What to know about Prop. 19:
– Property passed down to a child or grandchild will no longer hold tax benefits unless that child or grandchild makes the property their primary residence.
– This prop primarily impacts Californians who own multiple properties and have previously benefited from Prop 13, or children who inherit homes without making them their primary residence
– If the individual passing down the property is a partial or fraction owner, only that fraction will be subject to a reassessment of tax interest and will not affect any of the remaining owners.
– The Prop may result in some lost revenue for the state, as eligible owners can transfer property taxes up to three times statewide and some property owners aim to transfer their properties prior to the February 16 start date. Additionally, enforcing the law will require more personnel and may be difficult in some instances.
We recently had the opportunity to sit in on our client FinDec’s monthly webinar series — this one was impactful for California residents with property and also sheds light on some of the underlying questions surrounding this year’s Proposition 19, a measure that narrowly passed during the November election (51 percent of the state voted in favor of it).
Anthony M. Despotes, JD, a principal with Neumiller & Beardslee, was the webinar guest who broke down the ins and outs of Prop. 19 and how California residents impacted by it can start preparing now. Despotes practices in the areas of tax, trusts, probate and estate planning and business and commercial law. FinDec Chief Investment Officer Tolen Teigen, served as the moderator during the Dec. 9 webinar.
First off, why does California have so many ballot propositions?
Before wading into the waters of Prop. 19, it may be worth quickly sharing with both California and non-California residents why the state has so many propositions. As an outsider looking in, it may be easy to ask the question: Why does California always have these “props” on the state ballot during elections?
The origins of direct legislation in California actually come from a medical doctor who moved from Philadelphia to Los Angeles in the late 1800s. In 1895, Dr. John Haynes was a founder of the California branch of the Direct Legislation League, which focused its efforts on “winning the rights of initiative, referendum, and recall both statewide and in every local jurisdiction.”
There are dozens, sometimes more than 100 propositions on the ballot every decade in California and this has been happening for more than a century. Californians have adopted a number of reform efforts through the initiative process — ranging from term limits, ending bilingual education, adopting animal protection laws, ending racial preferences, and adopting one of the most comprehensive drug reform measures in the country. This is according to Ballotpedia (akin to Wikipedia for political nerds).
But it’s a watershed proposition in the late 70s that we turn to as we set up the webinar on Prop 19 and what it means today.
The impact of Prop. 13
One of the most famous propositions was the 1978 Proposition 13, which reduced property taxes in the state by about 57 percent. Prior to that, some people were losing homes in the state because they couldn’t afford to pay their property taxes. Prop 13 is considered a landmark law in California.
Specifically, the law, which passed overwhelming in the late 70s, “constrained the ability of local governments to raise revenues by requiring a supermajority vote on tax measures, rolling back property tax assessments to 1975 levels, limiting the property tax rate to one percent, and restricting the growth of property tax increases to two percent annually,” according to the Public Policy Institute of California.
But, it has had its fair share of criticism over the years. In a 2018 opinion piece in the LA Times on the 40th anniversary of Prop 13, Conor Friedersdorf argued that: “Californians remain among the most highly taxed people in the nation; low property taxes have been more than offset by increased income, sales and gas taxes. That might not be so bad if Proposition 13 was thereby rendered a wash. But it’s not. Its effects are deeply regressive taxation and distorted local economies and housing markets.”
Friedersdorf points to California’s low rate of homeownership (55 percent, second lowest in the nation only to New York) and that “new homeowners face a much bigger property tax burden than their older, often wealthier neighbors,” as reasons to take another look at Prop 13.
Major propositions to modify Prop 13 in 2020
In addition to Prop. 19, which we’ll explore further, there was a second measure, Prop. 15 that would have made major changes to Prop. 13. Essentially, it would have removed commercial properties from the tax increase limits of the 1978 law while maintaining residential within the limit structure. While that one received endorsement from prominent politicians (including California Gov. Gavin Newsome, Democratic Presidential Nominee Joe Biden and his VP and former California AG Kamala Harris, the measure failed with 51 percent of California’s voting no on Prop 15.
However, another change to Prop. 13, Prop. 19 did pass — also by a slim 51 percent majority vote.
What is Prop. 19?
Prop. 19 amends a part of the state constitution. It has two distinct parts:
Homeowners who are 55 or older, who are severely disabled, or who lose a home in a natural disaster can transfer their tax assessment to a new home within the state of California. If the new home is more valuable than your previous home, the tax value of the new home is factored in and added to the current tax assessment (although there still is a benefit). Tax assessment transfers can happen three times and homeowners have two years to sell their current home and buy a new one if they are looking to do so.
Homeowners can no longer pass a home to a child or grandchild without reassessing the home value…unless the child or grandchild makes it their primary residence. If the children who inherit the home choose to rent it out, the tax value can be reassessed.
It starts to get really interesting — and a bit uncertain as to how the law will play out — from here.
During the webinar, Despotes explained some of the ins and outs of the new law.
