The following examples will illustrate how Proposition 13 applies:
Example 1: Your mother and father transferred real property to a revocable living trust. The trust provides that on the death of the first spouse, the trust property will be allocated to a survivor's trust, a marital trust with QTIP provisions, and a credit (bypass) trust. The bypass trust income is to be distributed to the surviving spouse for life, remainder to you and your brother. [Note: The bypass trust is designed to take full advantage of the deceased spouse's Unified Gift and Estate Tax Credit ("credit"), currently worth $600,000, and is usually funded with the first $600,000 (or the maximum credit amount, if less) of the deceased spouse's estate.]
Will a CIO of the real property in the bypass trust occur --
Answer: A CIO would not occur until your father dies (second death), when you and your brother become owners of the property. See Empire Properties v. County of Los Angeles, 44 Cal. App. 4th 781 (1996); Title 18, §462.160(b)(2) of the California Code of Regulations. Interspousal transfers are excluded from the definition of CIO under R&T Code §63, including "[t]ransfers to a trustee for the beneficial use of a spouse, or the surviving spouse of a deceased transferor, or by a trustee of such a trust to the spouse of the trustor."
Note: if the bypass trust provisions gave the trustee power to distribute income to the surviving spouse, along with a discretionary "sprinkling" power to distribute income to the children, there could be a CIO. See Hartog and Schenone, Tripping Over the Gopher Holes: An Estate Planner's Guide to Proposition 13 (Part I), 2 Cal. Tr. & Est. Q., Winter 1996, at p. 6-7; 10.
Example 2: In Example 1, you must claim the parent/child exemption --
Answer: You must file an exemption within three years after your
father dies, or within six months after receipt of a notice of a "supplemental"
or "escape" assessment arising from the transfer of the real property, whichever
occurs first. See Empire Properties, 44 Cal App. 4th at 781; Probate
Code §7000 and §7001; California Academy of Science v. County of Fresno, 192 CA3d
1436 (1987); R&T Code §63.1(e)(1) and (2). A supplemental assessment, issued by the
county assessor when a CIO is detected, reflects the new tax liability resulting from the
CIO. An escape assessment notifies the taxpayer of taxes due for prior years, when an
unreported CIO occurred.
Example 3: Assume you leave a parcel of real property to your three children when you die. After your death, but before distribution of your estate, child 1 transfers his right to receive an interest to child 2. May child 2 and child 3 claim the exclusion from reassessment for the entire property?
Answer: Title to the real estate will transfer to your children
on your date of death, subject to the administration of the estate (generally, payment of
creditors' claims, estate expenses and taxes). Prob. Code §7000 and §7001. See California
Academy of Sciences, 192 CA3rd at 1436. Thus, the transfer from child 1 might trigger
a CIO as to one-third of the real property. Hartog & Schenone, (Part I), supra,
at p. 8-9. Arguably, a qualified disclaimer of the interest of child 1 would prevent this
result.
Note: If property is subject to a revocable trust, a non pro rata distribution to a child could require partial reassessment if the distribution from the trustee exceeds the share the child is entitled to under the terms of the trust. See Letter to Assessor issued by the State Board of Equalization (SBE) on January 23, 1991; Hartog and Schenone, (Part I), supra, at p. 9.
Example 4: Assume that you transfer to your child a 50% undivided
interest in a parcel of real property, with a full cash value of $500,000. You and your
child then each transfer your interests in the property to a family limited partnership in
which your child has a 50% limited partnership interest, and you have a 50% general
partnership interest. Does a CIO occur?
Answer: No. The transfer of an undivided interest in real
property to your child is exempt under R&T Code §63.1; the second step is excluded
from a CIO under R&T Code §62(a)(2) because you and your child owned the same
proportionate interests before and after the transfer.
Example 5: Now assume that in the above example, you transfer
your property interest directly to the family limited partnership in exchange for the same
partnership interests. Has a CIO occurred?
Answer: Yes, although you wind up with the same result as in Example 4 above, you have caused a CIO. This was not a transfer to a child, but to a partnership; thus, the parent/child exclusion does not apply to the transfer. Penner v. County of Santa Barbara (1995) 37 CA4th 1672, 44 CR2d 606 (1995). The transfer of any interest in real property between a legal entity and an individual is a CIO pursuant to R&T Code 61(j).
The "step transaction doctrine" (defined in example 10) will often permit you to ignore the intermediate steps and focus on the end result; however, the courts have stated that this doctrine will not apply to invent steps that never occurred. Id. A transfer first to the children and then to the partnership would not be a CIO (even if a greater than 50% interest were transferred), as long as the partnership interests are proportionate to each owner's property interests prior to the transfer. R&T Code §62(a)(2).
In Penner, the transfer to a partnership resulted in a
supplemental assessment which increased the property's value from $337,276 to $2.3
million. In an unfortunate triumph of form over substance, Penner illustrates the
harsh consequences that can occur under Proposition 13 for an otherwise harmless estate
planning oversight.
Example 6: If you substitute your spouse for your child in
Example 4, would the property be subject to reappraisal for tax purposes?
Answer: No; the interspousal exclusion of R&T Code §63
applies to this transfer.
Example 7: In Example 5, if you substitute your spouse for your
child, does the transfer of the property first to a family limited partnership (or other
entity) and then to your spouse invalidate the spousal exclusion?
Answer: R&T Code §63 provides a broad exclusion from CIO of all transfers between spouses. Nonetheless, the same rationale as applied with the parent/child exclusion in Penner could apply to the interspousal exclusion under these circumstances. This is not a transfer between spouses, but a transfer between an individual and a partnership, which is a CIO under R&T Code §61(j).
