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Changes in California Property Tax Law: Planning Opportunities With Principal Residences

The passage of Proposition 19 by California voters in November 2020 made significant changes to the exemption from property tax reassessment for transfers between parents and children. (Read our November 2020 alert here.) Before the passage of Proposition 19, the transfer of a principal residence between a parent and child could be fully excluded from property tax reassessment, regardless of the market value of the property or whether the child subsequently used the property as a principal residence or for some other purpose. Under the previous exemption, children not only received the benefit of the existing taxable value of the property but could also pass some or all of that benefit along to their own children. Prior to Proposition 19, it was beneficial for property tax purposes to own a principal residence directly through a living trust so that the parent-child exemption could be used to fully exempt the residence from property tax reassessment.

Proposition 19 repealed the existing parent-child exemption and replaced it with a much more limited one. Beginning with transfers occurring on or after Feb. 16, 2021, the parent-child exemption is limited to transfers of a principal residence that at least one of the transferee children will use as a principal residence, as well as to certain farm property. In addition, even if a transfer qualifies for the exemption and the property will continue to be used as a principal residence by a child, a principal residence with a fair market value in excess of the residence’s current assessed value as of the date of transfer, plus $1 million (adjusted for inflation), will trigger a partial property tax reassessment. Given these limitations, the new parent-child exemption is likely not going to be available in most cases where children inherit a principal residence.

To preserve the assessed value of the principal residence when it is transferred to children (typically at death), you should consider forming a limited liability company owned by your living trust to be the direct purchaser of the residence. For California real property where a business entity, such as an LLC, is the original purchaser, a transfer of all or any portion of the LLC interests will generally not cause a “change in ownership” triggering a reassessment unless the transfer causes any person to obtain, directly or indirectly, more than 50% of the ownership interests in the entity (called the “change in control” rule). In the case of an LLC or partnership, control is measured in economic terms by ownership of more than 50% of the total partnership capital and more than 50% of the total partnership profits; the actual control of management decisions by a manager, the general partner, or other partners or members is not relevant. For purposes of applying the “change in control” rule, there is no attribution of ownership between family members or other related persons. With respect to trust owners, an interest held by a revocable trust is treated as being owned for property tax purposes by the trust settlor(s) who have the power to revoke the trust, and an interest held by an irrevocable trust is treated as being owned by the current beneficiary(ies) of the trust.

When an LLC is the original purchaser of a California residence (or any other real property), the property is not reassessed at the death of the first spouse even though the surviving spouse will come to own 100% of the LLC because the inter-spousal exclusion applies and trumps the change in control rule. When the surviving spouse dies and the LLC interest passes to at least two children, as long as no child comes to own more than 50% of the LLC (whether directly or through an irrevocable trust for the child’s benefit), there would be no reassessment of the property. This same planning works if the property will pass to beneficiaries other than children, as long as no beneficiary comes to own a more than 50% interest in the LLC.

This same planning will not work, however, if you first purchase the residence in your individual name(s) or through your living trust and then contribute the property to an LLC that you wholly own. In that scenario, in addition to the change in control rule described above, the property will also be reassessed when more than 50% of the LLC interests have been transferred, cumulatively (excluding transfers to spouses). For a residence or other property contributed to an LLC, the transfer of the LLC interests at the death of the second spouse would trigger a reassessment (even if no single beneficiary receives more than 50% of the LLC in the transfer), as would transfers during your lifetime of more than 50% of the LLC interests. This cumulative 50% transfer rule does not apply when the LLC or other legal entity is the original purchaser of the property.

As with all planning, there are other factors you should consider in deciding whether to acquire a principal residence through an LLC. For example, since a residence is not income producing, the lender may require that the LLC owners guarantee any mortgage debt, which is generally undesirable since it causes otherwise nonrecourse financing secured by the residence to become recourse to the LLC owners. Some banks may also charge a higher interest rate on the mortgage if the residence is purchased through an LLC. New federal requirements for reporting the beneficial ownership of entities, including LLCs, also may soon apply. (Read our article “New Beneficial Ownership Reporting Requirements for Privately Held LLCs and Other Entities” here.) But depending on your circumstances and overall goals, acquiring your residence through an LLC may be a powerful way to generate significant and long-term property tax savings when the residence passes to your children.