If you own property in California, whether your personal residence, OR a rental property, you know about Proposition 13…otherwise known as “Prop 13”.
What’s the worry? An increase in property taxes through a re-assessment. Property taxes aren’t cheap and it’s critical for property owners to understand the history and the tricks to avoid higher property taxes.
Why did we need Prop 13?
According to the Howard Jarvis Taxpayer’s Association, the tax rates on properties in California prior to Proposition 13 averaged a little less than 3% of the market value and there were no limits on tax increases and so some properties taxes increased by 50% to 100% in just 1 year which was disastrous for those living on fixed incomes.
When did Prop 13 come into effect?
Proposition 13 was enacted in 1978 as a constitutional amendment and placed restrictions on property tax increases. Controlling the property tax rates on homes and businesses was critical. Prop 13 took the problem head on by providing that property tax rates could not exceed 1% of the property’s market value, which is established at the time of purchase, and property taxes could not increase more than 2% per annum unless the property was sold. As a result, a buyer of a property or owner of existing property could predict with reasonable certainty what their property tax liability would be. The property tax base would be established based on the price you paid for the home and increases would be limited to 2% unless the home was sold. As a result, adjoining neighbors who own similar types of property may pay drastically different property tax rates depending on when they acquired the property.
For investors of real estate in California who want to benefit from Prop 13, it is important to understand the rules governing property tax reassessment when you are structuring your real estate portfolio for asset protection or estate planning as the failure to properly claim a reassessment exemption could result in your property taxes reassessed to current fair market value. Under the rules, property tax increases are limited to the 2% per year unless there has been a “change in ownership” which triggers reassessment. There are several key exemptions which by law do not constitute a “change in ownership” which is important for owners or investors of real estate to know which includes the following:
- Transfers between spouses or registered domestic partners. Interspousal transfers do not trigger reassessment whether it is a transfer is between spouses, a transfer as part of a divorce, or transfer to spouse as a result of a death.
- Parent-Child or Grandparent-Child exclusions. The purchase or transfer of real property which is the principal residence of the transferor between parents and children is not considered a change in ownership. For other real property that is not the transferor’s principal residence, the transfer of the first one million dollars ($1,000,000) of the value of the property is not considered a change in ownership. Transfers from grandparents to grandchildren qualify under similar rules, except it only applies if the parents of the grandchildren who qualify as children of the grandparents are deceased.
- Transfers to or from entities. Transfers into an LLC or corporation do not constitute a change in ownership so long as the proportional interest in the property is exactly the same. So if Husband and Wife own a property 50-50 and transfer the property to an LLC in which they also own 50-50, no reassessment would occur.
- Transfers within entities. A transfer of fifty percent (50%) or less of any interest in a partnership, LLC or legal entity is generally not considered a change in ownership. The key for this exclusion is whether the transfer of partnership interests results in a change in controlling interest. For example, if I own 51% of an LLC that owns real estate and I buy out the other 49% interest owners, there is no change in ownership because there is no change in controlling interest.
- Transfers to trusts where the trustor(s) and beneficiaries remain the same. Trustor(s) would be the ones who own the property and set up the trust. If the trustor(s) and beneficiaries are the same, then the interest retained is deemed substantially equivalent and so no change in ownership occurs. However, if the property is transferred to a trust that has beneficiaries different from the trustor, then that could trigger reassessment, unless the trust is revocable. Transfer to a revocable living trust (which most estate planning trusts are) is not a change in ownership until the trust becomes irrevocable.
This list above is an initial summary of some of the main exclusions and is not exhaustive list nor a complete explanation of all the details for each exclusion.
California requires that a claim for exemption be timely filed which, in general, is within three years after the transfer giving rise to the exemption claim. This is especially important for children who receive real estate in California from their parent’s trust. In the case Empire Properties v. County of L.A., the parents put a property in a revocable living trust. Mom died in 1984 and dad subsequently passed in 1987 upon which their trust became irrevocable. The Court found that a change in ownership occurred upon the father’s death in 1987 and since the children did not file a claim for exemption until 1991, they were precluded from claiming the parent-child exclusion and the Court concluded that the reassessment was proper even though it could have qualified for the parent-child exclusion. SO IT IS IMPORTANT TO FILE EXEMPTIONS TIMELY ESPECIALLY FOLLOWING THE DEATH OF AN OWNER. Each county has forms to claim the exemption and in most cases, the exemption would be claimed on the “Preliminary Change of Ownership Form.”
Finally, when structuring your real estate for asset protection or estate planning, if there are multiple exemptions that can be claimed, it is recommended that you claim each exemption separately and do not skip steps. For example, if a husband owns a California property 100%, but wants to transfer the property to an LLC owned 50-50 by husband and wife, the husband should first transfer the property to the wife claiming the spousal exclusion, and then transfer from husband and wife to the husband and wife owned LLC claiming the proportional interest transfer to an LLC. If the husband as the sole owner transfers instead directly to the husband and wife owned LLC, it would trigger reassessment of the property despite the fact there were exemptions that could have prevented reassessment. We have seen this done incorrectly before and so don’t miss out on a reassessment exclusion just because you wanted to skip a step.
Given how fast many properties in California have appreciated, it is very important to understand the Prop 13 rules governing property reassessment when developing a structure for your assets and your estate.
There are usually no do-overs if you do it wrong, so make sure you claim your reassessment exclusions correctly or else you may be stuck with paying a higher property tax for as long as you have the property.