For decades, to minimize estate tax, Moms and Dads transferred their California real property into a Family Limited Partnership (“FLP”) or Family LLC (“FLLC”), and then gave away interests in the FLP or FLLC to their kids. The property tax time bomb is that it is inevitable that there will be a property tax reassessment of the property that Mom and Dad put into the FLP or FLLC no later than the date both Mom and Dad have died.
After a property is contributed to a FLP or FLLC, that property will be reassessed when the original partners or LLC members have transferred, cumulatively from the beginning, more than 50% of their FLP or FLLC interests. This rule, called the “original co-owners rule,” sets the timer on the property tax time bomb and causes a change in ownership and a full reassessment of the property Mom and Dad contributed when Mom and Dad have transferred more than 50% of their FLP and FLLC interests.
If the property has been in the FLP or FLLC for decades, the property tax bill might increase by 5 or 10 or even 20 times over the current tax bill.
But there is a solution. First, find out if your FLP or FLLC is ticking. If it is, then, second, terminate the FLP or FLLC and distribute the real property to the partners or members, as tenants in common. This distribution must be in the exact proportion of their FLP or FLLC interests. If it’s done carefully and correctly, then this distribution will not cause a reassessment. This isn’t for amateurs, so get professional help.
After that, Mom and/or Dad can make transfers of TIC interests to the kids during their lifetime or at their death without a change in ownership by using the $1,000,000 per person exemption for transfers of assessed value (not fair market value) from parents to their children. After making those gifts, it might be possible to put the property back into an FLP or FLLC, if that’s desirable.
Since Mom and Dad can each give during their lives or at their death $11,580,000 of property without gift or estate tax, much estate planning now focuses on maximizing the income tax basis of property. Getting rid of the FLP or FLLC will help maximize the income tax basis of the real property.
With property values and interest rates down due to Covid-19, now is a great time to make transfers to reduce the size of a taxable estate. In a taxable estate, the property tax savings must be weighed against a possible increase in the taxable gross estate.
The property tax time bomb can be avoided in the first place if the FLP or FLLC buys property in its own name, rather than the individuals buying the property as tenants in common or joint tenants and then contributing it to an FLP or FLLC.
If passed by the voters, a Proposition on the November 2020 ballot will repeal the need for this planning for commercial real property by reassessing to fair market value commercial and industrial real property every three years. But the need will remain for residential rental property.
California Revenue and Taxation Code section 62(a)(2), 64(d) and 63.1.
California Property Tax Rule 462.180(d)(2).