Parents, Kids, and Inheritance of Real Property
By Joseph Ferrucci
January 2, 2018
For Californians who own real property, reassessment of real property is a critical estate planning issue. At the time of death, the transfer of real property to estate beneficiaries constitutes a change of ownership, triggering reassessment and in all likelihood an increase in property tax, which could make it financially impossible for the beneficiaries to keep the property.
For Californians with children, California law provides a way to eliminate or reduce property tax reassessment at the time of death. Under Prop. 58, a transfer of real property from parent to child is excluded from reassessment, provided that the child timely files an exclusion application with the county assessor after the parent’s death.
But parents should proceed with caution. Without proper estate planning, children may not be able to make full use of the parent-child exclusion. If a property owner wants his or her children to keep the family home (or other real property), the estate plan can and should be structured to avoid reassessment traps.
Use estate planning to double the $1 million exclusion cap.
The parent-child exclusion can be used for the parent’s principal residence regardless of value. For other real property, the exclusion is limited to $1 million in assessed value. But with some relatively simple estate planning, a married couple can double the $1 million cap, saving future generations tens of thousands of dollars in property tax.
Consider the example of a retired married couple, with three adult children. The couple owns their home and two parcels of residential rental property. All their assets are community property. The home is worth $1.2 million. The two rental properties have a combined assessed value of $1.5 million but a fair market value of $3.0 million. The couple has a typical estate plan that leaves all assets to the surviving spouse outright when the first spouse dies, and then when the second spouse dies, the estate plan leaves all remaining assets to the three children equally. The first spouse dies in 2018 and the second spouse dies five years later in 2023.
On the death of the first spouse in 2018, the transfer of the rental property to the surviving spouse will pass free of reassessment under a different exclusion altogether – the spousal exclusion. On the death of the surviving spouse in 2023, the transfer of the rental property to the children will qualify for reassessment exclusion up to $1 million, leaving the remaining $500,000 of assessed value subject to reassessment.
The estate plan in this scenario missed a crucial point. The $1 million exclusion is allowed for each parent, but by leaving all assets to the surviving spouse at the death of the first spouse, the estate plan essentially abandoned the first spouse’s exclusion. In this example, the missed planning opportunity would result in an approximate property tax increase of $5,000 per year (if $500,000 in assessed value is re-assessed to $1 million, and taxed at a rate of 1%) for as long as the children continue to own the rental property.
At the death of the first spouse, instead of leaving all assets to the surviving spouse outright, the estate plan could instead leave some of the rental property to the children. For example, if the children received half of the rental property on the death the first spouse, and the second half on the death of the second spouse, i.e., $750,000 in assessed value from each parent, then each half would pass under each parent’s respective $1 million exclusion and fully escape reassessment.
Alternatively, the first spouse’s $1 million exclusion could also be preserved by holding the inheritance of the rental property in a bypass trust for the benefit of the surviving spouse, with the children as mandatory remainder beneficiaries of the real property. The advantage of the bypass trust would be to allow the surviving spouse to use the rental income for support during his or her remaining life, while still using the first spouse’s parent-child exclusion to ultimately pass the real property to the children. A disadvantage of the bypass trust is that bypass trust assets will incur more capital gains tax in the long run. The relative tax impacts have to be evaluated on a case by case basis.
Avoid estate planning that prompts sibling-to-sibling transfers of real property.
Even if real property qualifies for the parent-child exclusion on the death of a parent, it could become subject to reassessment later there are transfers between siblings.
Returning to the example above, consider what happens when the parents’ residence is distributed to the three children following the death of the second parent. The distribution to the three children is eligible for the parent-child exclusion. The children then end up being co-owners of the residence in equal thirds. But in the future, if one of the children decides she wants to sell her share to the other two siblings, the sale of her one-third interest to the siblings will be subject to reassessment, because sibling-to-sibling transfers are not exempt from reassessment.
The same reassessment risk occurs if the siblings decide on non-pro rata distribution directly from the parents’ estate plan. That is, in contrast to the example above (where the residence is distributed to the three children and there is a later transfer between the siblings), consider the scenario where one child decides immediately after her parent’s death that she does not want an ownership interest in the residence, and title is transferred directly from the parents’ trust to the other two children. Even in this scenario, one-third of the residence would be viewed as being “transferred” from sibling to sibling and subject to reassessment.
In an effective estate plan, parents can avoid this result. A few options are available.
