ince the adoption of Proposition 13 in 1978, many long-time income property owners have benefitted greatly from property tax assessments that have grown more slowly than market values. This has given them property tax savings frequently equal to 20-30%, or more, of cash flow before property taxes.
However, when you pass that property to heirs, other than your spouse, it will usually suffer reassessment. Fortunately, the property tax law gives each owner the ability to exclude some property from reassessment when it passes to children (and in limited cases, orphaned grandchildren). Generally, the parent-child exclusion from property tax reassessment applies only to transfers of either your principal residence (regardless of market or assessed value), or property which, when transferred to children, has an assessed value of not more than $1 million per transferor during the transferor’s life.
For many of you, that may seem like enough. But, for others, it will not protect all of the property you will ultimately want to transfer for the benefit of your children. This article will introduce you to an estate planning strategy that can leverage the parent-child exclusion from reassessment by a factor of 10 or more. This strategy can be combined with other strategies to limit exposure to estate and gift taxes and still preserve access so your wealth can be used for your benefit during your life.
Dealing with estate and gift tax exposure has become particularly important for many owners, since current law mandates about a 50% cut in the current estate tax exclusion of $11.58 million per person at the start of 2026. Worse, if the administration changes in 2021, or later during your life, I expect a greater, and sooner, reduction in the estate tax exclusion, likely before 2026. [See my article entitled “New Estate Taxes Could Cost AOA Members Millions of Dollars” in the September, 2020 AOA News or request a copy from me.]
Basic Steps in the Strategy
This strategy involves a series of carefully coordinated STEPS to achieve the desired result. Normally, in tax planning, whether for income, estate, gift or property taxes, a so-called “Step Transaction Doctrine” collapses coordinated steps and makes it difficult or impossible to get the result you want by doing it one step at a time if you would not get the result in a single step. However, as explained below under the caption “WHY THE STEP-TRANSACTION DOCTRINE DOES NOT APPLY HERE”, when the legislature adopted the statute governing the parent-child exclusion, it also adopted a non-codified Note to negate the application of the Step Transaction Doctrine to this strategy.
So, let’s consider the steps involved in this strategy. [Please do not try to do this without competent legal assistance. To maximize the benefit of, and the chances of success for, the strategy, for income, estate, gift and property tax purposes, it must be carefully implemented, and you would probably need experienced counsel to do it well.]
STEP 1: You (that may be an individual, or it can be two spouses) put your property into an LLC owned by you. So long as the LLC upon formation is owned in the same percentages as the property, this is not treated as a reassessment event, but just a change in the form of ownership. I normally am not a big fan of LLCs which you continue to manage and control, due to practical limits on liability protection, cost and potential adverse impacts on the parent-child exclusion from reassessment.
However, by using these steps properly, the LLC can be the key to leveraging the parent-child exclusion from reassessment. NOTE: there are a lot of choices to be considered in forming and using an LLC which you should review with counsel and, often, also with your CPA and insurance agent.
STEP 2: You transfer 50% of the LLC interests to your child or children. This will not be treated as a transfer of the underlying property for property tax purposes, so long as the total transfers of interests in the LLC from inception are not more than 50%. This step does not use any of your parent-child exclusion for property tax purposes. If you want to coordinate this with estate and gift tax planning, you may substitute one or more trusts for the benefit of your children in place of a direct transfer to the children of LLC interests. And, you can often build in trust provisions which, as a practical matter, can make sure your wealth will be available for you to spend if needed (a vital topic to discuss with your planner, but beyond the scope of this article).
If you use a trust, it can be drafted to be treated as though it is you for income tax purposes, even though it will not be owned by you for gift and estate tax purposes, while the property of the trust will be deemed to be owned by your children for property tax purposes! Planning to get these different tax treatments, where desired, may seem complex, but is usually possible (under current law) where desired, and substantial precedent supports each leg of the different treatment.
The transfer can be structured as a gift for gift tax purposes (using some of your remaining gift tax exclusion, which may be the full $11.58 million still applicable in 2020). If you do not have (or do not want to use) this much of the gift tax exclusion, it can be a “sale” (in part or in total) for gift and estate tax purposes, but ignored for income tax purposes(so you recognize no taxable gain) .
Having the trust ignored for income tax purposes requires use of a so-called “Grantor Trust” structured to be you for income tax purposes. Sophisticated estate planners often use this kind of trust, though the details about how we do this and why this works are beyond the scope of this article.
STEP 3: The owners of the LLC liquidate it and distribute the underlying property to the owners pro-rata to their ownership, who become tenants in common. The result will be that the property will be owned 50% by you and 50% by the children (or the trust treated as the children) for property tax purposes. This will be treated as just a change in the form of ownership for property tax reassessment purposes, and not a reassessment event.
STEP 4: You give a small part of your tenant in common interest in the property to the children (or the trust for their benefit) – this will likely use a little of your estate and gift tax exclusion and a little of your parent-child exclusion. This needs to be planned carefully in light of your remaining estate, gift and parent-child reassessment exclusions.
STEP 5: The tenants in common (you and the children, or trusts for the benefit of you and the children) contribute their interests to a new LLC, owned pro-rata to their percentage interests. This step is again treated as a mere change in form of ownership, and not a reassessment event. But, at that point, the children own a majority of the LLC for property tax purposes, directly or through the trust for their benefit.
