Navigating the Labyrinth: Proposition 19 and Inherited Property in Trusts

Proposition 19, officially known as the “Home Protection for Seniors, Severely Disabled, Families, and Victims of Wildfire or Natural Disasters Act,” dramatically reshaped the landscape of property tax law in California. Its impact on inherited property, particularly when held within a trust, is profound and often misunderstood. In short, Prop 19 severely limits the ability to transfer a low property tax base to heirs, even those inheriting through a trust, unless specific conditions are met, primarily involving the property becoming the heir’s principal residence within a defined timeframe.

This change has created considerable complexity for estate planning, demanding a careful review of existing trust structures and strategies to mitigate potential tax consequences. Let’s delve into the details.

Understanding the Pre-Prop 19 Landscape: Propositions 58 and 13

Before Proposition 19, California enjoyed relative clarity under Propositions 58 and 13. Proposition 13 established the 1% property tax rate based on the assessed value at the time of purchase, with limited annual increases. Proposition 58 allowed parents to transfer their primary residence to their children, and up to $1 million in other real property, without triggering reassessment for property tax purposes. This meant that a child inheriting property, whether directly or through a trust, could often retain the parent’s low property tax basis.

This arrangement facilitated generational wealth transfer and provided a significant tax benefit for families. However, Proposition 19 fundamentally altered this picture.

The Core Changes Introduced by Proposition 19

Prop 19, effective February 16, 2021, substantially curtailed the property tax benefits previously available to heirs. The key changes are:

• Elimination of Most Parent-to-Child Exclusions: Prop 19 significantly narrowed the Proposition 58 exclusion. Now, the only transfers between parents and children that may qualify for a low property tax basis are when the inherited property becomes the child’s principal residence within one year of the transfer date.
• Principal Residence Requirement: Even when the inherited property is the principal residence of the heir, there’s a limitation. The assessed value can only be adjusted upward if the fair market value at the time of transfer exceeds the assessed value by more than a specific amount, known as the “Proposition 19 exclusion amount.” This is calculated as the assessed value plus $1 million.
• Elimination of Grandparent-to-Grandchild Exclusion (in most cases): The ability to transfer the property tax base from grandparents to grandchildren where the parents are deceased was generally eliminated.
• No Exclusion for Other Real Property: The $1 million exclusion for other real property was also eliminated, meaning any non-primary residence property will be reassessed at its current market value upon transfer.

How Proposition 19 Impacts Trusts

The effect of Prop 19 on trusts holding real property is significant. The crucial question becomes: Does the beneficiary inheriting the property through the trust intend to use it as their principal residence?

• Property Becomes Principal Residence: If the heir intends to live in the inherited property as their principal residence and meets the one-year deadline, they might be eligible to maintain the parent’s low property tax basis, subject to the $1 million exclusion amount mentioned above. The trust must be structured carefully to ensure the transfer qualifies under Prop 19.
• Property is Not Principal Residence: If the inherited property is not going to be the heir’s principal residence, the property will be reassessed to its current fair market value, potentially resulting in a substantial increase in property taxes. This applies regardless of whether the property is held directly or within a trust.
• Trust Structures and Control: The type of trust also matters. Revocable trusts, commonly used in estate planning, are generally considered “pass-through” entities for property tax purposes. This means the transfer from the parent to the trust, and then from the trust to the child, is treated as a direct transfer from parent to child, subject to Prop 19 rules. Irrevocable trusts, however, can introduce complexities. Depending on the trust terms and the level of control the beneficiary has over the trust assets, the transfer might be considered a change of ownership, even if the property becomes the beneficiary’s principal residence. This area requires expert legal advice.

