How to Navigate Proposition 19 When Inheriting Real Estate

If you’re anticipating inheriting real estate from an older family member, understanding how Proposition 19 impacts property taxes is essential to making informed decisions. While inheriting property can be a valuable asset, California’s property tax laws present challenges that could result in significant financial obligations.

Let’s explore the potential pitfalls of Proposition 19 and consider strategies to minimize property taxes, ensuring you can retain the family home and maximize its value for future generations.

What is Proposition 19?

Passed by California voters in November 2020, Proposition 19 made significant changes to the rules governing property tax reassessment upon inheritance. Under prior law, real estate passed from parents to children could maintain its existing low property tax assessment, thanks to Proposition 13, which capped property taxes at 1% of a home’s assessed value and limited yearly increases to 2%.

With Proposition 19, however, several key changes took effect:

1. Limited Parent-to-Child Exclusion: This exclusion from property tax reassessment only applies if the property is the parent’s primary residence AND the child uses the inherited property as their primary residence. If the property is used as a rental or vacation home, it will be reassessed to its current market value, often resulting in a sharp increase in property taxes.

2. Cap on Exclusion Amount: Even if the child makes the inherited property their primary residence, the exclusion is limited to the home’s existing assessed value plus $1 million. Any portion of the property’s market value that exceeds this threshold will be reassessed at the current market rate.

Pitfalls of Inheriting Real Estate under Proposition 19

1. Higher Property Taxes on Non-Primary Residences

If you inherit a property and choose to rent it out or use it as a second home, it will be reassessed at its current market value. This can lead to much higher property taxes, sometimes making the property unaffordable to keep.

2. Substantial Tax Increases for High-Value Properties

Even if you plan to live in the inherited home, real estate in areas with high market values can still trigger higher property taxes. With the exclusion capped at $1 million over the home’s assessed value, properties in the San Francisco Bay Area, Los Angeles, and San Diego can easily exceed this threshold.

For example, if a home is currently assessed at $500,000 for property tax purposes but is now worth $2.5 million, the exclusion only applies to $1.5 million ($500,000 assessed value plus $1 million). This leaves $1 million subject to reassessment at market rates, potentially leading to a significant tax increase.

3. Pressure to Sell Inherited Property

Increased property taxes may force some heirs to sell family homes they would prefer to keep. This can disrupt long-term wealth-building opportunities and erode generational property ownership, particularly for families who have owned real estate for decades.

Solutions to Minimize Property Taxes

While Proposition 19 presents challenges, several strategies can help reduce the financial burden and allow you to retain inherited property.

1. Move into the Inherited Property

One way to avoid a full property tax reassessment is by making the inherited property your primary residence. By doing so, you can take advantage of the $1 million exclusion from reassessment. Though this might not eliminate all tax increases, it can prevent a more drastic rise in property taxes.

For example, if the home’s current assessed value is $500,000 and its market value is $2 million, the new assessed value would be $1 million (market value minus the exclusion), rather than the full $2 million, significantly reducing the tax increase.

2. Consider Gifting the Property Before Death

For some families, it may be advantageous to transfer ownership of the property before the original owners pass away. Gifting the property while the older generation is still alive can prevent Proposition 19 from coming into play. However, this strategy must be carefully planned, as it can have capital gains tax and gift tax implications.

Before proceeding with any gift or transfer of real estate, it’s crucial to consult with an estate planning attorney and a tax advisor to understand the full financial impact and determine the best course of action for your family.

3. Use a Family PARTNERSHIP or LLC

Placing real estate into a family partnership or a limited liability company (LLC) can offer flexibility and long-term planning benefits. While it may not entirely avoid property tax reassessment, it can help structure the transfer of the property in a way that aligns with your broader estate planning goals. An LLC can also offer protection from creditors and help manage the property among multiple heirs.

4. Rent or Sell Strategically

If keeping the property as a primary residence is not an option, renting it out could generate income to cover the increased property taxes. Alternatively, if the property’s value has risen significantly, selling it might make sense. A well-timed sale could provide substantial financial benefits and help avoid the long-term tax burden.