- Specific Gifts. The estate plan can make a specific gift of each property to a child, each of which would qualify for the parent-child exclusion. In the example above, the estate plan could be written to gift the residence to the first child, one rental property to the second child, and the second rental property to the last child. This approach may not result in equal distributions, depending on the property values, but if parents wish to equalize the value of the distributions between the children, parents can explore using life insurance, equity loan proceeds, or other assets to make sure each child gets, on net, one-third of the value of the parents’ trust.
- Right of First Refusal. As another option, if parents do not have equalizing assets, the estate plan can give a child a right of first refusal to purchase a property from the trust. A purchase under a right of first refusal, by a child from a parent’s trust or estate, qualifies for the exclusion.
Both of these options require the parents to know which child wants which property, or simply to make the decision for the children. As difficult as that choice might be for parents, it alleviates the need for the children to make even more challenging decisions for how to divide real property after the parents’ deaths, while facing the prospect of reassessment.
If parents have not taken additional precautions in the estate plan to avoid reassessment traps, then the children will have to attempt to avoid reassessment when administering the estate plan after both parents have passed away.
- Equalizing Assets. If the estate plan allows non-pro rata distributions, and one child does not wants the residence (returning to the example above), and there are sufficient other assets of equal value to distribute to the other children, then the distribution of the property to one child will qualify for the exclusion.
- Equity Loan. If there are no equalizing assets, or insufficient equalizing assets, then the fiduciary can attempt to create liquidity by obtaining an outside loan against the equity of the residence. The residence then could be distributed to two of the children subject to the loan, and the cash proceeds of the loan could be distributed to the child who opted out. It can be difficult or expensive, however, to obtain such a loan, which limits the feasibility of this approach.
- Disclaimer. If the child not only does not want the residence but also is willing to forgo all or a portion of her inheritance, and she timely executes a written disclaimer, then the residence can qualify for the parent-child exclusion upon transfer to the other children
Because these post-death options only work in the best of circumstances, it is generally advisable for parents to come up with an estate plan that avoids triggering deemed transfers from sibling to sibling.
Consider pros and cons before transferring real property into an entity.
To take advantage of the parent-child exclusion, the transfer of title must take place between parents (or their living trust) and children. Transfers of shares of entities between parents and children do not qualify. Therefore, before transferring real property into limited liability companies (LLCs) or other business entities, property owners should carefully weigh the possible loss of the reassessment exclusion against the benefits of the entity structure.
Certain other parties may qualify for the exclusion.
Both natural born children and adopted children (specifically, those adopted during minority) are eligible for the parent-child exclusion. In addition, subject to certain rules and limitations, step-children, spouses of children, and grandchildren (under Prop. 193) may also qualify for the parent-child exclusion. More specifically, the parent-child exclusion is available in the following circumstances:
- The property owner has a step-child, even if the owner’s spouse pre-deceased, so long as the owner has not remarried.
- The owner’s pre-deceased child left a surviving spouse who has not subsequently remarried.
- The owner has grandchildren from a pre-deceased child, and the grandchildren’s other parent is deceased or remarried.
This flexibility allows property owners more opportunities for passing real property at death free of reassessment.
Examine fair market value on the date of death.
Keep in mind that using the parent-child exclusion is optional and may not always be advisable. In urban areas of California, property values tend to rise year over year, which makes the parent-child exclusion a powerful tool for preserving property tax basis. But property values may not increase everywhere all the time, depending on marketing conditions. If the fair market value of real property at the date of death is less than the assessed value, it would be better not to apply for the parent-child exclusion and allow the property to reassess to the new, lower value. For a property that has declined in value, allowing the property to reassess would actually reduce the annual property tax bill.
In conclusion, while the parent-child reassessment exclusion is a powerful tool for reducing taxes on estate beneficiaries, beware of reassessment traps. Estate planning is crucial to make full use of the exclusion. The right estate plan can make it more financially feasible for children to retain ownership of real property after the parents have passed away. For help with reassessment issues in your estate plan, contact your estate planning attorney.
DISCLAIMER: This article contains general information about legal topics. It is not, and is not intended to be, legal advice. Your use of information in this article does not make Joseph Ferrucci, Attorney at Law P.C., or any of its attorneys, your attorney and does not establish an attorney-client relationship. Every case must be analyzed independently, based on the specific and unique facts of the case. If you have questions about your particular case, consult with a licensed, qualified attorney. This article is intended for personal use only, and not for publication or distribution.
© 2018 Joseph Ferrucci, Attorney at Law P.C.