Planning for Property Taxes and Proposition 13 – May 2015

  1. BASIC PROPOSITION 13 RULES.

    Clients many times want to transfer real estate that the client has owned for many years. Also, clients will fund legal entities with real estate which has been owned by the client for many years. In such cases this real estate probably has a low property tax assessed value due to California's Proposition 13.1 Clients generally do not want to lose the benefit of their real estate's low assessed property tax basis when their real properties are transferred to a new legal entity or to another person. In other words, clients do not want to have a "change of ownership" of their real estate which would result in a reassessment of that real property for California property tax purposes (whether that real estate is contributed to an LLC, partnership or otherwise transferred).2

    A change of ownership of real property includes:

    (i) the transfer of a present interest in the real estate, such as by a contribution or sale of that real estate;

    (ii) the creation or termination of a tenancy-in-common in that real estate, unless the transfer is to or from the real property's owners in proportion to their ownership of the real property;

    (iii) transfers of real estate between a partnership or other legal entity and a partner or other person, unless that transfer is in direct proportion to the owners' interests in the real property;

    (iv) if a person obtains majority ownership interests in any partnership, limited liability company or other legal entity;3 or

    (v) if more than 50 percent of a partnership's or a limited liability company's "original co-ownership" percentages are transferred.4

    When deeds are recorded with the County Recorder's office in California, a Preliminary Change of Ownership Report (sometimes referred to as a "PCOR") must accompany that deed at the time that deed is delivered to the County Recorder's office for recordation. The PCOR form contains a list of various exemptions to a change of ownership that could apply to that transfer of real estate.

    California statutes and property tax rules promulgated under Proposition 13 provide planning opportunities to structure the transfer of real properties to partnerships, LLCs and corporations and to avoid there being a change of ownership.

  2. "SAME PROPORTIONATE OWNERSHIP" EXCEPTION TO A "CHANGE OF OWNERSHIP," UNDER SECTION 62.

    The California statute provides that if real property is transferred to a partnership (or to a LLC) in which the former co-owners of that real property own partnership interests exactly equal to their prior co-ownership interests in that transferred real property, then the transfer does not constitute a change in ownership.5 These former owners (who now own partnership interests) are then referred to as the "original co-owners."

    Example: Assume two individuals own a 60 percent tenancy-in-common interest and a 40 percent tenancy-in-common interest in an apartment building. The two individuals contribute by deed their respective tenancy-in-common interests to a limited partnership, in which one individual takes back a one percent interest as a general partner and a 39 percent interest as a limited partner, while the other individual takes back a 60 percent interest as a limited partner. There is no change of ownership under Section 62(a) because the proportionate ownership of the individuals in the apartment building (60%/40% as tenants-in-common) was the same as their percentage interests in the limited partnership after the transfer of the apartment building to the partnership.

  3. CHANGE OF OWNERSHIP EXCEPTION FOR TRANSFERS BETWEEN SPOUSES OR REGISTERED DOMESTIC PARTNERS.

    A transfer of real property between husband and wife or between domestic partners is not a change of ownership.6

  4. CHANGE OF OWNERSHIP EXCEPTION FOR TRANSFERS BETWEEN PARENTS AND CHILDREN.

    An important exception to a change of ownership is that a transfer of real estate between a parent and a child is not a change of ownership to the extent the aggregate full cash value (for property tax purposes) of all property transferred under this exemption is $1,000,000 or less; or that the transferred property is the transferor's principal residence.7 Thus, two spouses owning community property in the aggregate have a total exemption of $2,000,000 of cash value of real estate.

    It should be noted that this parent-child exemption does not apply to the transfer of partnership interests between parents and their children, but only applies to the transfer of the fee interest in the real property between parents and their children. Therefore, when parents transfer real property to a partnership in which their children are to receive partnership interests, the parents should use a two-step process if the parents want to qualify for the parent-child exemption. First, the parents should transfer a portion of their real estate's fee interest to their children utilizing the parent-child property tax exemption. Second, the parents and their children should then transfer their respective interests in the real estate into the partnership utilizing the "original co-owner rule" of Section 62(a)(2).

    4.1. Trusts for Benefit of Children. Transfers to children include transfers to an inter vivos or testamentary trust where that child has a present trust beneficial interest under §63.1(c)(9) of the California Revenue and Taxation Code. Thus, if the child holds a "present beneficial interest" in the trust (such as being the sole trust beneficiary), then it will be deemed as if the real property was transferred to that child, and the transfer may qualify for the parent-child or other exemption.8

    Example: Parent establishes a GRAT under which the parent receives all of the income from the GRAT for seven years, with the remainder interest vesting in trust for the benefit of the child at the end of the seven-year GRAT annuity term. There is no property tax change of ownership during the seven years since the parent (who was the original owner of the real estate transferred into the GRAT) is the sole beneficial owner in the form of the trust annuity interest. After the seven years the real estate is going in trust for the child's benefit, and the parent-child exemption applies under §63.1. If the remainder beneficiaries are multiple children, then the parent-child exemption can be applied to that entire GRAT remainder interest held in trust for the children.

