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By John E. O’Grady and Katherine M. Watts

A little planning can go a long way and save your loved ones thousands of dollars every year. If you own property and want to transfer it to a family member or leave it to one when you die, California’s property tax is something to consider. This article will inform you on ways the law will allow you to plan for your loved ones to receive California real estate from you without reassessment.

California Property Tax
California real estate is generally taxed at 1% of the property’s “assessed value.” The assessed value is the fair market value as of the date of a change in ownership. The law allows for increases to the assessed value of up to 2% each year. When there is a change in ownership, the property value is generally reassessed and the new owner pays more property tax. If the value of your property has increased more than the rate the tax has increased (up to 2% per year), a reassessment will result in significantly higher property taxes. San Francisco property owners have the most to save by planning because San Francisco property seems to appreciate more than property in other parts of California.

If you are merely selling your home to a stranger, you probably don’t care about reassessment. However, if you want to transfer your property to your children, saving them thousands of dollars every year is well worth the cost of proper estate planning. Here is a simple illustration: say you purchased your home in 1998 for $100,000. The original property tax would be $1,000 a year. The amount that is taxed each year can be increased by up to 2% each year. So the property tax in 1999 would be no more than $1,020. Assume that you now want to sell the home and it is worth $1 million. The new owner would pay property tax on $1 million, or $10,000 the first year—far more than what you were paying.

Certain transfers within families are excluded from the general rule that a change in ownership triggers reassessment. These exclusions from reassessment include transfers between spouses and domestic partners. Note that domestic partners won the right to the same property tax breaks as husbands and wives on January 3 of this year when the California Supreme Court turned down an appeal by county assessors. This article focuses primarily on exclusions for parent to child transfers and the exclusion for transfers to certain trusts.

Parent to Child Transfers
Generally speaking, a transfer of property from a parent to a child is not subject to reassessment, so the child will pay the same lower rate the parent paid. But there are significant limitations to this general rule. Each parent may transfer their principal residence and up to the first $1 million of the full cash value of another property to their child without triggering a reassessment.

Your principal residence is the property where you would take a homeowner’s exemption; in other words, it’s the place where you actually live, not a rental or vacation property. The transfer of up to $1 million of the full cash value of another property is where it gets a little more complicated. The “full cash value” refers to the assessed value, not the fair market value of the property, so you can really transfer property worth far more than $1 million without triggering a reassessment. For example, if you purchased the property 30 years ago for $100,000 and it is now worth well over $1 million, the assessed value ($100,000 plus yearly increases of no more than 2%) is the amount to be considered, even though the child will receive a property worth well over $1 million.

Since each parent can transfer to the child, one child could theoretically receive two principal dwellings (although there will usually only be one) and up to $2 million of the full cash value of other properties. The “Claim for Reassessment Exclusion” form must be filed within three years of the transfer or before the property is transferred to another party. Failing to file the appropriate form can result in a reassessment.

While the concept of “parent and child” seems simple enough, there are some unique scenarios to be aware of. In addition to all “natural children,” children born to a parent with a registered domestic partner, stepchildren, and those adopted before they reach 18 are also eligible for the exclusion. The spouse of a child (son- or daughter-in-law) is eligible until the relationship ends in divorce. If, however, the relationship ends because your child dies, the parent-child relationship is deemed to continue with the child-in-law until they remarry. There are also circumstances where foster children and foster parents can qualify.

A grandparent may also take advantage of this exclusion under specific circumstances and transfer to the grandchild without reassessment. All the child’s parents must be deceased before the grandparents qualify. Further discussion of additional restrictions on grandparent-grandchild transfers exceeds the scope of this article.

Beware of Limited Liability Companies and Other Entities
Many owners transfer their property to an entity such as a limited liability company to protect their other assets from lawsuits. One cost of doing so is that the property will be reassessed when the interest in the limited liability company is given to the children by gift or inheritance. This is because the parent-child exclusion only applies to transfers of real property, not of interests in an entity. For example, if you transfer your property to a limited liability company and then transfer at least a majority interest to your child, there will be a change in ownership and reassessment of the entire property. For property tax purposes, it would make more sense to simply transfer the property to the child directly, rather than going through an entity such as a limited liability company.

Transferring your property to an entity may be a good idea if you don’t have children. In addition, most transfers to entities that result in one spouse gaining an ownership interest over the other do not trigger reassessment. This is because the interspousal exclusion from reassessment is broader than the parent-child exclusion.

A transfer of real estate to entities that do not result in a change in the beneficial ownership interest will not trigger reassessment. These rules can’t be fully covered here, so consult a qualified tax practitioner before making any transfers to make sure they best suit your situation.

Transfers to Revocable Living Trust
Another way to transfer your property without triggering a reassessment is to transfer it to a revocable living trust. This option may be used if you are not ready to transfer your property now and you want to make provisions for it after your death.

For a trust to be revocable, you as trustor must reserve the right to terminate the trust and retain all trust property. When property is placed in a revocable living trust, there is no “change in ownership” and thus no reassessment. All that changes upon death is that the revocable living trust usually becomes irrevocable. Your revocable living trust should contain planning to qualify for the parent-child or another exclusion to avoid a “change in ownership” and thus reassessment upon your death.

Transfers to Irrevocable Trust
When property is transferred to an irrevocable trust during your lifetime or upon your death, or the beneficiary of such a trust is changed, there has been a change in ownership for property tax purposes and there will generally be a reassessment.

There will not be reassessment if the parent-child exception applies. With proper planning, you can leave your property to your children in trust and not have to worry that they will be burdened with high property taxes, and you can still hold on to the property for the duration of your life if you so choose.

When property is left to more than one child, one child may want the property and the other will want money or assets of equal value. If the trust merely provides the property to both children equally (each getting a one-half interest), one will then have to transfer the interest to the other in exchange for money. This would no longer be a parent-child transfer, but would be a sibling-to-sibling transfer, which is not excluded from reassessment. Thus a change in ownership has occurred and the property will be reassessed.

Non-pro-rata Trust
To avoid this result, create a “non-pro-rata” trust, one that provides for unequal distribution of the trust assets. A non-pro-rata trust can allow one child to get the property and others to get other trust assets or cash of equal value without triggering a reassessment.

Property transferred by trust is treated very differently than property transferred by will. The law provides that the trustee has the power to distribute trust assets non-pro rata, unless the trust instrument prohibits non-pro-rata distributions. With a will, the property will pass to the estate beneficiaries in equal shares, unless the will specifically grants the executor the power to make non-pro-rata distributions.

Note that if a beneficiary receives a present beneficial use of the property or income from the property, then it is deemed that there has been a “change in ownership” and the property taxes will be reassessed. To avoid this, the beneficiary generally shouldn’t live on the property or collect rents from it.

Keep in mind that all beneficiaries must fall within an exception to avoid reassessment. If one beneficiary does not fall within an exception, the entire property will be reassessed.

Again, keep in mind that these are just some of the ways you can avoid reassessment, and that there are many more nuances in the law than can be discussed here. Discuss these ideas with your estate-planning attorney if you want to transfer real estate to your loved ones without reassessment.

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The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. The information contained in this article is general in nature. Consult the advice of an attorney for any specific problem. John E. O’Grady and Katherine M. Watts are with O’Grady Law Group, APC in San Francisco and they can be reached at 415-986-5000 or see www.ogradylaw.com. Copyright © 2008 by SF Apartment Magazine. All rights reserved.