Bypassing Proposition 19 and Property Tax Reassessments

Introduction

Proposition 19 has significantly altered the landscape of property tax regulations in California, particularly affecting the longstanding parent-child exclusion for property tax reassessment. This legislative change has directly impacted how real estate properties are transferred from parents to children, necessitating creative approaches for families and real estate investors eager to pass down real estate assets to their heirs in a tax efficient manner. To achieve this goal, real estate limited-liability companies (LLCs) need to be established and used as a vehicle for property transfers.

Ownership of real property through an LLC is governed by two distinct sets of rules under California’s Revenue and Taxation Code (R&TC): the (i) Change in Control Rules under Section 64(c) and (ii) the Change in Ownership Rules under Section 64(d). These regulations dictate that real property held by an LLC is subject to reassessment if there’s a change in control or ownership of the LLC. The specific circumstances under which the LLC acquires and holds the property will determine which of these two rules apply. The strategic use of the Change in Control Rules is increasingly recognized as the more tax-advantageous route of the two, offering a viable pathway to minimize potential tax liabilities arising from property transfers in a post-Proposition 19 era.

The Change in Control Rules

The Change in Control Rules are triggered when an LLC acquires real property through a transaction that constitutes a change in ownership (not to be confused with the Change in Ownership Rules for legal entities as discussed below), which is subject to reassessment. For example:

1. Parents intend to purchase Blackacre for $100,000.
2. Parents form Blackacre LLC and own all the ownership interests in Blackacre LLC.
3. Blackacre is acquired by Blackacre LLC in a transaction that is subject to reassessment because there was a change in ownership.

Under the Change in Control Rules for legal entities, a change in control occurs when a single party secures an ownership interest exceeding 50% in the legal entity that owns the property. This means that if no single party acquires more than 50% of the ownership interest in an entity, such as Blackacre LLC, the property held by that entity will not be subject to reassessment. This principle was examined and upheld in the case of Ocean Avenue LLC v. County of Los Angeles. Continuing on from the above example:

1. When the first spouse dies, the ownership interest in Blackacre LLC is transferred to the surviving spouse in an interspousal transfer that is excluded from reassessment under R&TC 63(b).
2. At the surviving Parent’s death, Blackacre is now worth $1,000,000 and the ownership interest in Blackacre LLC is transferred to Brother and Sister (50/50). Although cumulatively more than 50% of the ownership interests have changed hands, Blackacre is not subject to reassessment because neither Brother nor Sister own more than 50% of the ownership interest of Blackacre LLC and is still taxed at its original $100,000 value.
3. Brother has 2 children, Grandchild A and Grandchild B, while Sister only has one child, Grandchild C.
4. Brother and Sister die and the ownership interest in Blackacre LLC is transferred to the 3 grandchildren of Parents, 25% to Grandchild A, 25% to Grandchild B, and 50% to Grandchild C. Again, no reassessment.
5. Grandchild A dies and bequeaths his 25% interest in Blackacre LLC to his only son (Great Grandson). Grandchild B dies and bequeaths her 25% interest in Blackacre LLC to her only daughter (Great Granddaughter).
6. Grandchild C dies without children and decides to give all her 50% interest in Blackacre LLC to her favorite niece, Great Granddaughter. Since Great Granddaughter now holds more than 50% of the ownership interest in Blackacre LLC (75% to be exact, 25% from Grandchild B and 50% from Grandchild C), Blackacre is finally reassessed at its current market value.

As illustrated above, it is easy to see how the Change in Control Rules can effectively maintain a low property tax basis for generations. Without Grandchild C’s mistake, Blackacre’s low tax basis could have extended into another generation, showcasing how these rules can defer property tax reassessment and minimize tax liabilities over time.

The primary hurdle for many families in acquiring real property directly through an LLC lies in the significant financial resources required for such transactions. Beyond the absence of certain tax advantages that might be accessible through individual ownership, acquiring property via an LLC introduces complexities in financing, notably in securing a mortgage. Lenders often perceive loans to LLCs as carrying higher risks compared to individual borrowers, which can lead to more stringent borrowing criteria and potentially higher interest rates. Additionally, the administrative and operational requirements of managing property within an LLC, including compliance and minimum annual franchise taxes, further compound the challenges. These factors make the direct acquisition of property through an LLC a less viable option for most families, limiting their ability to leverage the protective and tax-efficient benefits of LLC ownership.

Given the above challenges, what happens when a couple purchases property under their own names and now wants to transfer that property into an LLC?

The Change in Ownership Rules

The Change in Ownership Rules for legal entities apply when real property is transferred to an LLC in a transfer that is excluded from reassessment. For example:

1. Parents purchase Blackacre for $100,000.
2. Blackacre is used as a rental property and worried about liability, Parents form Blackacre LLC and transfer their 100% interest in Blackacre to the entity.
3. Because Parents own all the ownership interests in Blackacre LLC (50/50), this transfer is considered a “proportional interest transfer” and is excluded from reassessment under R&TC 62(a)(2).

Under the Change in Ownership Rules, a change in ownership is recognized when more than 50% of the interests held by the original co-owners in the legal entity are cumulatively transferred. For example:

1. 20 years have passed and Blackacre is now worth $1,000,000.
2. Parents now wish to transfer 50% of their ownership interest in Blackacre LLC to their Daughter. Since 50%, but not more than 50%, of the Parents’ ownership interests have changed hands, Blackacre is not subject to reassessment and is still taxed at its original $100,000 value.
3. 10 years later, Parents now give 1% of their ownership interest in Blackacre LLC to their Son. Now, more than 50% of the ownership interests in Blackacre LLC have changed hands (50% to Daughter + 1% to Son = 51% transferred), Blackacre is now subject to reassessment at its current market value.

