Proposition 13, California Property Taxes, and Planning for Family-owned Businesses: the Change in Ownership Rules for Real Property and Legal Entities Held in Trust

• Publication year: 2014
• Author: By Matthew F. Burke, Esq.*

PROPOSITION 13, CALIFORNIA PROPERTY TAXES, AND PLANNING FOR FAMILY-OWNED BUSINESSES: THE CHANGE IN OWNERSHIP RULES FOR REAL PROPERTY AND LEGAL ENTITIES HELD IN TRUST

By Matthew F. Burke, Esq.¹*

The property tax field in California is rife with legal landmines, particularly when ownership of property is layered in trusts and in legal entities. It is crucial to understand how these rules work because an inadvertent change in ownership today can result in enormous additional property taxes over the expected period of ownership. Property owners are becoming increasingly sophisticated and litigious, and claims of malpractice in this area are becoming more common.

This article discusses the change of ownership rules, reassessment pitfalls and things a planner should take into account to minimize a client's real property tax burden.

I. INTRODUCTION

In California, it is fairly common to have family-owned businesses with significant commercial real estate holdings. Often these holdings were acquired twenty, thirty, and sometimes forty years ago and are owned in multiple tiers of legal entities. There may be leases, subleases, and ground leases with tenant-constructed improvements. To top it off, these legal entity interests have often been transferred into trusts.

Moreover, many clients continue to own property acquired prior to the passage of Proposition 13 ("Prop 13") in 1978, which property has a very low property tax base year value. That low base year value is of considerable worth, and older generations would like to pass that benefit down to their children and grandchildren. A change in ownership of a property under the California property tax laws would trigger reassessment for property tax purposes and the low base year value would be lost forever.

A change in ownership (as the term is defined in the property tax laws) of a property that has a low base year value can cost hundreds of thousands, and sometimes millions, of dollars in additional property taxes over the ensuing years. Much time is expended after an unexpected reassessment trying to rescind a transfer, with uncertain results and at great expense. Property owners have been known to threaten malpractice actions against their attorneys when they believe that reassessments could have been avoided or minimized.

When confronted with a client's portfolio of long-held California commercial properties, practitioners should be familiar with the basic property tax rules so that they can spot the issues, avoid the obvious pitfalls, plan for and explain the unavoidable changes in ownership, and add value by seeking expert guidance for the most sophisticated planning. Sometimes a property tax reassessment is unavoidable; but given the layers of complexity in ownership, with proper foresight and planning, sometimes a change can be avoided (or deferred) by a practitioner who has a deep understanding of the property tax laws.

Much has been written about Proposition 58, the parent-child exclusion from change in ownership, which the voters passed in 1986, and Proposition 193, the extension of that exclusion to certain grandparent-grandchild transfers, which the voters passed in 1996. This article does not discuss those exclusions in any detail. Unless otherwise indicated for illustration, this article assumes that the limits on these exclusions have been exhausted or they are otherwise unavailable, and that the reader has a working knowledge of those rules.² Suffice it to say that if property is owned in a legal entity, and the transferors have not used the maximum allowable parent-child and grandparent-grandchild exclusions, careful consideration must be taken to ensure that the exclusions are used appropriately without also risking the loss of some of the advantages from entity ownership. Since there are limits to these exclusions, it is important to consider other available strategies.

The following comprehensively discusses the basic rules, cases, and interpretations with which practitioners should be familiar when dealing with family-owned California commercial properties, whether owned directly in trust, or through legal entities in trust. To successfully advise these clients, it is important to understand the basic Prop 13 change in ownership principles, the "transferor" concept, and the change in ownership rules as applied to trusts, life estates and estates for years, leases, and legal entities. With a solid grasp of these rules, practitioners will be able to answer most basic questions and frame the issues for the more difficult ones.

