INTRA FAMILY SALE AND/OR INTRA FAMILY GIFTING OF REAL ESTATE IN CALIFORNIA
(Propositions 58, 193 and 13)
California law – Proposition 58, Proposition 193 and Proposition 13 – allow a parent or grandparent to transfer their current tax-basis to their children or grandchildren. The benefits can apply to a gift, sale or hybrid of the two.
More specifically, Proposition 58 and Proposition 193 allow a parent or grandparent to gift or sell their real property during their lifetime, or gift their property at death, to their child or grandchild, and concurrently transfer their Proposition 13 tax basis, and other Proposition 13 benefits, along with the property, thus saving the child or grandchild potentially thousands of dollars per year for as long as they own the property.
PROPERTY TAX SAVINGS ARE SIGNIFICANT
Due to the tremendous benefits of Proposition 13, many long term owners continue to pay property taxes based upon their original purchase price (or price as determined when the proposition was enacted), with annual increases not to exceed two percent, regardless of current value. This can be especially beneficial in areas such as Newport Beach, Laguna Beach, Costa Mesa, Orange County and other coastal communities that have seen incredible growth in property values.
For example, assume a parent’s home in Newport Beach is currently worth $2,500,000. They purchased the home long ago for low a low six-figure amount and due to the enormous benefits of Proposition 13 are paying about $3,500 a year in property taxes. If the child were to purchase a home for $2,500,000 today, that would equate to a $25,000 annual property tax bill (assuming one percent, not including various municipal bonds and other taxes commonly found on property tax bills). Transferring the property tax basis of the parent’s home, and therefore that $3,500 a year bill, just saved this hypothetical child $21,500 a year in property taxes. $21,500 a year, for as long as they own the home.
Principal residences have no cap in value, all other property, such as investment properties or second homes, have a benefit cap of $1 million, in which case a mother/grandmother and father/grandfather can combine their exclusions for a limit of $2 million. If the property is worth more than said caps, then a new blended property tax basis will be configured by the county.
NOTE – Another property tax benefit, Propositions 60 and 90 (allowing homeowners over the age of 55 to sell their home and purchase a replacement home of equal or lesser value and maintain the property tax basis of their original home) cannot be combined with a gift or sale of the original home to a child under proposition 58. One benefit or the other, not both.
HOW TO PASS THESE BENEFITS
There are three primary ways to transfer real property between family:
1) Gift during life (gift);
2) Gift after life (inheritance), or;
3) Sale during life (sale), whereby the child purchases the home, at fair market value or otherwise, using (a) the child’s own money and/or financing, and/or (b) seller financing, via a loan from the parent or grandparent, to be repaid, much like a traditional bank loan.
Note – a sale under fair market value and/or ‘gift of equity’ could be a partial gift for tax purposes (as to the amount below fair market value) and thus a hybrid of these options.
An owner can only gift or sell what they own; therefore, any debts or encumbrances on the property should be addressed (and may require being addressed by any third-party lender, see below).
To ensure clear title, and ability to transfer title, considerations should be made for any debt on the property, encumbrances, and county requirements (including required cover sheets, potential fees, taxes or other requirements for filing with the county).
These and other considerations may warrant professional assistance such as an attorney, title company, escrow company, or a combination of several professionals to ensure clear title, documentation and appropriate recording.
If the home has an existing mortgage (i.e. a home loan used to purchase the home, or home equity line used borrow money against the home), you likely cannot transfer title without violating the “due on sale” clause found in most loan agreements. Most mortgages are not automatically transferable, you will have to contact the lender to see if an assignment, subject to qualification, is possible. Often, the child or grandchild will need to obtain a new home loan to pay off, and replace, the existing.
Likewise, if the home has any other type of lien or encumbrance recorded against its title, those will pass to the new owner (or worse) and must be considered, resolved or accepted. Careful review and consideration of liens and encumbrances are critical.
GIFTING YOUR HOME TO YOUR CHILD OR GRANDCHILD
A property can be gifted during the owner’s lifetime, or written into an estate plan to transfer the property upon the owner’s death.
Title can change hands with some routine paperwork and filings with the county recorder’s office. Many real estate attorneys, title companies and other real estate professionals can assist. The parties can often work with the county recorder’s office to locate the necessary paperwork to complete and file themselves. However, the parties should explore the use of a title company to ensure clear title on the property (see above discussions).
SELLING YOUR HOME TO YOUR CHILD OR GRANDCHILD
A parent or grandparent can sell their property to their child or grandchild, at fair market value, or any amount, and take advantage of these benefits.
The child or grandchild can purchase the home with their own cash, their own loan, a loan from the parent or grandparent, and/or a hybrid of a new loan and some form of gift from the parent or grandparent, such as a “gift of equity,” which can be used to satisfy a down payment (see below for additional discussions on gift of equity).
CASH USED TO PURCHASE
If the child or grandchild has actual cash to purchase the property from the parent or grandparent, then money and title can change hands with some routine paperwork and filings with the county recorder. However, the child or grandchild purchasing the home should explore the use of a title company to ensure clear title on the property (see above discussions).
NEW TRADITIONAL LOAN USED TO PURCHASE
If the child or grandchild will require a loan to purchase the property, their lender (i.e a traditional bank, a mortgage broker, or otherwise) will likely require certain routine documents associated with any arms-length sale including a purchase agreement (i.e. contract to purchase the home), use of a bonded and insured escrow company and clear title / title insurance. As such, any debts or encumbrances on the property will need to be resolved as part of the sale. Most lenders will mandate existing mortgages, tax payments, etc., be resolved as part of the transaction.