As illustrated above, the Change in Ownership Rules are not very effective in avoiding tax reassessment when compared to the Change in Control Rules. However, there are scenarios where the Change in Ownership Rules can provide some benefits.

1. Sister (age 20) and Brother (age 50) purchase Blackacre for $100,000.
2. Blackacre is used as a rental property and worried about liability, Sister and Brother form Blackacre LLC and transfer their 100% ownership interest in Blackacre to the entity.
3. Because Sister and Brother own all the ownership interests in Blackacre LLC (50/50), this transfer is considered a “proportional interest transfer” and is excluded from reassessment under R&TC 62(a)(2).
4. 25 years have passed and Blackacre is now worth $1,000,000.
5. Brother dies and his 50% interest in Blackacre LLC is passed down to his children. Since 50%, but not more than 50%, of Brother and Sister’s ownership interests have changed hands, Blackacre is not subject to reassessment.
6. Another 20 years have passed and Blackacre is now worth $2,000,000.
7. Sister dies and her 50% interest in Blackacre LLC is passed down to her children. Since more than 50% (100% to be exact) of Brother and Sister’s ownership interests have changed hands, Blackacre is now subject to reassessment at its $2,000,000 value.

In the above scenario, because of the large age gap between the siblings, the Change in Ownership Rules allowed the property to avoid reassessment for 20 years.

Pushing the Limits of the Change in Ownership Rule

The following example illustrates a sophisticated approach to transferring property ownership within a family, leveraging the rules around “proportional interest transfers” to avoid property tax reassessment. This strategy involves a series of carefully structured transactions involving the establishment of multiple LLCs, allocation of ownership interests, and eventual dissolution and reformation of these entities. While each step individually adheres to the law, collectively, they push the limits of the Change in Ownership Rules.

1. Mother establishes Blackacre LLC1 and transfers Blackacre into the entity, owning 100% of the ownership interests in Blackacre LLC1, a “proportional interest transfer” that is excluded from reassessment under R&TC 62(a)(2).
2. Mother then allocates 50% of Blackacre LLC1’s ownership interests to Daughter. Since 50%, but not more than 50% of the Mother’s ownership interests have changed hands, Blackacre is not subject to reassessment.
3. To avoid the transactions being perceived as a single event that could trigger a reassessment, Mother and Daughter maintain ownership of Blackacre LLC1 for a period of years.
4. Subsequently, Mother and Daughter dissolve Blackacre LLC1, taking Blackacre into their names as co-owners, each holding a 50% ownership interest. This is again a “proportional interest transfer” that is excluded from reassessment.
5. Mother and Daughter then create Blackacre LLC2, into which the Blackacre is transferred. Both Mother and Daughter possess an equal 50% ownership interest in Blackacre LLC2, mirroring their ownership interests in the property pre-transfer. This again, is also a “proportional interest transfer” that is excluded from reassessment.
6. After a period of years, Mother transfers her 50% ownership interest in Blackacre LLC2 to Son. Since 50%, but not more than 50% of Blackacre LLC2’s ownership interests have changed hands, Blackacre is not subject to reassessment.

The final arrangement sees the siblings each owning 50% of Blackacre LLC2, with Mother having fully divested her interest while simultaneously avoiding tax reassessment. However, this strategy may fall under scrutiny due to the Step Transaction Doctrine, a principle in tax law that views a series of formally separate steps as a single transaction if they are part of a cohesive plan with a specific intended outcome.

The doctrine is applied to prevent tax evasion through complex arrangements that, when viewed individually, comply with tax laws, but when considered as a whole, constitute an abuse of the tax code. In this scenario, the sequential transfers of interest in Blackacre through different LLCs and eventual redistribution of ownership could be seen as an integrated transaction aimed at circumventing reassessment rules.

If authorities determine that the steps were prearranged parts of a single plan to transfer property without reassessment, they might disregard the formal separateness of the transactions. Consequently, the entire sequence of transfers could be treated as one taxable event, negating the intended tax benefits.

Conclusion

Proposition 19 has fundamentally shifted the property tax landscape in California, necessitating creative strategies for transferring real estate assets from parents to children while seeking to maintain tax efficiency. Establishing and utilizing real estate LLCs emerges as a compelling approach in navigating these changes, particularly by leveraging the Change in Control Rules which offer the best pathway to minimize tax liabilities for the heirs. However, the financial and operational challenges of acquiring property directly through an LLC present significant hurdle for many families.

The sophisticated strategies involving proportional interest transfers and the establishment of multiple LLCs, although legally sound on a step-by-step basis, must be approached with caution due to the potential implication of the Step Transaction Doctrine. This doctrine underscores the importance of considering the integrated nature of transactions that might appear to circumvent reassessment rules, thereby posing a risk of being viewed as a single taxable event.

Given these complexities, families are advised to not only consult with their Certified Public Accountants (CPAs) to determine the most tax-efficient method for transferring real property, but also seek the advice of legal counsel to thoroughly assess the legal risks and their own risk tolerance levels in the proposed transfer. By doing so, families can make informed decisions that align their financial goals with the law.