With the passage of Proposition 19 and the change of administration in the White House, there is a lot of confusion about real property transfers, capital gain and estate taxes. With an estate exemption of $11.7M per individual under current law most people think estate taxes won’t affect them and in most cases they are correct. Many people are also thinking that since their parent’s estates are relatively small Proposition 19 and a change in the step up in basis will not affect them either, but they just might be surprised!
Proposition 19 went into effect on February 16, 2021. In California it changed the favorable property tax reassessment rules for real property transfers between parents and children.
Under prior law, a transfer of ownership would generally result in a reassessment for property tax purposes, with two major exceptions:
- Principal Residence Exclusion – This exclusion allows the transfer of a principal residence/ family farm of unlimited value between parents and children.
- $1 Million Lifetime Non – Principal Residence Exclusion – This exclusion allows the transfer between a parent and children of up to $1 million of assessed value of all other types of property, for example second homes or rental properties.
Under Proposition 19 – for transfers on or after February 16, 2021:
- Principal Residence/Family Farm Exclusion – this exclusion has been modified
in two ways:- A child must occupy the principal residence or home within one year. On
the other hand, a family farm does not need to be a principal residence. - Only the first $1 million of increased assessed value is excluded from reassessment.
- A child must occupy the principal residence or home within one year. On
- The $1 Million Lifetime Non -Principal Residence Exclusion has been eliminated.
For example: Mom, a widow, owns a home she bought in 1970 for $30,000. Mom dies after Proposition 19 goes into effect. The kids inherit the house and would like to rent it to earn some income. The value of the house is now $650,000. The current assessed value is $100,000. Under the old law, they could have kept the house as a rental and paid property taxes on the $100,000 assessed value, which would be around $1,200 per year. Under the new law, the property will be reassessed to the current value of $650,000, so, the new property taxes would be around $6,700 per year. An increase of $5,500 per year in property taxes. But it is not all bad news. The increase in the real estate tax and depreciation deductions would decrease rental income thus lower income taxes. This could mitigate much of the increased real estate taxes.
However, if a child, in the above example, chose to occupy the inherited residence within one year of Mom’s passing there would be no reassessment.
Instead of keeping the house, the kids could decide to sell it. Under current law, Mom’s house will get a step up in basis to its fair market value at her death. This does not apply if the house is gifted prior to death, in which case, the child would take Mom’s carryover basis.
If Mom were to sell the house right before her death, she would realize a capital gain of $620,000 ($650,000 value less the $30,000 basis). Because Mom sold her principal residence, she could exclude up to $250,000 of the capital gain. If we assume a combined federal and state capital gains tax rate of 25%, her taxes would be $92,500 and her net proceeds would be $557,500. If the kids were to inherit the house and sell it for $650,000 shortly after Mom’s death, they would have no gain and no tax.
We expect that there will be more changes to the income, gift, and estate tax laws in 2021. These changes could have an unexpected impact on property you own. It is important to become educated on real property transfer tax laws and how they may impact your inheritance and the legacy your parents have worked hard to build and pass on.