After the property is contributed to the partnership, unlimited
transfers of partnership interests to a spouse would likely be excluded from a CIO by most
assessors pursuant to Property Tax Rule 462.180(d)(2).
Example 8: Assume that you and your business partner have a 51%
and 49% interest, respectively, in a partnership. The partnership purchased real property
several years ago, when a reappraisal for property tax purposes occurred. If you purchase
your partner's 49% interest in the partnership, will another reassessment be required?
Answer: No. Under a recent amendment to R&T Code §64(c)
resulting in new section 64(c)(2), when a majority interest in a partnership obtains all
remaining ownership interest (majority owner becomes sole owner), no CIO occurs. [This
statute overrules the result in Zapara v. Orange County, 26 CA 4th 464, 31 CR2d 555
(1994).] This rule, however, is limited to partnerships.
Example 9: Assume that you own an apartment building, and your
business associate owns a warehouse of equal value. You both transfer your property to a
corporation in exchange for 50% of the stock each. Is this a CIO?
Answer: Yes. This results in a 100% CIO of both the apartment building and the warehouse. The interest in the property transferred changes after transfer [R&T Code §61(j)]. You both started with a 100% interest in your own parcel, and ended up with 50% of stock in the corporation. If the corporation later distributes the parcels back to you and your associate, there would be a further change in ownership of 100% of each parcel. 18 Cal. Code Reg. §462 (j)(2)(B), Ex. (III), (iv); see Kern v. County of Imperial, 226 Cal. App. 3d 391, 276 Cal. Rptr. 525 (1990).
Note: the transfer of real property from a general partnership to individual general partners is likewise a change in ownership within the meaning of proposition 13. IRC §61(j); Munkdale v. Giannini (App 1 Dist. 1995) 41 Cal. Rptr. 2d 805, 35 Cal. App. 4th 1104.
Example 10: Assume that partner A and partner B each have a 50%
interest in a partnership that owns an office complex. You purchased a 50% partnership
interest from partner A. You and partner B liquidate the partnership and take equal
interests in the office complex as 50% tenants in common each. Partner B then sells his
50% interest in the office complex to you. Did a CIO occur? If so, when did the CIO occur
and what percentage of the property is deemed to have undergone a CIO?
Answer: Analyzing each step separately under the rules discussed above, a reappraisal of only 50% would occur when partner B sold you his or her 50% interest in the real property (the last step), even though you started out with no interest in the property and ended up with all of the property. However, in a case with analogous facts, the court applied the "step transaction doctrine" to collapse the three steps into a single transaction, finding that, in substance, a 100% CIO occurred. Shuwa Investments Corp. v. County of Los Angeles, 1 Cal. App.4th 1635 (1991).
The step transaction doctrine is an expression of a judicial principle that, in applying the tax laws, the substance of a transaction controls over the form. The Shuwa court concluded that the intermediate steps were intended at the outset to reach the ultimate result, and there was not a sufficiently substantial independent purpose for the transaction (other than to avoid a 100% property tax reassessment, when in substance, a 100% CIO occurred).
Note: The Penner court took the opposite approach and prevented the taxpayer from using the step-transaction doctrine; in both cases, the courts ruled in favor of the government and against the taxpayer.
Example 11: If you own a 60% interest in the limited partnership,
and transfer it to a revocable trust, is there a CIO?
Answer: No. R&T Code §62(d)(2) excludes transfers of
interests in entities to trusts where (1) the transferor retains a present interest in the
trust, or (2) the trust is revocable.
Example 12: Assume two unrelated individuals, A and B, purchase
property together and hold title as joint tenants. A dies. Does a CIO occur?
Answer: The general rule of R&T Code §65 is that the creation, transfer or termination of any joint tenancy is a CIO, resulting in the reappraisal of the portion transferred. The exemptions of R&T Code §62 (change in method of holding title, but not identity and proportion of title) and R&T Code §63 (husband/wife and parent/child) do not apply. Nor do the exceptions to the general rule provided in R&T Code §65(b)(c) and (d) apply to this situation, because A and B are not considered "original transferors," since they did not have an interest in the property before the creation of the joint tenancy.
Although the definition of "original transferors" in the statute is unclear, the requirement of an interest in the property prior to the creation of the joint tenancy can be derived from R&T Code §65(c), which informs us that the property held by the original transferor "prior to the creation of the joint tenancy" is reappraised when the joint tenancy terminates, unless the interest vests, wholly or partially, in any remaining original transferor. Thus, because A and B did not have an interest in the property prior to the creation of the joint tenancy, the general rule applies. When one of the joint tenants dies, a 50% reappraisal of the property occurs, an unfair result for unmarried individuals who desire to purchase property jointly.
A and B could not avoid this result by taking title initially as tenants in common, then transferring title to themselves as joint tenants, because R&T Code §61(f) expressly includes as a CIO "[t]he creation, transfer, or termination of any tenancy-in-common interest, except as provided in subdivision (a) of Section 62 and in Section 63."
Example 13: Assume that you separately own a parcel of real
property, and put it in joint tenancy with your partner. Your partner later quitclaims his
or her interest back to you. Is this a CIO?
Answer: No. Since you were the original owner, there is not a
CIO.
Before transferring real property, or interests within entities that own
real property, review the property tax reassessment rules and exceptions. If the property
is held in joint tenancy, understand the joint tenancy rules or seek a preliminary
determination from the tax assessor of the property tax consequences of the transfer. When
using a family partnership or other entity in estate planning, transfer interests to your
family members first, then have them transfer their property interest into the entity. In
multi-step transactions, make sure you have substantial independent business purposes for
the structure of the transaction. Technical compliance with the reassessment rules will
not necessarily preclude a court from finding a CIO in substance. Following these
precautions should prevent unintentional property tax reassessment when you transfer real
property.
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