California Proposition 19 and Gift Tax Issues

Proposition 19 and Gift Taxes

February 15, 2021 Deadline

Summary.

Proposition 19 should cause only a very small percentage of people to make gifts before the deadline.  It makes sense for certain properties where the decision has already been made to gift the specific piece of real property to a specific beneficiary(ies). 

Background.  Under existing law, a principal residence and $1m of assessed value real estate can be transferred to children without reassessment.  Prop. 19 limits this exemption to the principal residence “Family Home” or a “Family Farm” and excludes any other real property.   The considerations when making a lifetime gift of real estate do not change as a result of Prop. 19, and they remain, in order:

1.  Control

2.  Income

3.  Capital Gains Tax – Step Up In Basis

4.  Gift Tax

5.  Estate Tax

6.  Property Tax 

(Property Tax moves up to No. 4 for most people who have less than $11m (single) or $22m (couple).  

While Californians do cherish their low Prop. 13 property tax assessments, the preceding factors must be given deep consideration before making a gift to avoid Prop. 19.

                Control.  Longevity is the primary concern of Estate Planners.  A 75 year old client today is presumed to have a 30+ year time horizon.  Healthcare costs will be beyond anything that we can imagine.  While some families do operate on a basis of absolute trust and respect, where the promise of a child to take care of the parents forever would be respected… most families do not!  If you project the uncertainty of a 30 year time horizon (considering divorce, death, disease, lawsuits, bankruptcies, etc …) it is impossible to know how your children will act when you might need their help the most.

                Income.  With ultra-low interest rates, Lifetime gifts are now only suitable for the wealthiest families who know with certainty that they will not outlive their resources.  The current Gift/Estate Tax Exemptions have also eliminated the need for annual gifts for most.

                Capital Gains Tax – Step Up In Basis.  The Step-Up is one of the greatest tax breaks that exists today.  It is even better in a Community Property State like California!  It means that if your estate is under $11m (single) or $22m (couple) your children will pay NO tax at your death if they choose to liquidate the real estate.  It will certainly be a target of those who want to raise more tax revenue in the future, but for now, it remains the law.  If you make a lifetime gift of your real property you lose the Step-Up.

                Gift & Estate Tax.  When Democrats appeared to be heading into a “Blue-Wave” landslide there was talk of taking the unprecedented action of tax hikes (decrease in Gift Tax Exemption) that would be retroactive to January 1, 2021.  That would mean any substantial Gifts would have to be completed by December 31, 2020.  Such a tax hike would not only be unprecedented, it would be very unfair to law abiding Americans who make their decisions based on existing law.  When considering whether the Gift Tax is a factor in your decision to make a Prop. 19 gift you should focus on February 15, 2021.  It seems unlikely that any decrease in the Gift Tax Exemption would be effective as of that date, but you should make your own judgments as to political matters.

Property Tax.  As to a principal residence, now called a “Family Home”, the rules have not changed enough to affect most people.  There is a “Family Farm” exemption as well – but it is so low that it will not benefit many in CA.  What is really at stake under Prop. 19 are things like vacation homes and investment property. 

The most practical planning opportunity is probably with vacation homes.  Parents can give a paid off vacation home away and then literally “pay rent” to their children to use it in the future.  The rent may be enough to cover the annual operating expenses.

Investment properties rarely cash-flow.  Sometimes an investment property is a real gem that is easy to keep occupied and does in fact cash-flow.  If you have one of these, and one of your children / beneficiary(ies) has a special relationship with this property, ie. they know how to manage the property and they know the tenants, this may be a candidate for a pre February 15, 2021 gift to avoid Prop. 19.  Only do this if you believe that the beneficiary will keep the property and obtain the greatest possible advantage from avoiding Prop. 19.

Warning.  Children / beneficiary(ies) have always found reasons to justify their parents making lifetime “gifts”.  Prop. 19 is very likely to be used for this purpose in the coming weeks.  Every parent/donor should know that the evidence shows that these “gifts” will be most likely be liquidated in the short-term in disregard of the above.

Final Warning- the Assessor.  The Assessors’ Offices across CA have become much more sophisticated in analyzing conveyances that are attempts to avoid reassessment.  Any transfer to a Trust, LLC, or any other entity, made between November 5, 2020 and February 15, 2021 is going to be particularly well documented, recorded (no pun intended) and highly scrutinized.  All of this information  is public record.  California Assessors will keep details of these 2020-2021 transactions forever and can come back at any time in the future to review the true nature of the transaction and determine whether a change of ownership did in fact occur.  There is no entity that provides “asset protection” from the Tax Collector because the property itself is subject to the tax liability.