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The Tax Prophet Newsletter   Issue # 53 September, 2007

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In This Issue:
Introduction
Example
Pro-Rata Share
Non-Prorata
Encumbrances
Conclusion


Trust Transfers and Proposition 13 - Part Two

Introduction

As I discussed in last month's newsletter, California's Proposition 13 permits certain transfers between parents and children or grandparents to grandchildren ("parental transfers") without incurring a property tax reappraisal.

Parental transfers involving a trust or a will may also qualify for the exclusion. What happens when the trust estate is distributable to one or more beneficiaries?

Example

Suppose the last surviving parent dies and leaves an estate, in trust, worth $2.0 million equally to four children. The estate consists of a principal residence worth $500,000 and cash, stocks and bonds worth $1.5 million.

Each child is to receive $500,000 from the trust. Child One, however, wants the residence distributed to him, and the trustee and beneficiaries all agree.


Pro-rata share

In the past, some county assessors treated the trust distributions on a "share and share alike" basis, meaning that each beneficiary received $125,000 worth of the residence.

A distribution of the residence one beneficiary would cause a change in ownership (a property tax reappraisal) as to $375,000.


Non-prorata share

California's State Board of Equalization (SBE) has clarified the treatment of this distribution. If the trust agreement or state law allows for a non-prorata distribution of assets, then the trustee could distribute the residence to Child One as his full $500,000 share of the trust estate. Consequently, the parental exclusion would apply to the residence.


Encumbrances

When there is a encumbrance (mortgage or deed of trust) secured by the property, the property is valued at its net equity (fair market value less the encumbrance). In our example, assume the residence was worth $800,000 and there was a $300,000 encumbrance.

Child One would receive a $500,000 distribution, the net equity in the property, and there would be no change in ownership.

Assume the property was worth $800,000 and there was no encumbrance. The estate increases to $2.3 million and Child One's share is now $575,000.

If the trust borrowed $225,000 against the property, then distributed the property to Child One (the net equity is $575,000), who then either assumed the existing encumbrance or refinanced the property in his own name, he would receive the full benefit of the parental exclusion.

The $225,000 in loan proceeds would be distributed equally to the other three beneficiaries.

Note: SBE recently ruled that Child One cannot encumber the property by issuing a promissory note to the trust. The encumbrance must involve a third party lender or a beneficiary who is not receiving the property.


Conclusion

The parent to child exclusion applies to non-prorata distributions of real property. By having the trust encumber the property to reduce its value, the full exclusion may be utilized.

The trustee, however, should borrow the funds from a source other than the beneficiary who is receiving the property to avoid a later challenge by SBE.



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All contents copyright 2007 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet is a registered trademark of Robert L. Sommers.