Inheriting real estate in California under Proposition 19 presents a unique set of challenges, especially regarding property tax reassessment. Understanding these rules and being proactive about tax planning can help you navigate the complexities and preserve your family’s assets.

Consulting with an experienced estate planning attorney, CPA, and financial advisor is essential for finding solutions that fit your specific situation. By taking thoughtful steps now, you can protect the value of your inheritance and ensure it remains a valuable resource for your family’s future.

Full Video of the January Living Trust Seminar

The seminar below was presented live on January 21, 2023, by Matt Shafae, at the reSolve Group offices in Palo Alto. We covered basic estate planning, how to review an existing estate plan, how to care for minor children, and a basic survey of the taxes involved in an estate plan.

The screen may be hard to view on the video. Click here for a copy of the slides to follow along.

Avoid the Estate Planning Banana Peel – Don’t Add Your Kids on Title to your Home

Many aspects of estate planning in California center around avoiding the need for probate court. Adding a death beneficiary to an asset or adding a co-owner on title to an asset are two ways to avoid the need for probate court when you die. Well, that sounds pretty easy. Why don’t we all just do that and call it a day?

Put simply, adding co-owners and death beneficiaries to assets only addresses one situation: that 1) you have died; 2) that the beneficiary/co-owner is alive upon your death; 3) the beneficiary/co-owner has capacity and is over 18 years old upon your death; and 4) the beneficiary/co-owner does not have creditors nipping at their heels.

There are so many other scenarios that can occur. All it takes is for any one of the four factors above to be false for your simple plan to become complicated and problematic. Besides that, there are tax implications for adding people onto title of your assets.

Let’s illustrate with a common example. A widowed parent owns their own home, and has two children. The parent figures that it would simplify everything if they add their two children onto the title of the home. That way, upon the parent’s death, the children receive the home, in equal shares, without having to go through the probate process.

What gets overlooked in the above hypothetical are the following considerations.

Death v. Incapacity

The only way to avoid probate in the above example is if the parent dies. If the parent is alive but incapacitated (think: dimentia), the children have no authority to act on the parent’s behalf by simply being co-owner of the home. They now co-own a property with someone who cannot handle their own affairs. They would have needed the parent to sign other legal documents, such as a durable power of attorney.

Similarly, if either or both children are incapacitated upon the parent’s death, probate may be necessary to receive ownership of the home unless the incapacitated child signed a durable power of attorney themself. Or, if the children are not yet adults, they cannot own the property outright without legal guardians involved.

Creditors

When the parent adds the children as co-owners to any asset, including their home, the parent is entangled with that child’s financial life, including that child’s creditors. If the child is going through a divorce, or someone is suing them for money, or the child owes taxes or other debts, or if the child files for bankruptcy, then the parent’s home is now subject to the claims of the child’s creditors. The parent may have to figure out how to get their own house back!

Additionally, if the child faces those same creditors after the parent’s death, there is no barrier between receiving full ownership of the house and satisfying those creditors’ claims. Ultimately, the child may end up losing the home to their creditors, which is certainly not what the parent intended.

Creating Capital Gains and Property Tax Problems (Click here for a brief discussion of taxes)

When the parent adds their children to title, the parent is making a lifetime gift of that portion of the home. This in itself could trigger a gift tax issue. Gift tax issues aside, typically when the parent dies, all of the capital gains built into the home are eliminated upon the parent’s death. But only the capital gains associated with the portion of the home that the parent owned at death. The portion of the home that the children now own do not receive what is called a “step up in basis”, and the capital gains for the children’s portion are not eliminated. If the parent kept all 100% interest in the home, then all of the capital gains would have been eliminated. After putting their children on title during their life, the parent is now creating a capital gains problem for the children when they sell the home.

Adding multiple children to title can also create adverse property tax implications. Even though Prop 19 has severely limited the application of the parent-child exclusion, there is still an opportunity for the parent to transfer the home to one or more children with some relief from increased property taxes. However, when more than one child is added as co-owner, the home could get reassessed when one child decides to buy another out in the future since that is not a parent-child transaction.

