Prop 19 and how it impacts inherited property for California residents
In November of 2020, Proposition 19 passed and it gives people over age 55 more ability to transfer their home’s property tax base to another home – a boon for retirees wanting to downsize or move. Yet, as we have covered in another blog post on Prop 19, this law has significant implications for California property owners who are looking to pass on a home as an inheritance.
In this article, we’ll review some of Prop 19’s basic provisions as related to California tax code and go over a hypothetical case in which this new law is impacting the decisions made by families regarding inherited property.
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As estate, tax, and financial planning advice are specific to the individual case, nothing in this article may be construed as a recommendation of any sort. This is an entirely hypothetical scenario, and any similarities to real situations are entirely coincidental. For financial advice related to Prop 19 or other issues, please consult a professional financial or tax advisor.
Prop 19 and inherited property: a hypothetical scenario
Say you and your spouse have owned your home for 35 years and your current taxes are low relative to the value of your home. Suppose you have three children and in your estate plan you plan to divide your assets fairly between these children.
As is the case in many families, you may have left it up to your successors as to how exactly the assets get divided. Perhaps some of them have said they would like to inherit the house and live there if you leave it to them. It’s hard to predict the specifics of how it would work out given that they probably won’t be inheriting for many years. Transferring a major asset like a home can have serious tax consequences, and they are subject to change now that Prop 19 will apply.
Up until the February 15th deadline, a personal residence transferred by inheritance or gift to children is excluded from reassessment, so the children also receive the “low” property tax bill as well. Prop 19, in short, limits this exclusion significantly.
Prop 19 requires that if the home is not used as a child’s personal residence within one year, it is to be reassessed at market value when inherited. Let us look at how it may impact families and the choices they face by looking at a hypothetical example with more details.
What options should you be considering if you want to minimize significant increases in tax burden for your beneficiaries?
Options created for California families under Prop 19
Generally, you are faced with two basic options:
Allow the new law to apply going forward (take no action)
Transfer the property to your children on or before February 15th, 2021
For purposes of this example, let’s assume you bought your house in 1985 for $200,000; and now, even though your home is worth $2,100,000, the assessed value for property tax purposes is $400,000 – making your annual property tax $4,000 (thanks to the Prop 13 cap of 2%/year increases).
Again, this should not be construed as advice specific to any individual, but unfortunately, for a longtime California homeowner, there will likely be more taxes payable in the future – either income taxes or property taxes. No matter what choice you make, it is just a matter of opting for the better of the two.
Here’s an in depth look at each one.
Option 1: Wait until they inherit the property
If you make no changes, your children will inherit the home after you both pass away. The income tax basis of the home will be stepped up to the current market value at each of your deaths. You children might be subject to higher property taxes if they keep the home.
Sell Scenario:
If your home is worth $3,200,000 when they inherit it many years from now, they could sell and not pay any capital gains tax. Even though there's $3,000,000 of appreciation in value (between the $200,000 original tax basis and the $3,200,000 sale), the value gets “stepped-up” to market value when you pass away.
Rent Scenario:
If your children decide to rent your home after inheriting it, they will pay property taxes based on the market value when inherited (the assessed value would equal the market value). So, if you both died on February 16th, 2021, the annual property tax would go from $4,000 to $21,000 (1% of the $2,100,000 new assessed value)!
Move-in Scenario:
If they instead decide to keep the home and one of them is willing to move in and claim it as a personal residence, the property tax would go up in our example. Under Prop 19, if the market value of your home is more than the assessed value plus $1,000,000, the property tax increases.
To illustrate this move-in scenario, let’s assume you both died on February 16th, 2021 and one of your children decides to live in the home. The assessed value of your home was $400,000 and it is worth $2,100,000. An additional amount is tacked on to the original assessed value under Prop 19: The market value of $2,100,000 minus the original assessed value of $400,000 plus $1,000,000 (or $700,000) – making the “new” assessed value $1,100,000. Your child would see their property tax increase to $11,000 (1% of the new assessed value).
Option 2: Pass the house to your children now
Your children will get ownership of the home now and take the original cost of the purchase (the tax basis) along with your assessed value of $400,000 (giving them the Prop 13 property tax rate of $4,000/year). There would be no income taxes due on this transfer, however, this would use part of the amount you are able to give without federal estate taxes (currently $11.7 million/person).
You would need to work with an attorney to form an agreement or trust to handle how the property is treated, and to cover things like maintenance costs, and an allowance to live in the home rent free.
Giving part of your assets now is a tricky choice because it not only impacts your current finances and overall estate plan, but it may limit what you can do in the future. What if you decide to move to another state, downsize to another home in California, or travel the world and rent out your home? What if you decide you want to use a reverse mortgage?
Sell Scenario:
After you pass away, if your children ever decide to sell the home, they would have to pay capital gains taxes on the difference between your original purchase tax basis of $200,000 and the market value at death. Using the same numbers from above, if the market value is $3,200,000, it would amount to income taxes on $3,000,000 of appreciation. Using an overly simple 20% capital gain tax rate, that would be $600,000 of taxes due!
Rent and Move-in Scenarios:
Your children benefit from having the lower assessed value and property tax. They can decide to later rent the home or move in – subject of course to any conditions of the prior agreement or trust that was originally established.
Complicating Factors and a Possible Option 3
If you own rental real estate or have a Qualified Personal Residence Trust (QPRT) and are now thinking over your choices given Prop 19, we urge you to work with your professional team as these cases are more complex and other considerations should be made.
We have seen some references to “Option 3”, basically a combination of Options 1 and 2 above, where an incomplete gift can be made to children. The idea would be to get the best of both worlds - preserve the Prop 13 assessed value and get a step-up in basis at your death.
We are not able to judge the efficacy of this sort of approach but will point out that Propositions, by their nature, leave many questions and possible loopholes that are later addressed with further legislation and implementation guidance. It would be wise to consider this if you decide to pursue this option.
Conclusion on Prop 19 and property inheritance in California
In general, if you have a highly appreciated home and you are certain your children will sell it after inheriting it, you should consider retaining ownership as-is; conversely, if you are certain your children will never sell the home, you should consider transferring ownership before the deadline.
Which option should a family choose? It depends on a myriad of personal and financial factors. If you have not yet sat down with your legal, tax or financial advisor to go through them and are considering making a move, you may wish to do so promptly. Technically, any transfers must be made on or before February 15th, 2021 to avoid Prop 19 treatment, but because that’s a state holiday, plan to get it done several days before then!
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Contributor
Chris Jaccard, CFP®, CFA is a lead advisor with Financial Alternatives in La Jolla, CA. When he’s not working on home improvement projects or trying to keep up with his kids, he loves to help successful families consider their alternatives and make better financial choices with the EXPERT™ Advisory Process. Schedule a time to chat about your situation or the latest project.
Source: California State Board of Equalization. Proposition 19 – The Home Protection for Seniors, Severely Disabled, Families, and Victims of Wildfire or Natural Disasters Act. Retrieved from Proposition 19 (2020) – Board of Equalization (ca.gov)