Estate Planning Strategies in the Age of Proposition 19

Given the constraints imposed by Prop 19, estate planning must adapt. Here are some potential strategies:

• Review and Revise Existing Trusts: It is crucial to review existing trust documents to ensure they align with current goals and consider the potential property tax implications of Prop 19.
• Consider Lifetime Gifts: While subject to gift tax rules, making lifetime gifts of property before death might offer some benefits, particularly if the property’s value is expected to appreciate significantly.
• Strategic Use of LLCs: Transferring property into a Limited Liability Company (LLC) and then gifting or bequeathing LLC membership interests can sometimes offer planning opportunities. However, these strategies are complex and require careful legal and tax analysis to avoid unintended consequences.
• Focus on the Principal Residence: If maintaining the low property tax basis is paramount, ensure the property is structured to qualify as the heir’s principal residence, and that they meet the one-year occupancy requirement.
• Purchase Strategies: Exploring options like purchasing the property from the estate or trust, rather than inheriting it, can sometimes trigger different tax consequences.

The Importance of Professional Advice

Proposition 19 has created a minefield of complexities regarding inherited property. It is crucial to consult with an experienced estate planning attorney and a qualified tax advisor to navigate these rules effectively and develop a strategy that aligns with your individual circumstances and goals. Generic advice is unlikely to suffice; a tailored approach is essential.

Frequently Asked Questions (FAQs) about Prop 19 and Trusts

FAQ 1: What qualifies as a “principal residence” under Prop 19?

The principal residence is the dwelling where a person resides for the majority of the year. Factors considered include voter registration, driver’s license address, and bank statements. It must be the individual’s true, fixed, and permanent home and principal establishment.

FAQ 2: What happens if I inherit property in a trust, but don’t live in it right away?

You generally have one year from the date of transfer (often the date of death) to establish the property as your principal residence. Failure to do so will likely trigger reassessment to the current market value.

FAQ 3: Does Prop 19 apply to out-of-state property inherited from a California resident?

No. Proposition 19 applies only to real property located in California.

FAQ 4: Can I still transfer property to my spouse without reassessment?

Yes, transfers between spouses are generally exempt from reassessment, even after Prop 19.

FAQ 5: If I inherit a partial interest in a property held in a trust, does Prop 19 apply?

Yes, Prop 19 applies to the portion of the property you inherit. If you intend to make it your principal residence, the rules apply to your share of the property.

FAQ 6: How is the “Proposition 19 exclusion amount” calculated?

The exclusion amount is calculated as the property’s assessed value plus $1 million. If the fair market value at the time of transfer exceeds this amount, the property will be reassessed, but only to the extent it exceeds the exclusion amount.

FAQ 7: Does Prop 19 affect commercial properties held in a trust?

Yes, Prop 19 eliminates the parent-to-child exclusion for commercial properties. Any transfer of commercial property will trigger reassessment to the current market value.

FAQ 8: Can I avoid Prop 19 by disclaiming my inheritance?

Disclaiming an inheritance means legally refusing to accept it. While this might avoid immediate property tax consequences for you, it doesn’t eliminate the tax implications for whoever inherits the property next.

FAQ 9: What are the reporting requirements for claiming the Prop 19 exclusion?

You must file specific forms with the county assessor’s office to claim the exclusion. These forms require detailed information about the transfer and your intent to use the property as your principal residence. Consult with a professional to ensure proper filing.

FAQ 10: Can I gift property to my children before my death to avoid Prop 19?

Yes, gifting is an option, but it’s essential to consider gift tax implications and potential loss of control over the property. Consult with an attorney and tax advisor to weigh the pros and cons.

FAQ 11: If I inherit property from a trust and then sell it shortly after, will I be reassessed?

If you didn’t establish the property as your principal residence, it will be reassessed upon transfer to you from the trust. Selling it shortly after won’t change that fact. You’ll be subject to capital gains taxes on the sale.

FAQ 12: How does Prop 19 affect stepchildren inheriting property through a trust?

Prop 19’s parent-child exclusion applies to stepchildren only if the stepparent had a relationship with the stepchild while the child was a minor.