal entities. A separate set of rules applies in determining whether a transfer of an interest in a legal entity will constitute a “change in ownership” and trigger a reassessment of the NAV of property for property tax purposes. Illustration:
- Mom and Dad hold all interest in a limited liability company as community property with right of survivorship. The LLC holds title to a $2m apartment complex on top of the cliff in Isla Vista.
- Dad dies and Mom now holds all interest in the LLC.
- Mom dies and Daughter succeeds to her interest in the LLC.
- The transfer of the interest in the legal entity from Mom to Daughter constitutes a “change in ownership” of the LLC – even though it is a transfer between from parent to child.
- As a result of the change in ownership, the entire $2m apartment complex will be reassessed so that the NAV aligns with current FMV.
In this scenario, Mom and Dad sacrificed the parent-child exclusion, by holding the apartment complex in the LLC at their death, all in the name of limited liability protection. Perhaps no claims ever arose against them as landowners and the limited liability protection was not necessary… hindsight’s 20-20.
Under the Revenue and Tax Code, members of an LLC can make proportional interest transfers of real property to and from an LLC without triggering reassessment. For example, if A owns ½ of Blackacre and B owns the other half of Blackacre, they can transfer their interests in Blackacre to an LLC owned equally by them without triggering any reassessment of Blackacre.
Obviously, Mom should have just transferred the apartment complex from the LLC to herself sometime after Dad died and shortly before her death. This transfer would be a non-reassessable “proportional interest transfer.” The subsequent transfer from Mom’s trust/estate to Daughter would also be non-reassessable parent-child transfer. Unfortunately, death often strikes at inopportune times and without warning – making this a “risky play.”
It is especially risky for couples that own non-primary residence property with a NAV greater than $1,000,000. If one of them dies while any such property is held by an LLC, the future reassessment will likely be unavoidable. However, if Mom and Dad own non-primary residence property with a NAV under $1,000,000, it may be advisable to reap the benefits of LLC protection until the first spouse’s death. The survivor can then transfer the property from the LLC to herself, go without the benefits of LLC protection during her “overlife” period, and utilize the parent-child exclusion upon her death. Then again, landowner liability often strike as inopportune times and without warning – making this an even riskier play.
In conclusion, the parent-child exclusion is a tremendous benefit to Californians and all couples should ensure that their estate plan properly utilizes it.
1. caution must be taken here, as the spousal and parent-child exclusions from reassessment will be lost if the decedent’s trust – whether it is a bypass trust or a QTIP trust – provides for “sprinkling” among spouse and “descendants” (not just spouse and children). See SBE Rule 462.160.
