If you own real property in California, Proposition 13 ties the taxable value of your property to the fair market value of your property at the time you acquired it. In other words, as the value of your property rises with the market over the years and over the decades, your property tax bill will not rise significantly. Instead, the taxable value of your property—called the property’s assessable value—will be kept artificially low in relation to the actual fair market value of the property. This happens automatically under Proposition 13—no action is necessary on the property owner’s part.
But what happens when you want to transfer that property? Will the transferred property retain its artificially low assessable value, resulting in ongoing tax savings? With proper planning, there are exclusions from reassessment that will allow just that—transferring property without triggering a reassessment. One of those exclusions is the parent-child exclusion, which allows the property’s assessable value to be passed from a parent to a child. When the property will directly pass to only one child, obtaining the full benefit of this exclusion is relatively simple and straightforward. However, when the property will be passed to more than one child, strategic planning is required to avoid losing the benefits allowed by this powerful tax-saving exclusion.
A properly structed living trust is the ideal vehicle to memorialize a distribution structure that ensures your children will be able to retain your artificially low property tax bill. By including clear direction to the future trustee of your living trust, you ensure that your children will be able to benefit from property tax savings for as long as they keep your property.
To illustrate, assume a couple (hereafter, “Parents”) purchase a home in 1976 for $50,000. The property tax rate on the assessed value of the home is a flat 1%. For the first year, in 1976, the Parents’ property tax liability would be $500. In 1977, assume that the fair market value of the property is $53,500. Under Proposition 13, the county assessor may only increase the property’s taxable base to $51,000 in 1977, because of the 2% cap. As a result, property tax in 1977 would be $510, and not $535.
Fast forward to 2020. Assume that the property’s fair market value is now $850,000. But, because of Proposition 13, the property’s assessed value is only $119,503. At 1%, this means property tax is a mere $1,195, instead of $8,500, a savings of $7,305 in 2020 alone.
Now, the Parents wish to update—or create—their living trust, and wish to leave all of their holdings, including the property purchased in 1976, to their only child. The trust provides for this disposition, and after both Parents pass away, the only child files a “Claim for Reassessment Exclusion for Transfer Between Parent and Child,” Form BOE-58-AH. Under Proposition 58, the only child will retain his/her Parents’ taxable base, carried forward from 1976, for as long as the property is retained (“Parent-Child Exclusion”). Proposition 13 created significant tax savings for the Parents in life, and Proposition 58 does the same for the only child after the Parents’ deaths.
The scenario presented above works great when only one child—as the sole beneficiary—is involved. But instead of one child, assume the Parents have two children. Now, porting the full Parent-Child Exclusion requires careful planning. To illustrate, assume the same Parents transfer the same property to the trust they updated or created in 2020. The trust calls for each asset of the trust estate to be distributed equally, or “pro rata,” to each of the children after both Parents have passed away. Each child receives 1/2 of their Parents’ Proposition-13-suppressed property tax base. If one child buys out the other sibling’s 1/2 interest—as commonly occurs—1/2 of the property will be reassessed at fair market value, and 1/2 will retain the Parents’ property tax base. This is because the exclusion only applies between a parent and a child—not sibling to sibling. This bad result gets worse as more children are added to the equation—and it is exceedingly common.
But no need to worry—this is where a living trust can come into play. The trust is drafted to allow a non-pro rata distribution from the trust estate to be made. This means that the trustee may allocate the home to one child as his/her trust share, while the other child receives cash or other assets of equal value for the other trust share. If the trust contains sufficient assets to cover these distributions (e.g., a home with a fair market value of $850,000 and cash of $850,000), this is easily done, and the child that received the home takes the full benefit of the Parents’ low property tax base. If the trust does not contain sufficient assets to make equal non-pro rata distributions, the trust directs the trustee to encumber the property with a loan from a third-party lender, which allows the trustee to make the non-pro rata distribution while retaining the full property tax benefit for the child.
If more than one child wants the home, you are even able to address sibling disputes/rivalries—some that reach back many years—through the trust. The trust directs the trustee to ascertain the home’s fair market value through an independent appraiser. The trustee then seeks bids on the property from each child, beginning at the home’s fair market value. Because the Parents’ full Proposition-13-suppressed property tax may be valuable to more than one child (e.g., each child would like to live in the same property for life and reap the benefit of the ongoing property tax savings), the children may try to outbid one another. The child that bids the highest over the property’s fair market value gets the home. The other child will not be disgruntled—or not as disgruntled—about losing the house, because he/she did not feel the house was worth what their sibling was willing bid over the fair market value. And this results in more cash in the sibling’s pocket.
Bottom line, if you foresee transferring your property to your children in the future, a properly structured trust and the strategic advice of experienced counsel will allow you to pass tax savings on to your children along with the house. And who doesn’t like to save tax dollars?