Los Angeles Trust & Probate Attorney
We Offer Virtual Consultations
Law Offices of Maria N. Jonsson, PC

Prop 19 - To Gift or Not To Gift

Many of you have reached out with questions about the newly-passed Proposition 19. This article attempts to shed some light, but does not in any way purport to offer any conclusive authority, as the CA Assessor’s Association and the CA Board of Equalization are currently hard at work to formulate and issue guidance and rules interpreting this Proposition. Moreover, this article ONLY discusses the parent-child exclusion portion of Prop 19.

WHO WAS BEHIND PROP 19, and WHEN DOES IT TAKE EFFECT?

Prop 19 was introduced by the CA Association of Realtors and backed up by over $50 million in funds aimed to have it pass. And, it passed by a very slight margin of a little over 400,000 votes….

Its effective date is Feb. 16, 2021, however, given that Feb. 15, 2021 is a Holiday, the effective date for making any Pre-Prop-19 transfers, is Friday, Feb. 11, 2021. Because the effective date was written in the bill itself, it is “set in stone,” and at this time, it is believed that this date (Feb. 16, 2021) cannot be “postponed” or “changed” to allow property owners adequate time to better plan on what to do.

BACKGROUND ON THE CURRENT PROPERTY TAX RULES

To understand the impact of Prop 19, below is a brief summary of how are property taxes calculated, and what are the current Parent-Child reassessment exclusion rules upon transfer of property to/from parents/children (and by extension – grandparents/grandchildren).

Property taxes are calculated at approximately 1% of the “assessed value” (which is the property value at time of purchase/transfer). Thereafter, under Prop 13, such assessed value (also called “base value”) is increased by approx. 2% each subsequent year.

Property taxes are generally changed in two instances: (1) due to new construction, and (2) due to Change in Ownership (“CIO”), such as transfers of property during your life (by sale or gift), or upon death.

Under current law, transfers excluded from the definition of “Change in Ownership” are those from parents to children and children to parents whereby:

  1. The Personal Residence is 100% excluded from reassessment, regardless of its value, and there are no restrictions on its use by the new owner; and
  2. All other real property – reassessment exclusion is capped at $1 million of its “assessed value” (not its fair market value).

HOW DOES THIS CHANGE UNDER PROP 19:

Under Prop 19, the Personal Residence is subject to partial reassessment exclusion, BUT ONLY IF the new owner moves into it within one year of the change in ownership, and claims it as their “new” personal residence (as explained below). And, any other real property is no longer subject to any reassessment exclusion – it is fully reassessed as of its change in ownership date (transfer by gift/sale/death).

How is the Reassessment Exclusion on the Personal Residence calculated under Prop 19?

The following formula is used to calculate what part (if any) of the personal residence being transferred is reassessed:

The “assessed value” (“AV”) at time of transfer PLUS $1 million is compared to the Fair Market Value (“FMV”) of the property at time of Change in Ownership (a.k.a., time of the transfer via sale/gift/death). (The Assessed Value is shown on your Assessor Tax Bill).

  • If the FMV is higher that the AV+$1 mil, then the property is not reassessed at all.
  • But, if the FMV is lower than AV+$1 mil, then the property is partially reassessed, to the extent the AV+$1 mil exceeds the FMV.

This is best understood with an illustration:

Example 1:

Assessed Value (AV) of home is $1mil.

FMV of home is $1.5 mil.

Assessed Value ($1 mil) Plus $1 mil = $2 mil.

ASK: Is the FMV of $1.5 larger than AV ($1 mil) + $1mil (=$2 mil)? –NO: $1.5 mil < $2 mil.

As such – No reassessment, no property tax increase. If the fair market value is less than the sum of the assessed value plus $1 mil, the home continues to be taxed at its assessed value of $1.5 mil.

For that reason, Prop 19 won’t even apply to homes whose assessed value plus $1mil does not exceed their fair market value. This would be the case for many California homeowners.

Conversely:

Example 2:

Assessed Value (AV) of home is $1.5 mil. (prop. tax is $15,000/yr)

FMV of home is $3 mil.

Assessed Value ($1.5 mil) Plus $1 mil = $2.5 mil.

ASK: Is the FMV of $3 larger than AV ($1.5 mil) + $1mil (=$2.5 mil)? –YES: $3 mil > $2.5 mil.

As such – Partial reassessment applies, which is calculated as follows:

The Difference between FMV ($3mil) minus (AV of $1.5 mil +$1 mil = $2.5 mil), or, $500,000, is now added to the Assessed Value of $1.5 mil ($500,000 + $1.5 mil = $2 mil). The property tax of 1% now applies to the COMBINED VALUE of $2 million. (new prop. tax is now $20,000/yr)

Note that the above examples only apply if the NEW OWNER MOVES INTO THE PROPERTY AND USES IT AS THEIR OWN PERSONAL RESIDENCE.

The Assessor would now require that the New Owner file a Home Owner’s Exemption form

(1) swearing under penalty of perjury that this is their new Personal Residence, and

(2) this form must be filed within ONE YEAR of the Change in Ownership date (changed from 3 years under current law).

Note that there can only be ONE property claimed as Personal Residence in the State of California. If the new owner does not move into the property within one year and file the Home Owner’s Exemption Form, the property will be reassessed and taxed at its FMV of $3 mil, so the property taxes will be $30,000/yr.

