Taxation & Tax Planning
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Important Future Planning for Real Property Tax Reassessment Avoidance
Now that proposition 19 is the law, and severely hampers a family’s ability to avoid reassessment of real property passing from one generation to the next, other tax savings strategies become important.
This email is to alert you to some further important methods for you to strongly consider to avoid future real property tax assessment increases.
The following new property tax increase avoidance techniques have arisen since this office created and put in place pre prop 19 effective date property tax saving plans for our clients:
o Use a LLC or partnership for direct future real property acquisitions from third parties; or
o For the partnerships or LLCs that already existed or that we formed to which real property was transferred by parents, utilize a series of entity dissolution and reformation structures to avoid or delay future reassessment for many years to come.
See details below.
1. Summary of Entity Planning strategies to avoid or minimize future real property reassessment
There are two ways to avoid real property tax assessments in the future:
• Form a new LLC created to acquire real properties directly from 3rd parties.
• For an existing partnership or LLC, engage in a series of dissolutions and new entity formations.
See detailed discussion below on how each of these works.
a. First Strategy-Form New Entities to buy the real property you want, when purchasing Real Property in the future from Third Parties
Entity planning will continue to be essential to deferring reassessment. Going forward, it is advisable to purchase real property in an entity with or without heirs. The parents can then makes gifts of entity interests to avoid a change in control and resulting reassessment.
By way of example, if a parent purchases real property through an entity, instead of directly, the parent will be the 100% owner of the entity (such as a LLC). The parent could still make gifts of interests in the entity, not the underlying property, to his three children (for example gifting them each a 1/6 interest). No change in control has occurred after those gifts because the no one person has acquired control (defined as more than 50%) after the gifts. Even upon parent’s death, each child only owns 1/3 of the entity. Thus none of them are in control. So long as no one person gains control, there will be no reassessment.
Thus, instead of parents or parents and kids buying real properties as tenants in common, create and use an entity to make future acquisitions of real property in order to take advantage of this rule to avoid reassessment for long periods of time, maybe forever, if no one person ever acquires more than 50% of the entire LLC.
b. Second Strategy-Avoiding Shift of more than 50% rule by series of old entity dissolution and new entity formation steps
For those of our clients who have or did engage in transfer of property into an entity, because they did not have the opportunity to purchase property directly through an entity from a third party, there are still opportunities going forward following the formation of the new entity this year or in future years that already owns real property.
For example, if the parent transferred real property to a new entity we formed for them, and transferred it to the new entity, we used what was called the proportional interest transfer rule to avoid reassessment when the property was transferred to the new entity or trusts, as partners.
Client parent was 100% owner of the entity until the transfer to the entity, or transferred percentages in the property to a trust for children or grandchildren, after which all transferred their interests to the new entity, this year.
Parent made gifts of up to 50% interest in the entity the their children. For example, if parent transferred to his three children (giving them 1/6 interest each in the new entity either directly or through a trust for each child). No reassessment at that point because of the proportional interest rule and therefore no transfer of control (meaning in this context a transfer of more than 50% interest in the entity that now owns the real property).
If no further planning is done, someday if more than a 50% cumulative interest over time is transferred in the entity, the real property will be subject to reassessment when that line is crossed some time in the future.
The gift in the entity made to the children are part of that cumulative 50% interest transfer. So, when parent dies and their 50% interest is transferred, the entire property is reassessed because at that time, more than 50% interest in the entity will have been cumulatively transferred (16 2/3 % + 16 2/3 % + 16 2/3 % plus the first 1% of parent’s 50% takes the entity over the more than 50% transferred line.
Under California law, Entities must report changes in control to the California State Board of Equalization.
New Strategy: However, while parent is still alive, the partners in the entity could do the following:
• parent and children could pull the real property out of the entity and take back proportionate interests in the real property equal to their interests in the partnership.
o No reassessment at that point due to the proportionate interest rule.
• Then, parent and children form a new entity.
• Then they contribute the property to a new entity for same percentage interests as in the real property;
• They will be once again subject to the cumulative transfer rules,
• but now when parent dies, then no reassessment at parents death, because parent only owned 50% which is transferred to the children in equal shares.
• Children now own 33 1/3 per cent each.
• There will be no reassessment until over 50% cumulative interest in the new entity occurs.
• Remember, 50% has been transferred. So…
o upon the transfer of only a 1% interest subsequently, will result in change in ownership.
o Thus, further strategy should be considered. See below.
• As a further planning strategy, the children may dissolve that entity and take the real property out in same percentage interests as in the entity prior to dissolution.
o Then the children form a new entity and contribute the property to the new entity taking back one third interest each.
o Result: no change in ownership until more than 50% transfer of interests in the new entity
• So, until two of the children die (assuming no other transfers in the new entity adding up to more than 50%) no reassessment if no other lifetime transfers.
There are some cautions to keep in mind in considering use of the second strategy to avoid property tax increases.
Caution no. 1: The parties must exercise caution as the assessor could determine that the multiple transfers so close in time to each other violates what is called the step transaction doctrine and does not avoid reassessment. Thus allow at least 1 to 2 calendar years between actions. This means the sooner you perform the first step, the sooner you can get the strategy in place.
Caution no. 2: A right to income or right to use property after a transfer is considered ownership by the Assessor and SBE. Therefore, if a transferor has an absolute right to reside free of rent or other payments or consideration payable to the transferee or receives income, there may be an issue with the assessor office with demonstrating a true transfer of ownership. California Rev and Tax Code 60; Pacific Southwest Realty v. County of Los Angeles (1991) 1 Cal 4th 155; State Bd of Equalization Property Tax Annotation 505.0072. Therefore, we must use rental agreements or other agreements to show that the transferor is not using the property just as before without payment of some sort that shows they therefore gave up something about the real property, and did not instead retain what they had before the transfer. I prepare rental and occupancy agreements for these purposes. Also, we would need to carefully structure the entity to avoid inadvertently creating what looks like a right to income or use that runs afoul of the rules.