By Jacob Passy
I own a house in Palo Alto, Calif., that I bought for less than $30,000 and is now worth almost $3 million. There are two things I would like help with:
How to retain my current tax rate under Proposition 13.
How to keep the step-up basis to avoid massive capital-gains taxes.
I am 80 years old and have three children. Will establishing an LLC or revocable living trust help? I still wish to retain the power to do as I wish with the property in case of need. It has a $400,000 mortgage, and it currently has a tenant with a one-year lease. Thank you for helping me do what I need, since December is the deadline for transferring deeds to relatives if I wish to retain the original tax basis.
Preparing in Palo Alto
‘The Big Move’ is a MarketWatch column looking at the ins and outs of real estate, from navigating the search for a new home to applying for a mortgage.
Do you have a question about buying or selling a home? Do you want to know where your next move should be? Email Jacob Passy at TheBigMove@marketwatch.com.
It’s never too late or too soon to strategize the best way to leave a sizable inheritance to your loved ones. And your dilemma, in particular, illustrates the challenges many longtime homeowners face when it comes to leaving real estate to their heirs.
You’ve benefited from longstanding tax arrangements that have made it feasible to maintain ownership of a home as expensive as yours in a pricier coastal real-estate market. And it seems clear from your letter that your children wouldn’t be able to afford the property taxes that would come with such a property if they were to buy it themselves today.
Before I begin to answer your questions, I want to commend you on remaining clear-eyed about what your children will do with your home upon your passing. Too often parents assume that their children or grandchildren will want to inherit the family home and live in it. The reality is, especially if your children are grown, they likely have homes of their own and no need to take another on, even as an investment property. If the past two, pandemic-marred years have taught us anything, it’s that it’s not always easy to be a landlord.
So I’m glad that you’re considering all possibilities — what the property-tax picture would be if your children did keep your longtime home, and what would happen in terms of capital-gains taxes should they sell it after you pass.
Property taxes just got more complicated in California
Now, let’s address your first question. For those who live outside of California, a quick primer: Proposition 13 is a state constitutional amendment that limited increases to the property taxes on homes throughout the state. Notably, a property could only be reappraised for tax purposes when a change in ownership occurred, when new construction was completed or if the market value declined.
But last year, another amendment that was approved by California voters, Proposition 19, changed key components to the taxation policy. While it allowed older or disabled homeowners or people displaced by natural disasters to transfer their existing tax-assessed value to a new home even if it was more expensive, it limited the ability to transfer such tax benefits among family members. Notably, in the past, a child could inherit a parent’s tax-assessed value along with a home, but it is not so straightforward now.
The good news is that converting your home into a rental property won’t necessitate a reappraisal of the home for property tax purposes. However, it could make a difference if and when your children inherit the home.
“The Prop. 19 rules say that you can pass a principal residence to your children, so long as it was the primary residence of the parents before, and it’s the primary residence of the child thereafter,” said Yin Ho, a California-based partner at international law firm Withers who specializes in real-estate law. Because the home is now a rental property, if you were to pass away now, your children wouldn’t be entitled to this benefit.
Ho noted, though, that if you were to change your mind in the future and resume living in the home yourself, you could preserve that benefit. However, your children would need to plan to live in the home after you died — if they didn’t, again, they would not be eligible.
The deadline to transfer property to one’s children proactively to retain the property-tax assessed value was back in February, so you’ve missed that window of opportunity. But such a transfer wouldn’t have been advantageous from a capital-gains-tax perspective, because it would have nullified your kids’ ability to receive the step-up in basis.
Similarly, if the property had been owned by an LLC all along, it might have continued to qualify for this tax break, Ho said, but because it wasn’t that strategy won’t help you here.
Rental homes can still receive a step-up in basis when inherited
When it comes to the step-up in basis, you’re fine there. Rental homes qualify for that the same as primary residences, Ho said. So long as your children are able to sell the home quickly when you die, they should face little in the way of capital-gains taxes. At one point some Democratic lawmakers were considering reducing or eliminating this tax benefit as part of the Build Back Better social-spending package, but those proposals went nowhere.
Nevertheless, there are reasons you may want to consider creating an LLC or trust to own the home. An LLC could offer legal and financial protection should problems ever arise with a tenant in the future. And a well-designed trust can keep property out of the probate process, allowing it to pass to kids more quickly after a parent’s death. That could help them sell the home more quickly and avoid a larger tax bill.
As I suggest to many readers who write in to The Big Move, an accountant or lawyer well-versed in estates and property ownership will prove extremely vital in helping you to determine the best path forward to ensure your children get the most out of your home. I hope this information will be a useful starting point for you as you explore what options are still at your disposal. Best of luck.
By emailing your questions, you agree to having them published anonymously on MarketWatch. <STRONG>By submitting your story to Dow Jones & Company, the publisher of MarketWatch, you understand and agree that we may use your story, or versions of it, in all media and platforms, including via third parties</STRONG> .