    If the child's trust contains a sprinkling power by which the trustee can "sprinkle" the income and principal among not only children (who qualify for the parent-child exemption), but also to non-qualifying beneficiaries (such as a nephew), then that entire trust would not qualify for the parent-child exemption, and there would be change of ownership upon the transfer of the real property to that trust.

  5. AFTER REAL ESTATE IS TRANSFERRED TO A PARTNERSHIP, THE LATER TRANSFERS OF PARTNERSHIP INTERESTS CAN TRIGGER A CHANGE OF OWNERSHIP.

    After a partnership is funded with real estate, the later transfers of partnership interests (whether by a gift or a sale) can trigger a change of ownership of the partnership-owned real estate.9

    5.1. The Transfer of More Than 50 Percent of Partnership Capital and Profits of the "Original Co-owners" Can Trigger a Change of Ownership. If, upon the real estate partnership's formation, the partnership claimed the benefit of §62(a)(2) as the real estate's transfer to the partnership being a change solely in the manner of holding title to the real property, then the original partners who created that partnership are defined as "original co-owners." If these "original co-owners" then subsequently transfer in the aggregate partnership interests constituting more than 50 percent of the partnership capital and profits, a change in ownership of all of this previously contributed partnership real property will result. Thus, a change in ownership of all of the previously contributed partnership real property will occur once the transfers of partnership interests cross this 50 percent threshold limitation.

    Accordingly, if client forms the partnership using the §62(a)(2) original co-owner rule exemption, then the contributing partners should not later transfer more than a 50 percent interest in their partnership capital and profits interests (of the original co-owners) in order to avoid a change of ownership (and the resulting reassessment of the partnership's underlying real property). Even the death of a partner (who is an original co-owner) is deemed a transfer and may result in a greater than 50 percent partnership interest transfer, thereby causing a change of ownership to the partnership's previously contributed real property.

    5.2. The Acquiring of Ownership of Greater Than 50 Percent Interest in Partnership Capital and Profits Can Trigger a Change in Ownership. Another property tax rule which can cause a change of ownership to occur is the so-called "control rule." Under the control rule, if any one person acquires a greater than 50 percent interest in the partnership's capital and profits, then a change of ownership results and a reassessment of the partnership's property occurs. 10

    5.3. Property Tax Step-transaction Rule. Under the California property tax rules, a "step-transaction doctrine" is applied when a series of transfers are made merely to avoid reappraisal of the real estate. In such case the "substance of the transaction rather than the form" will determine if a change in ownership has actually occurred. 11

    However, in the case of applying the parent-child exemption, the legislative history states that the step transaction should not apply. Thus, the step-transaction doctrine does not apply to transfers of real property and transfers of legal entity interests (such as partnership interests) between parents and their children.12

  6. EXAMPLE OF HOW TO TRANSFER REAL ESTATE AMONG FAMILY MEMBERS AND AVOID A CHANGE OF OWNERSHIP.

    The California State Board of Equalization has indicated that the parent-child exemption applied to the following transaction.

    Note from a federal gift tax standpoint the following transfer of real estate from parents to the son can be done gift tax free through gifts and sales to grantor trusts.

    Step 1: The husband and wife, as co-owners of the real property with a property tax assessed value of $5,000,000 and a fair market value of $65,000,000, transfer the real property to a partnership, with each spouse receiving a 50 percent partnership interest in the partnership. This transaction is exempt from a change of ownership because it is solely a change in the method of holding title under §62(a)(2). Husband and wife become "original co-owners" under §64(d).

    Step 2: Husband and wife each gift one-half of their partnership interest (which is a 25 percent partnership interest from each of husband wife) to their son, so that husband and wife each now own a 25 percent interest and the son owns a 50 percent interest in the partnership. Since husband and wife are transferring only a 50 percent total amount of their partnership interests in the partnership, there is no change in ownership under §64(d) since there is not greater than a 50 percent transfer. Furthermore, since the son is only acquiring a 50 percent partnership interest, there is no change of ownership under §64(c) (since not more than 50 percent control is transferred). Thus, there is an exclusion of this transfer of partnership interests from being a change of ownership.

    Step 3: The partnership liquidates and transfers the real property to the husband, wife and son in proportion to the husband's, wife's and son's respective partnership interests in the partnership, and husband, wife and son hold such property as tenants in common. Since before and after the transfer the partners own the exact same percentage interests (husband owning 25 percent; wife owning 25 percent; and son owning 50 percent) both in the partnership and after the liquidation in the real property as tenants in common, there is no change in the proportionate ownership interests of the transferors and transferees. Thus, the §62(a)(2) exclusion from change of ownership applies. Furthermore, husband and wife are no longer "original co-owners" since they are no longer partners in the partnership (the partnership has now liquidated).

