California has several rules that can have a substantial impact on your property taxes. Given the new limitations imposed by the 2017 Tax Cuts and Jobs Act on deducting state and local taxes (SALT), these rules are now more important than ever. Often, when real property is transferred, it is classified as a “change in ownership.” When a property experiences a “change in ownership” it is potentially subject to reassessment at its current fair market value unless an exclusion applies. There are several exclusions provided, such as certain exclusions for transfers between parents and children. However, the purpose of this article is to identify the basic rules involved when property is owned by a legal entity (e.g. partnerships, limited liability companies and corporations). In some instances, legal entities have owned real property for multiple decades. And, depending upon historical transfers of the underlying interests in these entities, such real properties may have been unknowingly subjected to reassessment.
Under Prop 13, 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” (i.e. fair market value) of the property when it undergoes a change in ownership (or undergoes new construction) after 1975. That value is referred to as the “base year value” (sometimes also referred to as the “assessed 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. Accordingly, if a property has not had a change in ownership (or undergone new construction) since 1975, it has a very low base year value. This is why it’s not uncommon for many properties throughout California to have a very low base year value, but have a fair market value that is hundreds of thousands, or even millions, of dollars above the base year value. Absent a change in ownership, Prop 13 restricts an increase in the base year value to the lesser of the California Consumer Price Index (“CCPI”) or two percent.
When analyzing potential reassessments for legal entities, there are typically one of two basic rules that apply: (1) change in control (under Revenue and Taxation Code Section 64(c)(1)); or (2) change in ownership (under Revenue and Taxation Code Section 64(d)).
Change in Control. This rule applies when a legal entity is the purchaser of the property. This is different from Change in Ownership because in this situation the property is not transferred by individuals to the entity, rather the entity is the original purchaser. The analysis under this rule employs the “ultimate control” test, but is more accurately described as the “change of majority ownership” rule. It states that when a single person or entity obtains (i) direct or indirect ownership or control of more than 50% of a corporation’s voting stock, or (ii) direct or indirect ownership of more than 50% of both the capital and profits interests in a partnership or limited liability company, there is a change in ownership of all real property owned by that entity (e.g. all real property owned by the entity is reassessed to its current fair market value).
A change in control does not occur unless a single person obtains more than 50% of the voting stock or the capital and profits interests, and a husband and wife’s interests are not attributed to one another. Therefore, a husband and a wife each obtaining 50% of an entity does not result in a change in control. However, some pitfalls to be aware of would be either inter vivos or post-death transfers of entity interests. In this same example, if Husband dies and his interest is transferred to Wife, then a change in control will occur.
Change in Ownership. Before discussing change in ownership issues, the proportional ownership interest transfer rule under Revenue and Taxation Code Section 62(a)(2) needs to be analyzed. As discussed above, a change in control is analyzed when the entity directly purchases the property. A change in ownership is analyzed when an individual (or entity) transfers real property to an entity. As a general rule, the transfer of any interest in real property to or from a legal entity is a change in ownership and results in reassessment of the property transferred. An exclusion from change in ownership applies for proportional ownership interest transfers of real property between a legal entity and an individual. Thus, if property is transferred between legal entities or between an individual or individuals and a legal entity, and the proportional ownership interests of the transferors and transferees (whether represented by voting stock or capital and profits interests in a partnership or limited liability company) remain the same, then the transfer is excluded from change in ownership and potential reassessment (absent an exclusion). For example, if A and B own real property as tenants in common, each as to 50% interests, and then transfer the property to AB LLC, the property is excluded from change in ownership so long as A and B each own 50% interests in AB LLC.
Assuming the transfer to the entity meets the proportionality requirements, the persons holding the interests in the entity immediately after the transfer are the “original co-owners.” Thereafter, whenever cumulatively more than 50% of the total interests in the entity are transferred by any of the original co-owners, there is a change in ownership of the property that was previously transferred to the entity. Any such transfers are generally referred to as being counted and cumulated. There are some exceptions applied to certain transfers that allow for such transfers not to be “counted and cumulated,” including the following: (i) interspousal and registered domestic partner transfers, (ii) transfers to certain trusts and (iii) proportional transfers (where the ultimate ownership of the property remains the same). It is clear that transfers to children and grandchildren must be counted and cumulated, and the parent-child and grandparent-grandchild exclusions do not apply when transferring these interests.
An interest that has been transferred by an original co-owner and counted toward the over-50% threshold is never counted again. For example, if A is an original co-owner and transfers a 10% interest to B, and then later on B transfers that 10% interest to C, it is counted and cumulated as a transfer of a 10% interest, not 20%. Original co-owner status ends when the property is reassessed or when the property is transferred out of the entity back to the owners as tenants in common.
Even the most basic rules involving transfers of real property in and out of entities, as well as transfers of interests in entities that own real property, can be complicated. If you have questions about these rules, or any other property tax related questions, please call any of the attorneys in Fenton & Keller’s estate planning and business transactions group.