Why Married Couples Should Probably Do Nothing in Light of Proposition 19 Passing
By Mary Korkodian
The passing of Proposition 19 is not good news for owners of real property in California. Prop 19 eliminates the ability of children to keep the same low property tax base that their parents enjoyed when the children inherit the parents’ property. (Some limited exceptions exist for the parents’ principal residence.)
However, the damage done by Proposition 19 could be compounded if parents convey low assessed value real property to their children in an attempt to avoid the impact of the Proposition.
At first blush, the transfer of properties before February 16, 2021 to take advantage of the $1 Million parent to child exclusion ($2 Million for married couples) looks appealing. But let’s dive a little deeper in our analysis. If both parents are living, properties with low assessed values in relation to fair market value means that the properties have probably gained substantial value over the years. Thus, the basis in the properties are very low relative to their fair market value. Inherited property gets a step up in basis, where gifted property keeps the same basis that the parents had.
How Does a “Step Up in Basis” Work?
If the children inherit property, the property would receive a basis adjustment; that is, the basis will be adjusted to the current market value of the property. With California’s historically booming real estate market, this often results in a “step up” in basis rather than a “step down.”
For example, if a property that was purchased for $100,000 by the parents is inherited by the children when the property was worth $1.2 Million, the children get a “step up” in basis to $1.2 Million. (It is like they purchased the property for $1.2 Million.) If the children then sold the property for $1.2 Million, there would be absolutely no capital gain realized and thus, no income tax to pay.
How does Basis Adjustment Impact my Decision to Gift Now?
If parents decide to gift property to their children before February 16, 2021 in order to take advantage of pre-Prop 19 parent to child exclusions, the children will not reap the benefit of a basis adjustment. Instead, the parents’ basis is “carried over” to the children.
Using the example above, if the children were gifted the $100,000 property during the parents’ lifetime, the children will take the parents’ basis of $100,000 and miss a step up in basis. If the children sold the property for $1.2 Million, they get the privilege of declaring $1.1 Million in capital gains and paying income taxes on that gain.
Thus, the gifting of properties now will result in the loss of the basis step up, which could cost the children a significant amount in income taxes down the road when they sell; indeed, perhaps much more than any savings on property taxes can produce.
Remember, if no gifting of property occurred, the property taxes would only increase in value when the second parent dies. Until then, Proposition 19 has no impact on families. Therefore, gifting now could save the children from paying increased property taxes after the second parent dies, but these property tax savings may never equal the additional income taxes that would need to be paid upon the sale of the property by the children. And since property taxes are deductible in rental properties, the disparity is even more pronounced because the taxes paid on the $1.1 Million gain are not deductible.
Are There Any Situations Where Lifetime Gifting of Appreciated Property Would Be Prudent?
Yes. (Provided the parents are financially able to survive said gifting!)
If one parent has already died and, as a result, the property received a step up in basis, a lifetime gift could be a very good choice.
Also, if we know that a California non-income producing property that is being gifted will never be sold during the lifetime of the child (for example, vacation homes and cabins that will remain in the family for decades), then lifetime gifting would be most appropriate prior to February 16, 2021.
However, if a property is an income-producing property that is never going to be sold, the decision becomes a little more difficult because getting a step up in basis will give the child the ability to shelter more rental income using the higher depreciation number. Avoiding the increase in property taxes will probably win out in this scenario when the math is actually performed. But it is a case by case analysis.
Decision Tree for Determining Whether to Gift Real Property to Children
With this blog is a decision tree in helping determine whether Prop 19 planning is the right choice. It does not cover all the various reasons why gifting is or is not a good plan; thus, it should be used as a starting point for analysis only.
Although everyone has a different set of facts to be considered, as we study all factors facing our California landowners, very few situations would dictate acting before February 16, 2021 to use the parent to child property tax exclusions.
Does that mean that gifting should not be considered? Actually, there are many reasons why gifting now could be a great idea. (The gifting just should not be motivated by the passage of Prop 19.) Consult with your attorney and your accountant. As a team, they can explore gifting opportunities.
Please Note: This document does not constitute legal advice. Please consult an attorney for legal advice on what to do in a particular situation.