    Step 4: Husband and wife transfer one-half of their respective tenancy-in-common interests to their son (12.5 percent by each parent to son), or $625,000 of assessed value by husband and $625,000 of assessed value by wife (12.5 percent interest by each parent x $5,000,000 property tax assessed value). The result is that husband and wife now each own a 12.5 percent tenancy-in-common interest in the real property and the son owns a 75 percent tenancy-in-common interest in the real property. Here, since real property is being transferred to the son (a total of a 25 percent tenancy-in-common interest transferred to the son by both parents), the §63.1 parent-child exclusion will apply, allowing each parent to transfer 12.5 percent (or $625,000) of assessed value to the son under this parent-child exclusion (which parent-child exclusion is subject to the $1,000,000 cash value limitation for each parent set forth in §63.1(a)(2)).

    Step 5: Husband, wife and son transfer their respective tenancy-in-common interests in the real property to a second partnership, with each of them receiving the same proportionate partnership interest, which each parent owns, in the new partnership, namely husband and wife each own a 12.5 percent interest and son owns a 75 percent interest in the new partnership. In this example, since there is no change in the method of holding title in which the proportionate interests of the transferors and transferees are exactly the same after the transfer, the §62(a)(2) exclusion applies and there is no change of ownership. Husband, wife and son are now new "original co-owners" under Section 64(d) in this new partnership.

    Step 6: Husband and wife transfer their remaining 12.5 percent partnership interest which each parent owns in the new partnership to their son, with the result that the son becomes the sole partner of the partnership (which partnership in turn owns the underlying real property worth $65,000,000). So that there is more than one partner, son uses his single-member LLC as a second partner for a small percentage of son's partnership interests. In this last step there is no change of ownership under §64(d) since the husband and wife are transferring less than a 50 percent interest. Furthermore, since the son owned more than a 50 percent partnership interest in the new partnership prior to the transfer, there is no change in control under §64(c). Thus, this Step 6 is excluded from being a change of ownership.13

    This six (6) step process has allowed, in this above example, the parents to transfer to their son $65,000,000 in value of real estate (which had a $5,000,000 tax assessed value) without there being a change of ownership for property tax purposes.

  7. TRANSFERS OF REAL ESTATE FROM A PARTNERSHIP TO ITS PARTNERS CAN TRIGGER A CHANGE OF OWNERSHIP.

    A partnership (or an LLC) may want to transfer some or all of the partnership's real estate to the partnership's partners. For example, partners may wish to liquidate real estate from the partnership. Alternatively, during the life span of a partnership, the partnership may distribute the partnership's real estate to only certain partners. These real property distributions from a partnership can cause a change of ownership to the distributed real estate. To avoid such a change of ownership, all of the partnership's partners must receive distribution of the partnership's real property in the exact same ownership percentages as such partners' partnership interests.14

    Example: Assume that the partnership is owned by four partners in equal percentages (25% by each partner). The partnership owns four real properties, each property having an equal value. The partners now wish to liquidate the partnership, with each partner to receive 100% ownership of one real property on the liquidation. If each partner receives a 100% interest in one of the four real properties upon liquidation of the partnership, there will be a change of ownership as to each real property distributed to the partners, since each partner owns a 100% interest in their one real property received in distribution (not a 25% interest in each of the four real properties). Thus, the proportionate ownership of each of the four properties changed under §62(a)(2) on the properties' distribution to the partners, which resulted in a property tax change of ownership for all four properties.

  8. HOW TO PURCHASE REAL ESTATE AND AVOID A CHANGE OF OWNERSHIP.

    When your client wants to purchase a new building they may wish to keep the old low assessed property tax value on the acquired building, and not have a change of ownership when they close their purchase of this building.

    Generally, transfers of interests in legal entities do not constitute a change of ownership of the underlying real properties owned by those entities. However, if there is a change in control of that legal entity (which means a transfer of more than 50% of the ownership interests of that legal entity); or where cumulatively over a period of time more than 50% of the interest in the legal entity are transferred by any of the "original co-owners" in one or more transactions, the underlying real property will be reassessed as a change of ownership.

    A change of ownership of real property held by a limited liability company has been held to not occur when all of the membership interests are sold but no one person or entity obtains, directly or indirectly, more than a 50% interest in the capital and profits. In the case of Ocean Avenue LLC, 173 Cal Reptr 3rd 445 (2014), an LLC owned improved real property. The owner of the LLC sold 100% of his membership interest to three separate entities, one entity which acquired a 49% interest; another a 42.5% interest; and the third an 8.5% interest. All of the owners of these three entities were related. However, in applying the indirect ownership test (there is no family attribution or entity attribution) no person acquired a membership interest that exceeded 50%.

