It’s common for estate planning strategies to include making gifts to children or other heirs of partial interests in real property or other assets. This can be an effective way to help beneficiaries and reduce estate taxes. But it can also have a serious downside if a gift or bequest inadvertently triggers “change in ownership” or "change of control" rules.
The cause of this potential problem is California’s Proposition 13, enacted in 1978, and the laws and regulations that implement it.
Prop 13 was passed to protect homeowners from what had been sharply increasing property tax bills resulting from the rising values of California real estate. It essentially froze tax bills at 1976 rates for current owners, except for small inflation-related increases.
If the ownership of the home or other property changes, Prop 13 rules require that it to reassessed for tax purposes at the market price. (New construction is also appraised at current values.)
A “change in ownership” is obvious when a home is sold. But according to the statutes and regulations, the phrase refers to any “transfer of a present interest in real property, including the beneficial interest thereof.”
Moreover, it doesn’t matter whether the change in ownership is voluntary or involuntary, or whether it results from a sale, gift, inheritance, the addition or deletion of an owner, or any other reason.
There are a few exceptions. For example, a transfer to a revocable trust, to a spouse, or, on a limited basis, of a principal residence to a child, qualifies for an exclusion from the change-of-ownership rules, provided that tax authorities are properly notified of the exemption.
If the real estate was held in a single-owner LLC by Mr. Smith, under the interspousal exclusion the transfer of that entity would also be exempt from reappraisal if it was inherited by Mrs. Smith.
Note that under Proposition 19, passed in 2020, the parent-child residence exclusion now only excludes the first $1 million over assessed value, and the child receiving a residence from a parent must use it as his/her own principal residence.
Also, any transfer between an individual or individuals and an entity, or between legal entities, that results solely in a change in the method of holding title to the real property, and in which the proportional ownership interests of the transferors and transferees in each and every piece of real property transferred remain the same before and after the transfer, is excluded from a change in ownership.
This is known as the proportional transfer exclusion. (See Revenue and Taxation Code section 62(a)(2) and Property Tax Rule 462.180(d)(2).)
However, other changes in ownership and/or control of an entity can trigger a reappraisal – and almost certainly a significant increase in property taxes.
Why is this important in estate planning? Because a gift or series of gifts of interests in real estate (or a corporation or partnership that owns real estate) can result in a change of control or a change in ownership, depending on the transfer(s) involved.
Here’s a simple example. John and Mary own an apartment building, which they originally bought as equal co-owners. John and Mary then transferred the property to a limited liability company (LLC), of which they each owned 50%. Because that transfer did not change their ownership stakes or the control each had, it did not trigger a reappraisal of the building.
They later proceeded to make gifts each year of 10% of the LLC to their children. After five years, the children own 50% and the parents own 50%.
If the parents then give the children even 1% more of the LLC, the kids will own more than half of the entity. Under the law, the cumulative transfer of more than 50% of the LLC interests by John and Mary to their children constitutes a “change of ownership” of the underlying property. The property will be subject to a reappraisal, and almost certainly to an increase in property taxes.
It may be relatively easy for a family to keep track of such transfers. But what if several owners are involved?
Let’s say four business partners each contribute their equal, undivided interests in real estate property in exchange for 25% interests in an LLC, one of many assets they hold. One partner gives her ownership interest to her children. A few years later, a second partner gives his interest to his kids. None of the partners thinks to inform the others of the gifts.
These transfers, totaling 50% of the LLC’s ownership, have not yet triggered a change of ownership.
But sometime later, a third partner gives 1% of his ownership interest to his child. Now 51% of the LLC is in the hands of new owners. Since more than 50% of the ownership interests in the LLC were cumulatively transferred by the original co-owners of the real property, there is a change in ownership of the LLC's real estate. So the property must be reappraised.
Note that in each of the examples above, the real estate was first owned by the original co-owners, who then transferred it to an LLC. Therefore, the transfers cumulatively of more than 50% of the LLC interests resulted in a "change of ownership" and reassessment of the underlying property.
But if the LLC was the original owner of the real property, then even if 100% of the interests were cumulatively transferred there would not be a change of ownership.
Moreover, there would not be a change of control of the LLC (resulting in reassessment of the property) unless the transfers of the LLC interests resulted in one person owning more than 50% of the LLC (literally had "control" of the LLC).
As these simple examples demonstrate, “change of control” and "change of ownership" can have substantial – and expensive – consequences. In real life, family and business situations can be quite complex, making the need for careful planning and analysis a critical part of tax and estate planning.