Quick background: Under Proposition 13, the assessed value of real property for calculating property taxes is only increased annually by an inflation factor, not to exceed 2 % annually. Completion of new construction or a change in ownership triggers a reassessment to a new base value equal to the current fair market value, meaning higher property taxes. The general rule in California is that any transfer of real estate is an event causing both transfer taxes and the reassessment of the property for property taxes.
There are, however, a few key exclusions that can be used to avoid this trigger and protect you from added tax liability.
Protecting Property Through the Creation of a Business Entity
A common strategy is the proportional interest exclusion. This allows individuals who own real property to transfer it to or from a legal entity (such as an LLC). The catch is that the individuals must have a proportional interest in the entity that is created First, assume two individuals own a property as equally. If the two transfer the property to a newly formed partnership (or LLC) and each receives an equal interest in the new entity, the transfer would not constitute a change in ownership, since the proportional ownership interest of each remains the same before and after the transfer. Accordingly, the property would not be reassessed upon transfer. However, if the two cotenants each receive a 49 % interest in the newly formed entity and a third party receives a 2 % interest in the entity, there would be a change in ownership, and the entire property would be reassessed. Next, assume one individual owns 100 % of one property and another individual owns 100 % of a separate property. If each transfers their respective properties to a newly formed partnership (or LLC) and each receives an equal interest in the new entity, there will be a change in ownership of 100 % of both properties, and each will be reassessed. This is due to the fact that the proportional ownership interests of the two owners have changed. Before the transfer each owned 100 % of their respective properties, while after the transfer each indirectly owns 50 % of both properties.
This rule also applies to transfers from legal entities (such as an LLC) to its owners. For example, assume an LLC owns two properties of equal value and that two individuals each own a 50 % interest in the LLC. If the LLC transfers one property to one of the individuals and the other to the other individual, there would be a 100 % change in ownership of both properties, and each would be reassessed. Before the transfer, the two individuals each held a 50 % indirect ownership interest in each property, while after the transfer, one owns 100 % of one property and the other owns 100 % of the second property. However, if the LLC transfers both properties to both individuals as joint tenants or as equal tenants in common, then there would not be a change in ownership, and the properties would not be reassessed.
Transfer amongst Entity Members
After real property has been transferred to or acquired by a partnership or LLC, the entity’s owners may want to transfer ownership in the entity amongst themselves or to outside investors. The general rule governing such transfers is that owners may transfer their interest on such entity without triggering a reassessment. However, there are several exceptions to this rule. The two main exceptions for partnerships and LLCs are the “change in control” and the “original co-owner” exceptions. The change in control exception provides that when an entity or person obtains control of more than 50 % of the voting stock of a corporation or obtains a majority ownership interest in any partnership or LLC, the purchase or transfer of that interest is a change of ownership of the real property. In other words, when a person or entity obtains more than 50 % of the total interest of a partnership or limited liability company, a change in control of the entity will generally be deemed to have occurred, and the real property will be reassessed. For example, assume two individuals each own a 50 % interest in an LLC. The LLC acquires a property from an unaffiliated third party, and that property is reappraised upon acquisition. One individual transfers a 30 % interest in the LLC to a third individual, and the second individual later transfers a 25 % interest in the LLC to the same third individual. Upon that person’s acquisition of a 55 % interest in the LLC, a change in control occurs, and the property is reappraised.
The original co-owner exception provides that if property is transferred to a legal entity, and the transfer is excluded from a change in ownership under the “proportional interest” provisions, the owners of the entity are deemed to be original co-owners. If more than 50 % of the original co-owner interests (collectively) are transferred, the property previously excluded from reassessment is reassessed. The original co-owner exception can be illustrated as follows: Two individuals hold equal interests as tenants in common in a property, which they transfer to an LLC. In exchange the two individuals each receive a 50 % interest in the LLC. There is no change in ownership since the transfer is merely a change in the method of holding title. The two individuals become original co-owners. One co-owner transfers 30 % of his interest in the LLC to a third individual, and the second co-owner then transfers a 25 % interest in the LLC to a fourth individual, there will be a change in ownership of the property upon the second co-owner’s transfer since this transfer will result in a transfer of more than 50 % of the original co-owner interests.
If an entity owns more than one property, there are certain instances in which a transfer of an ownership interest in the entity may cause a reassessment of one property but not the other. For example, assume an individual is the sole member of an LLC that owns a single property. The sole member subsequently transfers a second property to the LLC. This transfer is excluded from constituting a change in ownership and the individual is deemed to be the original co-owner only of the second property. If the individual subsequently sells a 20 % interest in the LLC to each of three other individuals (60 % altogether), the transfers will constitute a change in ownership for the second property because more than 50 % of the original co-owner interest was transferred. However, the first property has not changed ownership because no one person has obtained control of the LLC. If, on the other hand, the original member sold a 51 % interest in the LLC to any single individual, there would be a change of control, and all the real property owned by the LLC would be reappraised.
In another example, A, B, C, and D become original co-owners after transferring their tenant-in- common interests to a corporation, of which each person owns 25% of the voting stock. A sells all his stock to B, C, and D, all of whom now own 1/3 of the shares. If B where to then transfer his shares to a third party, there would be no change in ownership. Because original co-owner interests are not to be counted twice, only 50% of the original co-owner interests have been transferred: 25% from A and 25% from B. Note that the transfers between original co-owners are counted as transfers of original co-owner interests.
One of the many reasons real estate attorneys encourage their clients to take title to property from the beginning in the name of the LLC (rather than taking title in their own names and then transferring to an LLC) is to avoid the change of ownership risk.
Reporting Change in Ownership
If title to the property is being transferred by deed, the County receives a “PCOR” or preliminary change of ownership report form whereby the transferee reports the new ownership and claims any exclusions from reassessment. If LLC membership interests are being transferred, the property remains titled in the LLC, so no deed or PCOR is filed. Instead, the members are required to file a change of ownership of real property form with the State Board of Equalization within 90 days of any change of more than 50% of the original co-owners (cumulatively – in one or more transaction) or any change in control. Failure to timely file the Form BOE-100 can result in a significant penalty.
If you are considering transferring any property to or from your business, be sure to contact us about the best way to do this at [email protected].