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II. CHANGE IN OWNERSHIP

Because the property tax laws are complex and build upon one another, it is necessary to start with the basics. Under Prop 13,³ real property is originally assessed at either the value that was on the property's 1975-76 tax bill, or at the "full cash value" (which means fair market value) of the property when it undergoes a change in ownership⁴ (or undergoes new construction⁵) after 1975. That value is referred to as the "base year value." When a property undergoes a change in ownership, it is reassessed at fair market value, which becomes the property's new base year value. Understandably, if a property has not had a change in ownership (or undergone new construction) since 1975, it has a very low base year value.

Prop 13 allows for an increase in the base year value by a rate equal to the lesser of the California Consumer Price Index ("CCPI") or two percent. With this inflation factoring, the tax base is generally referred to as the "adjusted base year value." Prop 13 provides that the property tax is one percent of the adjusted base year value. The limits apply to all real property except for certain state-assessed properties (like railroads, pipelines, and utilities). Notably, Prop 13 does not distinguish between residential and commercial property.

When there is a change in ownership, there is a reassessment of the property to its fair market value, and if the fair market value has increased, this results in an increase in property taxes for every year thereafter, except in certain periods of declining markets. The paramount issue under Prop 13 is whether a transfer does or does not constitute a change in ownership, because a change results in the property being reassessed to fair market value for all years until there is a subsequent change in ownership (or new construction), and therefore increased property taxes.

The term change in ownership was not defined in Prop 13's actual ballot language and resulting constitutional amendment. The task of defining it was ultimately left to the Legislature,⁶ which adopted a statutory definition in Revenue and Taxation Code section 60.⁷ Section 60 provides that a change in ownership is a transfer of:

(i) A present interest in real property ("present interest"),
(ii) Including the beneficial use thereof ("beneficial use"),
(iii) The value of which is substantially equal to the value of the fee interest ("value equivalence" or "fee equivalence").⁸

This is generally referred to as the "three-prong test."⁹

The first prong, "present interest," protects transfers of future interests from being changes in ownership. For example, if A transfers his property to himself for life, remainder to his brother, B, there is no transfer of a present interest to B, and therefore no change in ownership. The third prong, "value equivalence" or "fee equivalence", is the key issue with leases, so the entering into of certain short-term leases is not a change in ownership because the leasehold created in the lessee is not equivalent to a fee interest.

The second prong, "beneficial use," is generally the focus when analyzing transfers involving trusts. According to the Task Force Report,¹⁰ the "beneficial use" prong is designed "to protect custodianships, guardianships, trusteeships, security interests, and other fiduciary relationships from unintended change in ownership treatment."¹¹ In certain of these fiduciary relationships, bare legal title and beneficial use may be split,¹² so even though bare legal title may transfer (when, for example, a trustor transfers property to a trustee), the beneficial ownership may not transfer (for example, in the case of a revocable trust). Or, if beneficial use does transfer, it may transfer to someone other than the trustee. In other words, for property tax purposes, the trustee holds bare legal title only; beneficial use either remains with the trustor or vests in the present beneficiary. All of the trust change in ownership analysis will involve looking at this beneficial use prong in one way or another.

III. TRANSFERS INTO, OUT OF, AND DURING THE COURSE OF A TRUST

The Legislature enacted in subdivisions of section 61 examples of transfers that do constitute changes in ownership, and enacted in subdivisions of section 62 examples of transfers that do not constitute changes in ownership (i.e., are "excluded" from change in ownership) under the three-prong test.¹³ The transfers that do constitute changes in ownership satisfy all three prongs, whereas the transfers that do not constitute changes in ownership fail to meet one or more of the three prongs. There are provisions in sections 61 and 62 and one regulation ("Property Tax Rules" or "Rules")¹⁴ that specifically address transfers into or out of a trust.

A. The Statutes

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Section 61, subdivision (h), contains a simple "what is a change in ownership" rule for trusts. Under section 61, subdivision (h), a change in ownership occurs when a revocable trust becomes irrevocable, and the beneficiary is someone other than the trustor or the trustor's spouse. This is the only provision in all the statutes that addresses when a transfer involving a trust is a change in ownership. In this situation, there is a transfer of beneficial use because someone other than the trustor becomes the beneficiary of the trust. By contrast, while the trust was revocable, the trustor was still considered the beneficial...