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Time Is Running Out For Prop 13 Transfers Of Property That Were Abolished by Prop 19

PROPOSITION 19: PROPERTY TAX AND ESTATE AND GIFT TAX ALERT

By

Robert M. Fanucci, J.D., Master of Laws (LL.M.) Taxation, New York University

Gagen, McCoy, McMahon, Koss, Markowitz & Fanucci

 

Although the passage of Proposition 19 creates some limited benefits by expanding property tax “portability” benefits that permit taxpayers over 55, victims of natural disaster and persons with severe disabilities, to transfer their Proposition 13 base-year value to anywhere in California, the Proposition takes away some very valuable and cherished property tax rules with respect to transfers of real property by gift, inheritance and sale between parents and children. Proposition 19 also does away with formerly eligible transfers between grandparents and grandchildren where the parents of the grandchild are deceased. The exclusion also applies to transfers from children to parents.

 

These changes, in many instances, may have dire property tax consequences, especially for taxpayers who purchased property many years ago and whose present Prop 13 tax basis is substantially lower than the current fair market value of the property. The limited benefits of Proposition 19 are significantly outweighed by unexpected property tax increases based on how long ago real property was acquired and the fair market value of the real property at that time compared to its fair market value today.

 

The good news is that Proposition 19 does not go into effect until February 16, 2021, so there is still some time to plan.

 

One Million Dollar ($1,000,000) Parent-to-Child Exclusion

In addition to substantially limiting the parent-to-child exclusion for the primary residence property, Proposition 19 deceptively repeals the $1,000,000 parent-to-child exclusion for other real properties. Family farms are not spared. Under certain fact patterns, this could have draconian property tax implications. By way of example, Farmer John acquires a 100-acre vineyard property in the heart of the Napa Valley in the 1960s for a few thousand dollars an acre. The vineyard currently has a Proposition 13 assessed value of $1,000,000, which is the basis on which property tax is calculated even though that is not its fair market value on the date of transfer.

 

The prime vineyard property has appreciated substantially over the years and is currently valued at $25,000,000. Farmer John, prior to the transfer, was paying approximately $11,000 in property taxes.

 

Were the transfer of this vineyard to a child to occur after February 15, 2021, the property would immediately be reassessed upon transfer based on the current $25,000,000 fair market value. Under this somewhat typical example for vineyards located in the Napa Valley, the property tax would increase from approximately $11,000 a year to $262,500 overnight. The heirs in most circumstances would likely have to sell the family farm in order to pay the tax bill if they were simply selling grapes on the open market and not into their own cult brand.

Th

 

e text of Proposition 19 makes no direct reference to the repeal of the $1,000,000 exclusion but rather refers the reader to a subsection of the California Constitution without specifically making mention that Proposition 19 is amending our State Constitution. The wording of Proposition 19 is very complicated to the point of being deceptive, and it is likely that most taxpayers and voters were not aware of this “gotcha.”

 

It is important to note that Proposition 19 does not apply to entities, which are subject to the complicated change of ownership and cumulative change of ownership rules, which are beyond the scope of this Tax Alert. Legal entities may still offer some property tax benefits, but there are many traps for the unwary.

 

Under the $1,000,000 exclusion, the $1,000,000 exclusion could have been applied to the transfer of the vineyard example above, resulting in no property tax reassessment, since the $1,000,000 exclusion is based on the property tax assessed value and not the current fair market value upon the date of transfer as noted above. Husband and wife are each entitled to a $1,000,000 exclusion. Both exclusions will now be lost on the death of the predeceasing spouse and the surviving spouse after February 15, 2021. Prior to the passage of Proposition 19, it was possible to take the $1,000,000 property tax exclusion of the predeceasing spouse on the death of the surviving spouse, assuming the predeceasing spouse left eligible property in trust for the surviving spouse.

Gifts

Certain taxpayers who are already inclined to make gifts to take advantage of the $11,580,000 (increased to $11,700,000 in 2021) estate and gift tax exemption may want to consider making such gifts of real property prior to February 16, 2021, for property tax considerations.

 

There is the possibility that significant estate, gift and income tax law changes may be around the corner in 2021, due to the significant budget deficit exacerbated by the pandemic and depending on whether the U.S. Senate majority flips from Republican to Democrat after the January 5th runoffs for the two Georgia Senate seats.

 

There also is a concern that any such legislation may be applied retroactively to January 1, 2021, a move by Congress that is not without precedent, albeit quite unpopular. In addition, there are proposals to reduce the current $11,580,000 estate and gift tax exemption to as low as $3,500,000 for estates and $1,000,000 for gifts.

 

The $11,580,000 gift and estate tax exemption indexed for inflation is already scheduled to sunset in 2026 and revert back to $5,000,000, plus the inflationary adjustment The concern, however, is that this reduction will occur next year, as it is more likely that the sunset provision of the Tax Cuts and Jobs Act would be accelerated from January 1, 2026, to an earlier date, such as January 1, 2021.

 

There also are proposals to limit or eliminate basis adjustments at death, increase the capital gain rate to 39.6%, increase the corporate and individual income tax rates, and phase out the Section 199A deduction. In addition, there is the possibility of a proposal regarding gain recognition at death, and a host of other estate and gift tax changes, including the loss of valuation discounts for family-owned entities, elimination of Grantor Retained Annuity Trusts (GRATS), reduction in value of charitable gifts, as well as other tax proposals beyond the scope of this tax alert.

Primary Residence Parent-to-Child Exclusion

Proposition 19 also significantly limits the parent-to-child exclusion for transfers of a personal residence, whether during the parent’s lifetime or at death. The parent-to-child primary residence exclusion is unlimited prior to February 16, 2021.

The new law will allow a parent to transfer a residence to a child only if the child establishes the home as his or her personal residence within one year of the transfer. Additionally, the exclusion is no longer unlimited but capped at the Proposition 13 value (“Factored Base Year Value”) plus $1,000,000.

 

By way of example, a residence is purchased many years ago. The Proposition 13 base year value is $900,000, and the property is worth $5,000,000 on the date of the transfer to a child. Under Proposition 19, the maximum allowed exclusion would be the $900,000 Proposition 13 base year value plus an additional $1,000,000, thus capping the exclusion at $1,900,000. Anything over this value would be subject to property tax reassessment, which may result in substantial additional property tax.

 

It should come as no surprise that the Board of Realtors backed Proposition 19, since it will result in many children having to sell the personal residence and other real properties, since they would not be able to afford the increased property tax and would not necessarily be able to rent the property because of the requirement that they must reside in the residence within one year of the transfer.

Conclusion

This Tax Alert is not legal advice, but a newsletter that explains some of the effects of Proposition 19, and should not be used to make legal decisions. Please consult with your attorney regarding the impact of Proposition 19 on your situation, including transfers to children, the gift and estate tax implications if the exemption is reduced dramatically in 2021, and numerous other proposed tax law changes. Additionally, it would be wise to seek guidance from your attorney on the benefit of using legal entities in property tax planning, as well as advice on how to avoid unexpected property tax reassessment in the event of a change of control or cumulative change of ownership.