The LLC Loophole in the Aftermath of Proposition 19
Proposition 19, enacted in the November Election, eliminates the parent-child exclusion from property tax reassessment for transfers of rental property from parent to child. As a result, real estate investors are looking for new ways to transition real estate to the next generation in a tax-efficient manner. The rules applicable to LLCs under the California Revenue & Taxation Code (R&TC) can provide a great loophole for avoiding higher property taxes.
Real property owned by an LLC is either subject to the Change in Control Rules under R&TC 64(c) or the Change in Ownership Rules under R&TC 64(d). Under those separate rules, real property owned by an LLC is reassessed whenever there is a change in control or a change in ownership. The manner in which an LLC acquires real property determines which set of rules to apply.
The Change in Ownership Rules
The Change in Ownership Rules apply when real property is transferred to an LLC in a transfer that is excluded from reassessment. For example:
- Sister and Brother inherit Greenacre from Parents (50/50).
- Parents of Sister and Brother bought Greenacre decades ago for $10,000. It is now worth $1,000,000.
- Sister and Brother pay peanuts in property taxes.
- Greenacre is situated on a beachside cliff in a college town. Worried about liability, Sister and Brother transfer their 100% interest in Greenacre to Greenacre LLC.
- Sister and Brother own all membership interest in Greenacre LLC (50/50), so this transfer is a “proportional interest transfer” that is excluded from reassessment under R&TC 62(a)(2).
A change in ownership under the Change in Ownership Rules occurs when cumulatively more than 50% of the original co-owners’ interest in the legal entity is transferred. For example:
- Brother dies and his 50% membership interest in Greenacre LLC is passed down to his children. Since 50%, but not more than 50%, of Brother and Sister’s interest has changed hands, Greenacre is not subject to reassessment.
- Sister gives 1% of her membership interest in Greenacre LLC to a local charity. Now, more than 50% of the membership interest in Greenacre LLC has changed hands and Greenacre is subject to reassessment. Instead of paying peanuts in property taxes, the LLC now pays around $11,000/year ($1,000,000 x 1.1%).
As discussed below, because the property tax basis in Greenacre was so low when Brother and Sister inherited, they needed to exclude their transfer to the LLC from reassessment. The far more beneficial Change in Control Rules were not available to them. Even still, by transferring to the LLC, the Change in Ownership Rules still provided some property tax savings. Had Sister and Brother continued to hold Greenacre as tenants-in-common, 50% of Greenacre would have been reassessed upon Brother’s death. The LLC would have been a great tool for limiting property taxes if, for example, Brother was significantly older than Sister.
The Change in Control Rules
The Change in Control Rules apply when real property is acquired by an LLC in a transaction where there is a re-assessable change in ownership. For example:
- Parents enter into a purchase agreement for the purchase of Blackacre for $10,000.
- Parents form Blackacre LLC and own all of the ownership interest in Blackacre LLC.
- Parents assign their rights under the purchase agreement to Blackacre LLC such that Blackacre is acquired by Blackacre LLC in a transaction that is subject to reassessment.
A change in control under the Change in Control Rules occurs when one party obtains more than 50% of the ownership interest of the legal entity. In other words, so long as no one party obtains more than 50% of the ownership interest in Blackacre LLC, it won’t ever be reassessed. For example:
- When the first spouse dies, the ownership interest in Blackacre LLC is transferred to the surviving spouse in an interspousal transfer that is excluded from reassessment under R&TC 63.
- At the surviving Parent’s death, Blackacre is now worth $1,000,000 and the ownership interest in Blackacre LLC is transferred to Brother and Sister (50/50). Although cumulatively more than 50% of the ownership interest has changed hands (and there would be a reassessment under the Change in Ownership Rules), Blackacre is not subject to reassessment because neither Brother nor Sister own more than 50% of the ownership interest of Blackacre LLC.
- Sister and Brother die and the ownership interest in Blackacre is transferred to 3 grandchildren of Parents. Still, no reassessment.
- Grandchild A dies and bequeaths his interest in Blackacre LLC to his only son (GGSon). Grandchild B dies and bequeaths her interest in Blackacre LLC to her daughter (GGDaughter). Grandchild C dies without children and decides to give the majority of his interest in Blackacre LLC to his favorite nephew, GGSon. Since GGSon now holds more than 50% of the ownership interest in Blackacre LLC, Blackacre is finally reassessed.
It is easy to see how the Change in Control Rules can keep the property tax basis low for generations. Absent Grandchild C’s blunder, the property tax basis of Greenacre could have been kept low for at least one more generation.
In conclusion, now that Proposition 19 has eliminated the parent-child exclusion for rental properties, real estate investors have a great incentive to acquire rental property directly using LLCs so that they can take advantage of the Change in Control Rules loophole. If you are an investor that acquired rental property a long time ago, transferring it to an LLC in a transaction excluded from reassessment may prolong reassessment under the Change in Ownership Rules. And, if you are an investor that recently acquired rental property directly in your name, with a spouse, or through your revocable living trust, it might be a good idea to transfer the rental property to an LLC in a transaction that causes reassessment so that you will fall under the more favorableChange in Control Rules. Parents could do this by forming an LLC, giving a fractional interest in the LLC to their children, and then transferring the recently acquired rental property to the LLC. Since parents’ proportional interest in the rental property and the LLC aren’t exactly the same, the rental property will be subject to reassessment. So long as the recently acquired rental property hasn’t appreciated too much, the property tax increase won’t be too bad, and the more favorable Change in Control Rules will thereafter apply.
The simple examples above are intended to provide a general overview of the California property tax rules as they apply to legal entities. There are countless other factors and rules that might apply. As a certified tax law specialist, my firm can help real estate investors analyze all situations and help to form and organize tax-efficient LLCs where desirable. Please contact us if you are interested.