The assessment of property taxes is an important consideration in any transfer of California real estate. An outright sale of property to an unrelated third party will usually trigger a reassessment at a higher tax rate. But some other transfers may be exempt from reassessment if structured correctly. Understanding the reassessment rules can save significant property taxes.
Overview of California Real Property Tax
County tax assessors assess all California real estate on January 1. The calculation of the tax involves several cascading provisions of the California Revenue and Tax Code.
- Section 51 – Provides that taxable value of real estate is the lesser of its base year value (which is compounded annually by an inflation factor and capped at 2 percent of the prior year’s value) or the full cash value, considering any reductions in value.
- Section 50 – Defines base year value as the full cash value or market value as of the later of March 1, 1975, or the date of the most recent change in ownership or new construction.
Because increases in the assessed value are capped at 2 percent of the prior year’s value, the increase in the fair market value of a property may be much higher than the assessed value.
Example: John purchased a property 30 years ago for $100,000. The property has appreciated at 8 percent per year and is now worth $1,006,265.69. But the assessed value for tax purposes is limited to an annual 2 percent increase. As a result, the assessed value is only $181,136.16. This means that John is only taxed on the $181,136.16 assessed value, not the $1,006,265.69 fair market value.
The 2 percent cap benefits homeowners by allowing them to pay tax on an assessed value that is less than the fair market value of the property. But the protection offered by the cap is lost if there is a change in ownership. Section 60 of the California Revenue and Tax Code defines change in ownership as follows:
A “change in ownership” means a transfer of a present interest in real property, including the beneficial use thereof, the value of which is substantially equal to the value of the fee interest.
When a change in ownership occurs, the 2 percent cap is removed and the property is reassessed at its then-current fair market value. This increase in assessed value results in higher property taxes.
Because a change in ownership causes a property to be reassessed at a higher value, it is important to determine whether a change in ownership has occurred and, if so, whether the change in ownership is exempt from reassessment. This is relatively easy when the property is sold from one party to another. With an outright sale to a third party, a change in ownership occurs and the transfer is usually not exempt from reassessment. But other transactions are more ambiguous. The most common exceptions involve transfers to spouses, transfers to children, transfers to joint owners, transfers to trusts, and transfers to business entities.
Changes in Ownership Involving Transfers to Spouses or Registered Domestic Partners
Like the California community property laws, the California Revenue and Tax Code treats a married couple as a single economic unit. As long as the owners were married at the time of the transfer, a transfer from one spouse to another does not cause reassessment.
The interspousal transfer exception applies to both lifetime and at-death transfers. Assume, for example, that the spouses hold title as community property with right of survivorship. This means that the property will pass to the surviving spouse upon the death of the first spouse to die. Upon the first spouse’s death, the surviving spouse will own the entire property. This at-death transfer will not cause a reassessment of the property for tax purposes.
The interspousal transfer exception also applies to transfers to spouses or ex-spouses as part of a divorce. A transfer to a spouse or former spouse in connection with a property settlement agreement or decree of dissolution of a marriage or legal separation will not cause the property to be reassessed for tax purposes.
Similar rules apply to registered domestic partners. A transfer of California real estate between registered domestic partners on or after January 1, 2006, is exempt from reassessment. This includes transfers in or out of a trust for the benefit of a domestic partner, the addition of a domestic partner on a deed, transfers up on the death of domestic partner, and transfers under a settlement agreement or court order upon termination of the domestic partnership.
Changes in Ownership Involving Transfers to Children or Grandchildren
There are two ways that a parent may transfer California real estate to his or her children without triggering property tax reassessment.
- Transfer of a Primary Residence – Transfers of the principal place of residence between parents and their children (there is no limit on the value of the residence); and
- Transfer of $1 million – Transfers of up to $1 million of real property between parents and their children, other than a principal place of residence.