“GIFT OF EQUITY” COMBINED WITH NEW TRADITIONAL LOAN
A “gift of equity” can be an enormous tool to aid a child or grandchild in purchasing the home. For example, if a home is worth $1,000,000, a traditional lender may want the child or grandchild to put 20% down, or, $200,000, in order to loan the remaining 80%, or $800,000. Instead of actual money being used as a downpayment, the parent or grandparent can “gift” $200,000 of their equity to the child or grandchild, which the lender will count as the down payment. Thus the child or grandchild can obtain a traditional loan without having to put down any actual money. [The parent or grandparent would be gifting that amount for tax purposes.]
LOAN FROM PARENT OR GRANDPARENT / “SELLER FINANCING”
The parent or grandparent selling the home can agree to ‘carry’ the financing for the child or grandchild. This is called “seller financing”. Essentially, the parent or grandparent can accept any amount of money (or none) as a down payment and agree to installment payments (i.e. monthly) from the child or grandchild over a set time (i.e. 30 years) to repay the balance.
Interest should be charged on the loan (check current IRS guidelines; generally below market interest rates are allowed, but must be reasonable as to avoid being a “gift”). The child or grandchild paying the loan can itemize the interest on their tax return, like any other home loan. Conversely, the parent or grandparent receiving the interest may need to report the same as income.
A “Deed of Trust” (i.e. a security instrument filed with the county recorded against the property’s title) and “Promissory Note” (i.e. contract between the parties regarding the amount of the loan and payment terms) should be drafted, signed and notarized, with the Deed of Trust recorded with the county, thus providing the lender (i.e. parent or grandparent) a security interest in the property to ensure payments.
Third-party servicing companies can be used to handle payments, collection (and even foreclosure).
BELOW FAIR MARKET VALUE SALE
The child or grandchild can purchase the home for any amount. However, if the purchase price is below the fair-market-value for the home, there is likely a “gift” being made in the difference.
For example, if a home is worth $1,000,000 and a child purchases the home for $600,000, then the parent has effectively gifted the $400,000 difference for tax purposes.
TAX CONSIDERATIONS / STEP-UP IN BASIS EXPLAINED
There are important tax considerations and a professional advisor may be warranted.
Most critically, gifting the property during lifetime (vs. as part of an estate plan after death) does cause the loss of a tremendous tax benefit for the heirs, namely the step-up in basis.
What does this mean? If a child or grandchild later sells a gifted or inherited home, they may have to pay capital gains taxes depending on a variety of factors. If a property is inherited, there is a “step-up” in basis of the value of the property (to the value at the time of death) for purposes of calculating capital gains when the property is later sold. The “step-up” essentially provides a higher value of the property when calculating any “gains” as compared to the sales price. The “step-up” can have enormous tax benefits for the heirs that will be lost by gifting property during lifetime.
Gifting Example 1 – Without a Step-Up In Basis
For example, a property was purchased by a parent or grandparent for $1,000,000 and, at the time of their gifting the property, was worth $3,000,000. Five years later, the property is now worth $4,000,000 and the child or grandchild who was gifted the property sells the property for $4,000,000.
There will be capital gains on $3,000,000 of “gains”, i.e. the sale price minus the original purchase price ($4,000,000 [sale price] – $1,000,000 [purchase price] = $3,000,000 [“gains”]).
Inheritance Example 1 – With a Step-Up In Basis
For example, the same property was purchased by a parent or grandparent for $1,000,000 and, at the time of their death, was worth $3,000,000. Five years later, the property is now worth $4,000,000 and the child or grandchild who was gifted the property sells the property for $4,000,000.
There will be capital gains on only the $1,000,000 of “gains”, i.e. the sale price minus the value of the property at the time of death, not based upon the original purchase price. ($4,000,000 [sale price] – $3,000,000 [value at time of death] = $1,000,000 [“gains”]).
This is the “step up in basis.”
Under this example, gifting of the property will cause the child or grandchild to pay tax on an additional $2,000,000 of capital gains.
Why would you gift a property vs. passing it in your estate plan? One simple answer is to enjoy seeing your child or grandchild own the property, perhaps raise children there, use for financial security, etc., etc. “You can’t take it with you.” For the same reason people choose to give their artwork, jewelry and other family valuables away during their lifetime, real property too can be gifted away to allow its use and enjoyment during the grantor’s lifetime.
Additionally, any gifted property, or any amount of a sale below fair market value, is counted against the lifetime gift exemption of the parent or grandparent giving the gift and may require the parent or grandparent report the gift on their tax return.
Proposition 58, Proposition 193 and Proposition 13 allow a parent or grandparent to transfer their current tax-basis to their children or grandchildren. The benefits can apply to a gift, sale or hybrid of the two and can amount to enormous property tax savings. Contact a real estate professional and tax professional to discuss your options.
– Devin Lucas
Author Devin R. Lucas is a Real Estate Attorney, Broker and REALTOR®, specializing in Newport Beach, Costa Mesa and Orange County coastal communities, serving individual and investors in residential real estate.
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– Orange County: http://www.ocgov.com/gov/assessor/programs/parentchild
– California: http://www.boe.ca.gov/proptaxes/faqs/propositions58.htm
– Complete information about Propositions 58 and 193 and the necessary forms are available at your local County Assessor and/or County Recorder’s office.
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