Can You Avoid California Real Property Tax “Changes-in-Ownership” (And Keep Taxes Down) When You Draft Discretionary Accumulation Trusts? Yes You Can!

Can You Avoid California Real Property Tax “Changes-in-Ownership” (And Keep Taxes Down) When You Draft Discretionary Accumulation Trusts? Yes You Can!

Ever since Californians passed Proposition 13 in 1978, county tax assessors generally can only raise the assessed value of California real property for property tax purposes by no more than two percent per year over the prior year's value.  But the assessed value can later be increased up to the current fair market value of the property for any year in which there is a "change in ownership."  This article suggests ways to draft trusts in which California real property may be held in order to avoid inadvertent "changes in ownership."

Relevant Property Tax LawSection 60 of the California Revenue and Taxation Code ("R&TC") implements Proposition 13 by providing that "[a] 'change in ownership' means a transfer of a present interest in real property, including the beneficial use thereof, the value of which is substantially equal to the value of the fee interest."  Sections 61 and 62 of the R&TC provide several examples of transfers that are or are not considered "changes in ownership."  R&TC Sections 63 and 63.1 provide that certain interspousal transfers and parent-child and grandparent-grandchild transfers, respectively, are excluded from a change in ownership.  The constitutional and statutory provisions relating to changes in ownership have been further interpreted and applied to specific transactions by regulations promulgated, and letters to assessors written, by the State Board of Equalization ("SBOE") and by court decisions.

Various sections of the R&TC, regulations and letters to assessors by the SBOE, and decisions of the California courts generally provide that a transfer of real property into an irrevocable trust, or the vesting of the right to possession or enjoyment of a remainder or reversionary interest following the termination of a life estate or other similar precedent property interest, is a change in ownership for property tax purposes, unless the property is received by, or a life estate or other similar precedent property interest therein is created in favor of, the settlor or his or her spouse, registered domestic partner, child, or grandchild (subject to certain limitations and conditions); and the vesting of the right to possession or enjoyment of a remainder interest following the termination of a life estate or other similar precedent property interest generally is deemed to be a transfer at that time by the settlor of the trust to the remainder beneficiary(s).  Therefore, the application of the charge-in-ownership rules and the exceptions therefrom to transfers of California real property to or within various trusts should be taken into consideration in drafting trust instruments.

The Problem.  Trust provisions have long been designed to minimize adverse income as well as gratuitous transfer (i.e., estate, gift and generation-skipping transfer ("GST")) tax consequences.  However, those provisions do not necessarily minimize adverse property tax consequences, and in fact may exacerbate them.

For example, typical discretionary accumulation provisions in a bypass (or credit-shelter) trust for the benefit of the settlor's surviving spouse, parents, issue, and/or others, a "family pot" trust for the benefit of the settlor's parents, issue, and/or others, and GST-exempt "dynasty-type" trusts for the benefit of the settlor's issue, that are designed to save income and gratuitous transfer taxes, generally will not qualify for the interspousal, parent-child, or grandparent-grandchild exclusion from a change in ownership for property tax purposes where California real property is included in the trust estate.

The Solutions.  In order to avoid this problem, estate planners should consider including the following provisions that are designed to avoid a change in ownership for California property tax purposes in instruments creating those types of discretionary accumulation trusts:

1.                  A discretionary accumulation bypass (or credit-shelter) trust instrument might provide that as long as the trust holds an interest in a parcel of real property situated in California that had an assessed value of less than its fair market value as determined for property tax purposes as of the time it was transferred to the trust (hereinafter "Appreciated California Real Property"), the trustee shall pay to the surviving spouse the entire net income with respect to that interest; and it might be prudent to also provide that the trustee may not pay to any other beneficiary any of the principal with respect to that interest. 

2.                  A discretionary accumulation "family pot" trust instrument might provide that as long as the trust holds an interest in Appreciated California Real Property, the trustee shall pay from time to time to one or more of the settlor's children [and/or parents] who are living the entire net income with respect to that interest; and it might be prudent to also provide that the trustee may not pay to any other beneficiary any of the principal with respect to that interest. 

3.                  A discretionary accumulation "dynasty-type" trust instrument with respect to a trust for the benefit of a child of the settlor and the child's issue might provide that as long as the trust holds an interest in Appreciated California Real Property, the trustee shall pay to the child the entire net income with respect to that interest; and it might be prudent to also provide that the trustee may not pay to any other beneficiary any of the principal with respect to that interest.

4.                  If the primary beneficiary of a dynasty-type trust is a grandchild of the settlor, the grandparent-grandchild exclusion from a change in ownership will not be available if either parent of that grandchild, who qualifies as a child of the settlor, is living.  Therefore, the instrument for such a trust might provide that as long as a parent of that grandchild, who qualifies as a child of the settlor, is living, the trustee shall instead pay to such parent the entire net income with respect to any interest in Appreciated California Real Property; and it might be prudent to also provide that the trustee may not pay to any other beneficiary any of the principal with respect to that interest. 

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Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients.  If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6296 or PMcCabe@mofo.com.

 

© Copyright 2010 Morrison & Foerster LLP. This article is published with the permission of Morrison & Foerster LLP.  Further duplication without the permission of Morrison & Foerster LLP is prohibited.  All rights reserved.  The views expressed in this article are those of the author only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients. The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.