The $1 million limitation is based on the assessed value of the property, not the fair market value. Because the assessed value typically trails the fair market value—especially in areas with high property appreciation—this means that a parent can transfer a property worth more than $1 million fair market value and still qualify for the exemption.
Example: John purchased property 30 years ago for $100,000. The property has increased in value each year, but for tax assessment purposes the increase in value is limited to 2 percent. Because the assessed value is subject to a 2 percent cap, the property is assessed at $181,000. It’s current fair market value is $2 million. Even though the fair market value of the property is $2 million, the assessed value of $181,000 is below the $1 million limitation. This means that John can transfer the property to his children without triggering reassessment.
In both cases, the property will only be exempt from reassessment if a completed application is filed on time with the county tax assessor’s office. The Claim for Reassessment Exclusion must be filed within three years of the transfer or before the property is transferred to a third party.
The parent-child exception applies to both outright transfers and transfers of the present beneficial ownership of California real estate by lifetime or testamentary trust. This allows parents to create trusts for the benefit of their children that qualify for the parent-child exclusion. A properly structured trust can leave assets for the benefit of the trust creator’s children without causing the property to be reassessed for tax purposes.
These two exemptions can be stacked and are applied on a per-parent basis. This means that, theoretically, a child could receive two primary residences and two additional properties of up to $1 million each in cash value without triggering reassessment.
Similar rules apply to transfers from grandparents to grandchildren, but only if the grandchild’s parent (i.e., the grandparent’s child) must have died on or before the date of transfer and the transfer occurred on or after March 26, 1996.
Changes in Ownership Involving Transfers Between Joint Owners
As discussed in our section on Using Deeds to Avoid Probate of California Real Estate, joint ownership of real estate can avoid the need for probate at a deceased owner’s death. Upon the death of a co-owner, property titled as joint tenants with right of survivorship or community property with right of survivorship will pass to the surviving owner. If the property is titled as a tenancy in common, the deceased owner’s share will pass through his or her estate, but could still pass to the surviving owner if, for example, the deceased owner’s will leaves the property to the other owner.
The California Revenue and Tax Code exempts the transfer of a principal residence from reassessment if the transfer occurs upon the death of one of the joint owners. This exemption applies to all forms of co-ownership, including tenancy in common and joint tenancy with right of survivorship. To qualify for exemption, the transfer must meet these requirements:
- The transfer must occur on the death of one of the joint owners;
- The two joint owners must together own 100 percent of the property as tenants in common or joint tenants;
- The two joint owners must be owners of record for the one-year period immediately preceding the death of one of the cotenants;
- The property must have been the principal residence of both joint owners for the one-year period immediately preceding the death of one of the cotenants;
- The surviving joint owner must obtain a 100 percent interest in the property; and
- The surviving joint owner must sign an affidavit affirming that he or she continuously resided at the residence for the one-year period preceding the decedent cotenant’s date of death.
If these requirements are satisfied, the transfer of property to one joint owner upon the death of the other joint owner will not be reassessed at a higher property value.
Property owned as community property with right of survivorship that passes to one spouse upon the death of the other spouse will also qualify for an exemption from reassessment under the rules that apply to interspousal transfers, discussed above.
Changes in Ownership Involving Transfers to Trusts
Property is often transferred into a living trust to avoid the expense and hassle of California probate. The California Revenue and Tax Code recognizes that transfers to living trusts for estate planning purposes rarely involves a change in ownership. Any transfer by a person—or by that person’s spouse or registered domestic partner—will not trigger a reassessment if:
- The person transferring the property is the present beneficiary of the trust; or
- The trust is revocable.
Likewise, the transfer from the trustee back to the person creating a trust described above is also exempt from reassessment. The creation of termination of a trust in which the trust creator retains the reversion (the right to reacquire the property at a specified time or on a specified event) will also qualify, as long as the interest of other beneficiaries is no longer than 12 years.