Co-ownership and death beneficiary designations lack any nuance. It only asks whether an owner is dead, and if the answer is yes, ownership of the asset automatically transfers to the other co-owners or to the beneficiaries in whatever condition or circumstance they find themselves. No discretion is involved to determine whether it’s a “good” situation to transfer ownership of the home to the co-owner or beneficiary. Additionally, It makes you vulnerable to your co-owners’ creditors, and could create unforeseen tax issues for your loved ones. The only surefire way to transfer ownership of your assets, with nuance and full discretion, is to create a comprehensive estate plan.

Proposition 19

Californians have passed Proposition 19 with a little over 51% of the vote. It will significantly change the California property tax scheme as it applies to parent-child transactions.

There are two main components to Prop 19:

1. Over-55 Rule. The first component allows homeowners who are either over 55, have severe disabilities, or are victims of natural disasters or hazardous waste contamination to purchase a new residence and retain their property tax assessment from thier current home. In other words, you can “take” your current property tax rate with you to your next home, even if the new home is worth more than your current home. And you can do this up to 3 times in your lifetime. This provision takes effect on April 1, 2021.

1. Limited Parent-Child Exclusion. The second component dramatically limits what is called the “parent-child exclusion” from reassessment. Parents may no longer transfer unlimited amounts of property to children and escape reassessment. This one takes a bit more explanation. This provision takes effect on February 16, 2021.

A Brief Explanation of the Parent-Child Exclusion

In very broad terms, the California property tax scheme--or “Prop 13”--taxes owners of real property (the legal term for “real estate”) based on the property’s “assessed value.” To keep things simple, think of the “assessed value” as the purchase price of the property. Based on that purchase price, the tax collector imposes a ~1% tax. The property tax is not adjusted until or unless there is a “change in ownership.” When there is a change in ownership, the value of the property is reassessed. Reassessment can increase the property taxes dramatically for the new owner. 

In 1986, California voters allowed for an exception to the general “change in ownership” rule that triggers reassessment. The exception is that if parents transferred their property to their children (either by gift, inheritance, or sale), then the assessed value (i.e. property tax rate) would carry to the children. In other words, if you received property from your parents, you would continue to pay the property tax rate your parents were paying. This exception was unlimited when parents transferred their primary residence, and was limited in value when parents transferred property that was not their primary residence (e.g., vacation home, rental property, etc.).

Now let’s fast forward to February 16, 2021. When Prop 19 takes effect, the parent-child exclusion described above will be abolished. In its place will be a far more limited exception. The new exception only allows escaping reassessment if parents transfer property to their children AND the children use the transferred property as their primary residence. In other words, if the children do not live in the house and want to use it as a rental property (or keep it vacant) then the property will be reassessed. 

For example, if a parent bought a house in 1972 for $200,000, then their property tax might be $2,000 a year, regardless of the house’s increasing market value. If the parents transfer the home to a child (either gift, inheritance, or sale) after February 16, 2021, and the child does not live in the house, the property will be reassessed to its current fair market value (say $2,000,000) and the tax will jump to $20,000 a year.

Your Options Going Forward

There is no straight answer here. There are MANY unknowns at play here: the pandemic, a potential recession, other changes in the law in the near future, and particulars about your life and family. All that we know is that Prop 19 will dramatically change parent to child transfers going forward. If you were planning to leave your children property with the presumption that they would enjoy property tax savings, then you may want to consider transferring to them prior to February 2021. However, please understand that a lifetime transfer now may carry capital gains implications forward to your children. It’s a balancing act. We cannot emphasize this enough: there is no one-size-fits-all solution here. Contact us immediately to discuss your situation, things you can consider, and available options.

A side note on timing: The California election is not certified until December 11. After that, there will be regulations that are issued about how Prop 19 will be implemented and how it will work. While we can provide guidance at this point, there are still some questions outstanding that we won’t know the answers to until after that date.