Prop 19 passed on November 3, 2020 and goes into effect in February of 2021. Prop 19 has a number of important consequences for inherited properties in California. Families now have a short period of time to take advantage of the current law and its rules regarding the “Parent Child Exclusion” for gifts of real property.
Perhaps one of the most important considerations is whether or not the benefit a pre-death transfer will outweigh the loss of the “step up in basis” for capital gains taxes.
Should you transfer a property to your child before February 16th 2021?
Under Prop 19, Californians have until February 16th of 2021 to do the following:
1. Transfer up to $1 million in property not used as a primary residence to a child while maintaining the property tax basis of the parent.
2. Transfer a primary residence of high value* to a child that the child takes as his or her primary residence, while maintaining the property tax basis of the parent.
To take advantage of the current tax exemptions, families may be considering a pre-death transfer of property prior to February 16th. Those families must exercise extreme caution here. They must strongly weigh the benefits of maintaining the parent’s property tax basis against the potential loss of the “Step Up in Basis” that kicks in when a property is transferred upon death.
What is a “Step Up in Basis?”
For a quick review, the “step up in basis” is the (often huge) federal tax break associated with selling a property that was inherited or transferred upon the death of a parent. The step up in basis rule also applies to other assets such as stocks.
For example, if a child inherits a property that his or her parent bought for $100,000, and then sells that property for $300,000, Federal tax law dictates that the child will not have to pay capital gains taxes on the difference ($200,000).
For tax purposes, the property’s old tax basis ($100,000) will be “stepped-up” to the property’s new tax basis, so that effectively the “tax basis” remains $100,000, despite the higher sales price. Note that this does not take into account improvements to the property or other adjustments to the valuation of the property’s tax basis at purchase.
If a property has appreciated in value significantly, this “step-up in basis” is a huge boon for children who inherit properties.
The key to getting the step up in basis is the transfer of the property at the death of the parent. If a parent transfers a property to a child before his or her death, there is no step up in basis should the child decide to sell the house in the near future.
If a property is transferred to a child prior to a parent’s death, that child may still get the benefit of some part of the capital gains tax exclusion if the child resides in the house prior to sale. The child’s exclusion would not be based on inheritance, but instead the IRS’s general guidelines regarding capital gains tax exclusions. If a property has been owned for many years, however, the tax benefit associated with a step up in basis will often dwarf the IRS’s “standard” capital gains tax exclusions.
This is particularly true for homes located in the SF Bay Area, where home prices have largely risen dramatically over time.
What’s the Bottom Line?
When it comes to property tax increases versus missing out on the step-up in basis, Californians who are considering taking advantage of the current property tax law prior to February should consider the following 3 factors:
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Does the child foresee selling the home at any point in the near term?
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How much has the property increased in value since purchase?
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Will the parent potentially need the home to pay for future potential costs such as long term care?
Aside from the present financial consequences of gifting a property in the next several months, I recommend consulting with an Estate Planning and Tax Professional before making any large transfers. In addition to financial consequences, large gifts to a child prior to death can result in adverse consequences. Estate litigation and loans taken out against the property by the child are just a couple examples of the potential downsides.
What is an Example of a Parent/Child who might Benefit from transferring property before Prop 19 takes effect?
Dad owns four properties and is in his early 90’s. He’s still in great mental health. Dad has significant cash on hand to pay for his expenses. He has two children, one daughter and one son. While Dad lives in his primary residence, called “the family home” in Prop 13 text, Daughter lives in one of his other properties. Daughter has limited income and has lived in the property for many years. She is happy there and has no future plans to move or sell the property. Right now, Dad has $1 million dollars that can be used toward a property tax exemption for a non-primary residence that is transferred to a child. After February 16th, he can only transfer his primary residence, with limits.
Dad has already bequeathed the property Daughter lives in to her in his Trust. His Son is in full agreement and the Trust has been structured so as to account for this gift to Daughter.
If Dad and Daughter wait until after Dad has passed away, Daughter will no longer get the Parent Child Exclusion for her property. She will now have to pay property taxes based on the current market value of the home. Because she has limited income, this could force her to sell.
In a situation such as this, Dad and Daughter should strongly consider working with an Estate Planning attorney to transfer the property now and make any necessary adjustments to Dad’s trust.
For questions about Estate Planning, Trust Administration, and Trust Litigation, contact our SF Bay Area Trust and Estate Law Firm at 925-322-1795.
*per Prop 19’s calculation for increasing the tax basis of an inherited primary residence
This article is only a general overview of the law, and is not meant to provide advice for your specific situation.