As an extension of the interspousal transfer rules, a transfer by a spouse is treated as a transfer by the other spouse for purposes of determining whether the property will be reassessed. In other words, property will not be reassessed upon transfer to a trustee for the beneficial use of a spouse, or the surviving spouse of a deceased transferor, or by a trustee of such a trust to the spouse of the trust creator.
Most revocable living trusts become irrevocable upon the death of the trust creator. This can create special problems under California law. When the trust becomes irrevocable—or if the trust is irrevocable to begin with—the transfer constitutes a change in ownership and is subject to tax if not structured correctly. To avoid this result, the trust may be structured in a way that qualifies for the parent-child exception (discussed above) or another exception from reassessment.
As discussed above, the parent-child exclusion applies to transfers in trust for the benefit of the trust creator’s children. This allows trust creators to leave property to their children in trust without worrying that the children will be burdened with higher California property taxes. But special care must be taken if there are multiple children and only some want the property.
Example: Upon John’s death, his revocable trust calls for a transfer of John’s property to his two children, Able and Beth, in equal shares. Beth does not want the property and offers to sell her interest to Able. The transfer of property from Beth to Able is a sibling-to-sibling transfer that does not qualify for the parent-child exception. As a result, the property will be reassessed at the current fair market value.
To avoid this result, the trust should be structured as a non-pro-rata trust that allows the trust assets to be distributed among the parties without a pro-rata split. In the above example, a non-pro-rata trust would allow Able to receive the property and Beth to receive assets of equivalent value. The right to a non-pro-rata distribution is assumed by California law unless the trust provides otherwise. Note, however, that the opposite is true for property that passes by will: Property that passes under a will is presumed to pass to the beneficiaries in equal shares on a pro-rata basis unless the will provides otherwise.
Care must also be taken to ensure that a non-qualifying beneficiary does not receive a present beneficial use of the property or receive income from it. If, for example, the non-qualifying beneficiary lives on the property or receives rent from it, property taxes will be reassessed. Only one non-qualifying beneficiary can cause the entire property to be reassessed.
Changes in Ownership Involving Transfers to Business Entities
Real estate is often transferred to limited liability companies or other business entities for liability and asset protection purposes. If property is transferred from an individual to a legal entity, or between two legal entities, the transfer is a change in ownership. Unless an exclusion applies, the transfer will trigger a property tax reassessment.
The California Revenue and Tax Code also contains a special look-through rule: If the ownership interest in a legal entity that owns California real estate is transferred, the transfer of the business interest is treated as a change in ownership of the property if:
- There is a change in control of the entity (more than 50 percent of the voting stock of a corporation or more than 50 percent of the ownership interest of a partnership or LLC); or
- When more than 50 percent of the interests of the original business owners (measured cumulatively) are transferred.
This rule prevents property owners from avoiding reassessment by creating a business entity to own real estate and then transferring the interest in the business entity instead of creating a new deed to the property.
There is a specific exception for the most common scenario involving real estate, where owners transfer property to a business entity and receive an interest in the business entity that is proportionate to their prior ownership of the property. Under the proportional ownership interest exclusion, a transfer of California real estate between one or more individuals and a legal entity—or between legal entities—is exempt from reassessment if:
- The transfer is simply a change in the method of holding title to the property (for example, a 50 percent interest in real estate converted to a 50 percent interest in an LLC that owns the real estate); and
- Both before and after the transfer, the proportional interests of the transferors and the transferees is the same for every piece of real property involved in the transfer.
This rule is intended to protect property from reassessment if there is no change in the economic interests of the owners.
Example: John and Mary each own a 50 percent interest in California real estate. For asset protection purposes, John and Mary each deed their 50 percent interest in property to Acme LLC. John owns 50 percent of the interest in Acme LLC and Mary owns the remaining 50 percent interest. Because the 50 percent interest in the LLC is equivalent to the 50 percent interest that John and Mary each held in the property, the transfer is exempt from reassessment.
If the ownership interests in the business entity are not proportional to the prior ownership interests in the property, the entire property is subject to reassessment.