SUMMARY OF FORMULA:

  1. Calculate the sum of the property’s Assessed Value plus $1 mil.
  2. Determine Fair Market Value of property at time of change in ownership (by appraisal)
  3. If FMV is Lesser than AV plus $1 mil – no reassessment
  4. If FMV is Greater than AV plus $1mil – calculate the difference
  5. Add the difference to the Assessed Value to determine the NEW COMBINED VALUE after transfer,
  6. Mindful that this can only occur in the context of the new owner MOVING INTO the property and filing a HOMEOWNER’s EXEMPTION with the Assessor within ONE YEAR of the transfer.

WHAT TO DO IN THE FACE OF PROP 19? TO GIFT OR NOT TO GIFT?

Given the looming deadline of Prop 19 (effectively on Feb. 11, 2021), folks are wondering of they should transfer their real property to their children NOW (prior to Feb. 11, 2021), or leave things as they are. The FEW factors to consider when making this very difficult decision include not only preserving the property taxes, but also income taxes, capital gains taxes, gift taxes, estate taxes, property rights, transfer to multiple children, if the property is of residential use, commercial use or mixed use, if the property is a single family residence/condo or a multi-unit property, etc. There are more questions than answers when considering all of the above.

PRESEVING PROPERTY TAXE BASE VERSUS CAPITAL GAINS TAXES (STEP UP IN COST BASIS)

When a parent GIFTS the property to a child during the parent’s life, the parent (donor)’s cost basis is transferred to the child (donee). In other words, the donee takes the donor’s cost basis in the property. At the parent’s subsequent death, there is no step up in the property cost basis (simply because the parent does own it any more at death).

Conversely, if the child INHERITS the property upon the parent’s death, the child gets a STEP UP in the cost basis to the parent’s date of death value of the property.

As such, if the Child Plans to SELL the parent’s property, they will pay much higher capital gains taxes on a gifted property than on an inherited property. While the property tax on the gifted property would be lower, if the child does not even plan to “reside” in it, but wishes to sell it, the damage of the higher capital gains tax is greater than the “savings” in property taxes.

Conversely, if the child plans to LIVE in the property, a gift during a parent’s life would make sense, to preserve the property taxes at the lower level (since capital gains taxes would be a moot point).

For this reason, when deciding TO GIFT OR NOT TO GIFT, it is important that this is a FAMILY DIALOGUE to discuss the Children’s intentions in the context of the Parents’ plans.

FEDERAL GIFT TAXES

The 2021 Lifetime Gift and Estate Tax Exclusion is now increased to $11,700,000 (or, $23.4 mil for a Family). As such, when gifting real property to children, the parents must file a GIFT TAX RETURN to report this gift which exceeds the annual gift tax exclusion that remained at $15,000 per donee in 2021. To file a gift tax return, the parents must file IRS Form 709. To substantiate the IRS Form 709, an appraisal of the property would be needed. As such, a conversation with a CPA is critical in making this decision.

ESTATE TAXES

The aforementioned gift of the property will “count against” the donee’s lifetime exclusion (a.k.a, the $11,700,000 per person), and will decrease the exclusion that would be available at the time of death of the parent. It is notable that the current $11.7 mil exclusion is scheduled to “sunset” on Jan. 1, 2026 (unless Congress acts sooner) and roll back to about $6 mil. As such, at death, the exclusion might be much, much lower, and would be further decreased by this lifetime gift. This could render the deceased parent’s estate TAXABLE for ESTATE TAX purposes, whereby the top estate tax rate is 40%.

This is why consulting with your CPA when making the important decision of “To Gift or Not To Gift” is an indispensible part of the decision-making process.

YOUR PROPERTY RIGHTS

Transferring your property during your life terminates your property rights. Someone else (your child) will be the legal owner of record, and they potentially could do a number of things with your home: mortgage the property, sell the property, or cause an encumbrance to be recorded against the property due to divorce, a judgment, a tax lien, etc. As such, if you plan to “grow old” in your child’s home, strongly consider your child’s personal circumstances and marital status before you let go of your residence or other property.

In that regard, while the personal residence is given some reassessment exclusion under Prop 19, while “any other real property” is completely stripped from such exclusion, it could make sense that vacation/rental property (rather than the personal residence) might be more suitable for gifting, if gifting is at all contemplated, and if such property is intended to be “preserved in the family” rather than sold (subject to all other considerations, including mortgage considerations noted next).

MORTGAGE CONSIDERATIONS

Provided your home has an existing mortgage - your Deed of Trust securing your loan most likely includes an Acceleration Clause that would cause the entire loan to be due and payable upon transfer of title without the consent of the Mortgage Company. As such, the child might have to qualify and assume the existing mortgage (or not be able to qualify/assume the existing mortgage due to their own credit, etc.). As such, it is prudent to consult with your mortgage company and a lender before changing title to your home.

SO MANY UNANSWERED QUESTIONS

As noted, the CA Assessor’s Association and the CA Board of Equalization (BOE) are currently working to promulgate rules interpreting the many unanswered questions that the language of Prop 19 presents. Among those are:

  • When transferring to multiple children, do ALL of them have to move into the property and claim it as their personal residence?
  • How long must a child “reside” in the residence, and does the partial reassessment exclusion stop if they “move out” if they want to rent it?
  • With multi-unit buildings, is only the unit that is claimed as “personal residence” subject to reassessment exclusion, and the remaining units are reassessed to present fair market value? (The anticipated answer here is YES, but still waiting for clarification from BOE)
  • How is the Assessor going to treat mixed-use buildings, whereby the ground floor is zoned for commercial use, and the upper floors are for residential use – also mindful that different “depreciation” rules apply to commercial versus residential use properties?

We have to “wait and see” how these questions will be addressed. Ultimately, given the unpopular effect of this Proposition to many homeowners, especially in the San Francisco/LA/San Diego metropolitan areas, it is not entirely unlikely that it could be repealed in the future.