    Example: Husband and wife acquire as community property a 100% capital and profits interest in a limited liability company which owns an office building. Each of husband and wife is treated as acquiring a 50% of the ownership interest in the LLC. Since the person selling their membership interest of the LLC are not original co-owners (because these original owners/sellers did not transfer the real property to the LLC under Section 62(a)(2)), then there is no change in control of the LLC under Section 64(c) and as a result there is no change in ownership of the real estate under Section 64(d). [See Example 7 of State Board of Equalization Rule 462.180(d).]

    Example: Assume two owners of an LLC desire to sell that LLC's underlying real estate (a retail shopping center) which has a $5 million property tax assessed value and a $200 million fair market value. This retail shopping center was originally acquired by the LLC directly from the prior owner. To avoid a change of ownership the two LLC members, instead of selling the underlying real estate, sell their LLC membership interest to three buying entities: Entity #1 owned by Mr. Bell, purchases a 33% membership interest; Entity #2 owned by Mr. Bell's children purchases a 33% membership interest; and Entity #3 owned by an investor group purchases a 33% membership interest in the LLC. Under the Ocean Avenue LLC case there should not be a change of ownership.

There have been legislative proposals to prevent the above tax planning, but none have been enacted by the California State Legislature.

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This Article contains general information on tax issues. Because each client's tax and factual situation is unique, nothing in this Article should be deemed advice on a specific transaction or to a specific person or client. Please contact Robert A. Briskin at (310) 201-0507 or by e-mail at rbriskin@rablegal.com for legal and tax advice.


1 See California Constitution Article 13A, and California Rev. and Tax. Code §§60 to 63.1. Proposition 13 enacted these changes in 1976 by amending the California Constitution. Proposition 13 made the 1975-1976 real estate assessed value that real estate's initial baseline property tax year for that real estate's property tax value.

Proposition 13 limited property taxes to being 1% of the real property's assessed value, plus certain local taxes. Proposition 13 also limited annual real property value increases for property tax purposes to the lesser of: (i) the baseline value, adjusted by an inflation rate of 2% per year; or (ii) the actual cash fair market value of the real estate. Although 1976 was the first baseline year, generally the baseline year will be the year of the real estate's acquisition or change of ownership. Thus, if a "change of ownership" occurs, then this 2% limitation does not apply, and the real estate is assessed to its then fair market value. See California Rev. and Tax. Code §61.

2 See California Rev. and Tax. Code §§60 and 61 for a list of items that constitute a change of ownership.

3 See California Rev. and Tax. Code §64(c).

4 See California Rev. and Tax. Code §64(d).

5 See California Rev. and Tax. Code §62(a)(2).

6 See California Rev. and Tax. Code §§63 and 62(d).

7 See California Rev. and Tax. Code §63.1. The $1,000,000 exclusion applies for each eligible transferor/parent. A grandchild would qualify for this exception to receive a transfer of property from their grandparent if that grandchild's parent (which grandchild's parent is the child of the grandparent transferring the property) is then deceased.

8 See California State Board of Equalization Annotation 220.0790.

9 Under California Rev. and Tax. Code §64(c), the California Franchise Tax Board now includes two questions on the California Partnership Tax Return asking about changes in ownership of entities. The California Franchise Tax Board then communicates the information from these questions to the California State Board of Equalization, which in turn then sends a Form 100-B "Statement of Change in Control and Ownership of Legal Entities" to the partnership.

10 See California Rev. and Tax. Code §64(c).

11 See Shuwa Investment Corp. v. County of Los Angeles, 1 Cal.App.4th, 1635 (1991).

12 See California State Board of Equalization letter to taxpayer at annotation 625.0196 issued December 8, 2005, where the State Board of Equalization states in citing this legislative history of the step-transaction:

"... it is the intent of the Legislature that the provisions of Section 63.1 of the Revenue and Taxation Code shall be liberally construed in order to carry out the intent of Proposition 58 on the November 4, 1986 general election ballot to exclude from change in ownership purchases or transfers between parents and their children described therein. Specifically, transfer of real property from a legal entity to an eligible transferor or transferors, where the latter is the beneficial owner or owners of the property, shall be fully recognized and shall not be ignored or given less than full recognition under substance-over-form or step-transaction doctrine, where the sole purpose of the transfer is to permit an immediate retransfer from an eligible transferor or transferors to an eligible transferee or transferees which qualifies for the exclusion from change in ownership provided by Section 63.1..."

13 See California State Board of Equalization Annotation 625.0196.

14 See California Rev. and Tax. Code §62(a)(2).

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