BENNINGFIELD FINANCIAL ADVISORS, LLC

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How California Prop 19 May Affect Your Home

Last month, California voters narrowly approved the most sweeping changes to the state’s residential property taxes in a generation. There are winners and losers under Proposition 19’s new tax rules, but some homeowners may be able to preserve their benefits if they act quickly before Prop 19 becomes effective in a few weeks on February 16, 2021.

Current California Law - Prop 13

To understand Proposition 19 requires understanding California’s property-tax history - in particular, Proposition 13, known as “the People’s Initiative to Limit Property Taxation.”

Until the 1930’s, when California implemented its state income and sales taxes, the state’s government was almost completely supported by property taxes. For several decades, California homeowners paid roughly the same 2% of their home’s value to pay for schools and local services. This worked fine until house prices began spiraling out of control in the 1970’s, causing property taxes to outstrip the ability of homeowners to pay them and threatening to force them out of their homes.

A taxpayer revolt led to the passage of Proposition 13 in 1978. Prop 13 cut property taxes in half and capped annual increases at 2% a year until a house is reassessed after a change in ownership such as a sale, gift, or transfer on death.

Subsequent expansions of Prop 13’s protections meant that just because a house changes hands, there’s not necessarily a “change in ownership” that triggers reassessment. For example, a parent-child exemption created in 1986 allows parents to transfer their home along with their low-tax benefits to their kids. This inheritance can become more valuable over the years as house prices rise more quickly than the 2% annual property-tax cap. 

As a result, we have a strange situation in California today where similarly situated homeowners often pay dramatically different taxes. A homeowner who recently bought a $2 million house might pay over $25,000 a year in taxes, once local assessments are added. The neighbor who owns an identical $2 million home that’s been in the family several decades might pay only $2,500 a year -- while receiving the same government services that property taxes support.

These kinds of disparities violate the “horizontal equity” principle of fair taxation, which says that similarly situated people should pay similar tax amounts for everyone to have confidence in the system. It was only a matter of time before clever programmers began creating property-tax maps, based on public data, to highlight the disparities.

Prop 13 also had a dark side for long-term homeowners: moving to a new home that had appreciated as quickly as their own often meant exposing themselves to much higher property taxes, since with some exceptions, they couldn’t port their low taxes to the new house. Many homeowners felt trapped, unable to sell their homes to downsize, upgrade, or move closer to the kids.

New California Law - Proposition 19

According to Prop 19’s proponents, it would reduce Prop 13’s disparities and liberate long-term homeowners. Left unsaid was how it would also likely generate more house sales and broker commissions, which is why its main proponent was the California Realtors Association, which spent $36 million to promote an otherwise long-shot tax measure.

Proposition 19 Winners

The winners under Prop 19 are identified in its title: “The Home Protection for Seniors, Severely Disabled, Families, and Victims of Wildfire or Natural Disasters Act.” 

Starting next April:

  • Anyone over 55 years of age, disabled, or victims of a wildfire or natural disaster will be able to transfer the assessed value of their California primary residence to a new home anywhere in California. 

  • They can do this three times in their lifetime, and they have two years to transfer their low property tax. 

  • If the new home is more expensive than their old one, their property taxes may rise, but not nearly as much as they would have before Prop 19.

The inclusion of wildfire victims in Prop 19 was smart. California was still in the midst of another horrific fire season while voters were considering the referendum, and it was heartbreaking to think that people could lose their homes and their ability to afford a new one overnight. Prop 19’s backers ran poignant television ads and even provided additional revenue to firefighters and their unions. Still, Prop 19 barely passed with only 51% of the vote. 

Prop 19 is a huge win for grandparents wanting to relocate from Sacramento to San Diego to buy a home closer to their kids and for couples wanting to downsize or upgrade to their dream home for retirement. But it’s bad news for many other families:

Proposition 19 Losers

The ones who lose under Prop 19 are families wanting children (or qualifying grandchildren) to inherit their parents’ homes and continue to enjoy their low tax benefits. 

Prop 19 severely limits these benefits for children who move into an inherited home and make it their primary residence. It eliminates Prop 13’s tax benefits altogether if they don’t move into the home, but choose to hold it as a vacation or rental property.

To illustrate, take the example of a San Francisco home purchased by mom and dad in the 1970’s for $100,000. Today it’s worth $2 million, but its assessed value under Prop 13 is $200,000, so the parents pay only about $2,500 a year in property taxes, after including local assessments.

Under Prop 13, an unlimited “principal residence exclusion” allows a child to inherit the house along with its $200,000 assessed value and the low $2,500 tax bill. The 2% annual cap also means that property taxes will rise only about $50 a year going forward.

Prop 19 caps the “principal residence exclusion” at $1 million, which means, in our example of a $2 million home, that the additional $1 million of value will result in taxes of over $10,000 a year (after local assessments), with increases of about $200 a year going forward.

Paying taxes on only half the home’s value may sound like a good deal. But it could be a dealbreaker for many middle-class families, since the taxes will be added to other costs such as insurance, annual maintenance and possibly a mortgage required for the kids to own the family home.