Change in ownership rules with properties
While Prop. 13 protected owners from reassessments, if property changed owners, there would be a reassessment of taxes. When properties are owned jointly or by a group of owners, reassessment happens when there is a change in 50 percent ownership change within a legal entity owning property.
There have always been a few exceptions in change in ownership rules as Despotes noted in the webinar.
The most significant change in Despotes’ practice with estate planning and succession planning is the “parent child exclusion.” Property passing from parent to a child is not subject to reassessment if it was the principal residence of the parent irrespective of the property value. The child would take that property base from the parent.
Also, a parent could pass $1 million worth of other property (vacation home, commercial, industrial, etc.). When determining $1 million, the law looked at assessed value and not fair market value. That could be millions worth of fair market transfer depending on the assessment and if the property has been in a family for decades. It was a pretty significant tool for parents to transfer property to children.
However, the planning strategy will be changing now that voters passed Prop. 19, according to Despotes.
How to maintain tax assessment benefits with property passed along to a child?
As stated earlier, there is one exception where the parent-child tax benefit can still persist. The key is a child would need to make the property their primary residence. Despostes said there has not been clear guidance on how soon after a transfer a child would need to move in full-time, but it seems that you need to file a parent-child claim in a county within one year that the property is transferred. On that claim, the child would need to show primary residence to inherit the tax assessments from Prop. 13.
How long would a child need to make the property a primary residence?
Again, there is a lack of guidance currently on this but there will most likely be a minimum on this. Despotes hope there is uniformity among all California counties on this issue, but there has not been a decision.
However, the benefit would only extend to a primary residence. It is no longer possible for parents to transfer their tax assessment from a vacation home or commercial property to their children.
There is a limit on the exclusion from an inherited property
Despotes noted there is a $1 million cap between the difference of fair market and assessed value when it comes to the tax assessment exclusion. “Not only does a child have to establish residency but there is also a cap on it,” Despotes said.
How does this impact state revenue?
“There is going to be lost revenue as a result of the eligible homeowners being able to transfer property tax base up to three times within the whole state,” Despotes noted.
The county will also need to have more enforcement, which means more personnel, to ensure the new law is carried out.
When it comes to increasing revenue from Prop. 19, the goal is to raise money for fire protection and local government, according to the proposition.
How does Prop. 19 affect people with more than one property
While parent-child exemptions are still possible when a child makes a property a primary residence, it will be problematic keeping property like long standing family vacation homes in a family without incurring significant increases in carrying costs.
From a child’s perspective, they are going to need to weigh whether or not they want to keep a second property with a much different tax bill than what their parents had as owner.
However, Despotes noted an example of a client he’s currently working on with a one-fourth interest in the property. “It’s a vacation-type home in Lake Tahoe. In the event that she dies and the property passes to her children, her one-fourth ownership is subject to reassessment. The entire property isn’t subject to it. Your fractional interest in a property doesn’t affect all owners.”
The impact of this might be lessened for income-producing properties like commercial properties where increased cost in taxes can be passed on to tenants in some cases, Despotes said.
Property owners preparing for Feb. 16 start date
Some people are trying to get transfers done between parents and children prior to Feb. 16, when the law takes effect.
Despotes noted that he is working with several clients on this right now who are expediting parent-child transfers in advance of the Feb. 16 deadline so their children can avoid a tax assessment.
After Feb. 16, there is no tax benefit to doing an inter vivos gift with a vacation home between parent and child, Despotes said. There may be other benefits, but not when it comes to taxes. For certain clients under certain circumstances, it would be appropriate to do a gift now. But it ultimately depends on their unique circumstances, Despotes said.
Properties preserved in trust
Unless you are making immediate changes (that is gifting a home to a child before Feb. 16) the parent-child exclusion will go away for properties that aren’t primary residence. Despotes noted that he is working with an elderly client with a home in Carmel, California, who is giving it to a child in advance of Feb. 16. They want to make a gift for gift tax and also to keep property tax basis low. They are making the gift into an irrevocable trust and making it very certain that the children are the only beneficiaries. The language needs to be very clear in trusts, Despotes said.
What if there are multiple children who are beneficiaries?
What happens if there are two children on a title — does the parent-child exclusion stay put if one of the two makes it a primary residence?
“My suspicion is that it would qualify — but that’s a guess though and there is not, to my knowledge, guidance on this issue,” he said.
How will primary residence be enforced?
Despotes’ hunch is that there may be an initial aggressiveness in claiming primary residence. The question will be how is this enforced by each county. Will it be where you are receiving mail? Will it depend on your driver’s license address? Were you registered to vote?
There is a lot of administrative burden that has been added and enforcement will be an issue, he said.
For recently purchased properties, Prop. 19 really isn’t an issue, Despotes noted. Primarily, Californians who should take note are those who own multiple properties — particularly with a second home or property that has been in the family for generations and benefited from Prop. 13. These are properties where the fair market far exceeds assessed value. The choice is to either make a transfer of ownership before Feb. 16 or have a discussion with children about the increase in taxes when the property is transferred. At that point, the children can either keep the property with the new assessments or sell it.