STEP 6: You transfer “your” remaining interest in the LLC to the children (or trusts for their benefit). This transfer of LLC interests constitutes less than 50% of the LLC interests, and no new person obtains majority ownership. Accordingly, the rules on changes in control or ownership of the LLC do not cause reassessment. Thereafter, if the LLC owners no longer desire to use the LLC, they can then liquidate it as a mere change in form, without reassessment.
THE RESULT: The entire LLC is owned by, or for the benefit of, the children, with no reassessment. Properly structured, we can protect tens of millions of dollars in property value from property tax reassessment with these “steps.” In most cases, when the ownership of the LLC (directly or through the trust) passes to benefit your grandchildren, it will remain exempt from reassessment under current law.
At the same time, unless the applicable estate tax principles change, we can also insulate the property from the burden of estate taxes even if the property values exceed the estate tax exclusions now, or exceed estate tax exclusions in the future (either due to reductions in estate tax exclusions, increases in value of the property, or a combination thereof). Again, under current law, the insulation can continue or be repeated for generations.
Why the Step-Transaction Doctrine Does Not Apply Here
For almost every tax purpose, the “Step Transaction Doctrine” would collapse a series of transactions structured like the six steps above into one or two steps, negating most of the benefit. The Doctrine applies, for most property tax purposes, when a series of transactions are made merely to avoid reappraisal, in which case the substance of the transactions, rather than the form of separate steps, determines if a reassessment event (or other tax significant event) has occurred.
And, except for property tax reassessment purposes, such doctrine would probably apply, so we do not use the steps to get additional estate and gift tax benefits. So, the transactions will need to be, and with today’s $11.58 million estate tax exclusion, usually can be, structured so that the collapse would not produce an estate or gift tax.
However, as mentioned above, the uncodified (i.e., a part of the legislation that got no section number) Note to Revenue and Taxation Code ‘ 63.1 clearly explained that the Legislature intended the Step Transaction Doctrine NOT APPLY to transactions among parents and children, even if they involve interim steps using entities (such as LLCs).
The staff of the Board of Equalization has consistently determined in interpretive letters that the Step Transaction Doctrine does not apply to “Steps” of the kind described above. These letters technically do not have precedential effect or the force of law.
The consistent interpretive letters both conform to the logic of the Note adopted by the legislature, and demonstrate an unwavering attitude of the Board of Equalization staff toward the inapplicability of the Step Transaction Doctrine to these steps.
The letters demonstrate that the Doctrine does not apply, even when using “steps” intended to get LLCs owned into the hands of children without reassessment. They further demonstrate the non-applicability of the Doctrine even if the values of the property in the LLC would exceed the amounts which could be protected from reassessment by the parent-child exclusion if the parent(s) transferred the real property directly.
So, although the non-applicability of the Doctrine has not been tested by the Courts, and there is always the possibility that a court would reach a different conclusion, we believe owners can be confident that local assessors and the Board are not interested in trying to use the Doctrine to challenge these transactions.
The Time for Planning is Now
My estate planning motto has never been truer. Now, more than ever: If you fail to plan WELL NOW, plan to FAIL.”
None of us know what the laws will be like in the future. The rule rejecting the Step Transaction Doctrine for these transactions using LLCs to get the effective ownership of property into the hands of children could be changed in the future. And, the virus deficit increases the chances of both a change in administration and adverse changes in tax rules.
The bottom line: If you have, or expect to have, property assessed above your parent-child exclusion from reassessment, but below market value, you should consider using the Steps described above to assure preserving favorable assessments for your children. And, if you think your net worth could grow before you pass much above $3.5 million as an individual, or $7 million as a couple, PLEASE spend some time with an experienced estate planner as soon as possible to evaluate what you can do to protect your wealth from substantial death tax exposure, particularly if there is a change in administration. Proposals endorsed by several candidates could make effective planning impossible after the end of this year.
Don’t let procrastination allow changes in the law to steal decades of sacrifice and hard work from your family. And, please do not wait until after we know the results of the election in November or later. It takes time to plan to these strategies well in the context of your family situation. It takes even more time to implement them in the best way. You should not expect planning done under the pressure of a change in administration at the end of the year to work as well for your family as planning that starts sooner.
We know from experience that owners of income properties care about planning for the future. Most of you have sacrificed for decades to build wealth, most of which you do not plan to spend, but which you want used to benefit your heirs. You probably did not build this wealth just to see much of it taken in unnecessary taxes when you die. Don’t let a change in administration blind-side your family. And, in all cases, consider how to use good planning to preserve favorable property tax assessment levels as long as possible.
If you want to consult with me and my wife Hinda, we would love to conference with you by video or phone (until the Covid risk of in person meeting has faded). Such a conference can help you evaluate your risks and planning alternatives. But, if you do not do a conference with us, please find an estate planner familiar with a range of advanced strategies who is also well-versed in issues relevant to the owners of income properties.
Kenneth Ziskin, an estate planning attorney, focuses on integrated estate planning for apartment owners to save income, property, gift and estate taxes. He also provides trust and probate administration assistance after the death of a loved one. He holds the coveted AV Preeminent peer reviewed rating for Ethical Standards and Legal Ability from Martindale-Hubbell, a perfect 10 out of 10 rating from legal website AVVO.Com, and is multiple winner of AVVO’s Client Choice Award. See Ken’s website at www.ZiskinLaw.com.
Ken also offers CONSULTATIONS FOR AOA MEMBERS in appropriate cases. Call him at (818) 988-0949.
This article is general in nature and not intended as advice for clients. This article may be considered attorney advertising. Please get advice from counsel you retain for your own planning. Drafted in August, 2020.