If the kids decide not to move into the inherited home and make it their primary residence, the property taxes will jump even more. Taxes will be assessed on the full market value of $2 million, resulting in an annual tax bill of over $25,000, after including local assessments.

The Los Angeles Times called Prop 19 “a cynical and unwelcome melding of good and bad tax proposals” and said “voters should reject it.” Yet families can thank the LA Times for the movement to curtail the parent-child tax exclusion.

In 2018, investigative reporters at the Times uncovered what became known as the “Lebowski loophole,” named after actor Jeff Bridges, who starred as “The Dude” in the “The Great Lebowski.” 

The Times reported that Jeff Bridges, together with his brother Beau and their sister were paying only $5,700 a year in property taxes on “a four-bedroom Malibu home with access to a semi-private beach and panoramic views of the Pacific Ocean.” They inherited the estate from their parents, who bought it in the 1950’s, but none of the Bridges siblings lived there. They were renting it out for $15,000 a month.

By contrast, the Times noted, a new purchaser of the $6.8 million home would have to pay $76,000 in property taxes. Further:

California is the only state to provide this tax break, which was designed to protect families from sharp tax increases on the death of a loved one. Without it, proponents argued at the time it passed, adult children could have faced potentially huge bills, making it financially prohibitive to live in their family homes.

But a Los Angeles Times analysis shows that many of those who inherit property with the tax breaks don’t live in them. Rather, they use the homes as investments while still taking advantage of the generous tax benefits.

The state legislator who authored the Prop 13 inheritance-tax break expressed remorse:

Thomas Hannigan, a former state assemblyman from Solano County and author of the inheritance tax break, admits he did not foresee that the heirs of homeowners would use his law as a moneymaker.

“I tried to do the right thing,” said Hannigan, a Democrat, in an interview with The Times. “Obviously, it had unintended consequences.”

Prop 19 Planning Strategies

Proposition 19 becomes effective two months from now on February 16, 2021. This means there isn’t much time to figure out how best to proceed if someone wants to preserve their Prop 13 benefits before that date.

We’re also waiting for the California Board of Equalization to issue implementing regulations to help answer numerous questions about the new transfer rules. According to one attorney, the BOE itself is scrambling to figure out what Prop 19 means for a variety of situations, so the odds are good that the regulations won’t be available before February 16th.

This makes planning difficult, and attorneys are advising clients that while they’ll need to decide which strategies to use now, it’s possible that whichever strategy they choose will not work as hoped.

With these caveats in mind, here are some of the considerations involved.

Gifting Directly to the Kids Now

This is the simplest strategy, with the lowest out-of-pocket costs, since you don’t need to hire an attorney to draft any documents. It’s also the one thing attorneys know will work under Prop 19, since the current Prop 13 rules are clear on parent-child transfers.

However, there are both income-tax and estate-tax implications to consider. For example, if a parent wants to stay in a home after giving it to a child, the child may want to charge the parent rent in order to avoid using some of their lifetime gift-tax exemption.

Gifting a house could also mean giving up a valuable capital-gains-tax benefit. When houses pass after death, they receive an “adjusted basis” to fair market value, which means the house could be sold immediately after death without generating any taxable gains. Gifting the house requires giving up access to the “adjusted basis,” which means the kids could pay significant capital gains if they sell it later.

Other potential downsides to gifting directly include:

  • The parents will lose control of the home as well as any rental income they’re receiving now.

  • A child may “die out of order” before the parent.

  • The house could become vulnerable to a child’s divorce, lawsuits or bankruptcy.

Gifting Home to a Trust

Gifting a house to a trust may offer valuable asset protection and other benefits, and attorneys are exploring a variety of trust options that families might use to get a double or triple benefit with property taxes, income taxes and estate taxes.

These are complicated strategies, though, with potential pitfalls, since we have no regulatory guidance on how Prop 19 will be implemented or precedence for which strategies will work. There are also legal fees to draft the trusts and the possibility that the BOE will challenge the strategy after issuing its rules.

All this means that while using a trust may be the most effective strategy, it’s also the riskiest strategy for attempting to preserve Prop 13 benefits.

Finally, with any type of irrevocable trust, there will be administrative costs and complexity to address afterwards. These costs may be worth it in the right situations, but should be carefully assessed.

Other Considerations

After 2020 we know our world can change quickly. In California we’ve had to contend not just with the pandemic, but with wildfires, floods, and earthquakes. Housing has been a good bet for many families up to now, but it’s hard to know how the future will affect properties being transferred today.

What do the kids want? The ski house in the mountains may have been wonderful for your family, but not so great for theirs. Make sure you’ll be handing them an actual benefit and not a family albatross. 

If you have more than one child, how are you going to equalize the gifts and bequests to the other kids? Do you have other assets to help with this; can they be liquidated or not; are they guaranteed to hold their value?

With personal finance, it’s rare for a transaction to make sense purely for the tax benefits. Yet these benefits often obscure the underlying merits of an investment or other decision. Taking a moment to consider the tax issues in the context of your family’s broader circumstances, and keeping in mind that taxes could change again tomorrow will help determine whether preserving your Prop 13 benefits is worth the tradeoffs.

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