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Originally published in Estate Planning, Trust & Probate News (now, California Trust & Estates Quarterly), published by the Estate Planning, Trust and Probate Section of the California State Bar, Part I: Vol. 13, No. 3 (Fall, 1993); Part II: Vol. 13, No. 4 (Winter, 1993). © Dibby Allan Green 1993, 2000.
Updated June, 2000.
Go to Part I
In Shuwa Investments Corporation v. County of Los Angeles (1991) 1 Cal. App. 4th 1635, 2 Cal. Rptr. 2d 783, (concerning transfer of the ARCO Plaza in Los Angeles) the court applied the "step transaction doctrine" whereby the end result of the transaction was determinative of a change in ownership requiring reappraisal, and not each step taken individually, which would have resulted in a lesser reappraisal. In the Shuwa case, three separate steps of a transaction were viewed by the court to actually be only component parts of a single transaction. The court determined that the substance of the transaction (the end result) controlled over the form of the transaction (each individual transfer) such that the total transaction subverted the "intent of the people in passing Proposition 13 . . . ."
As the Shuwa facts are complex, a more simple example is as follows. Suppose real property with a 1975 tax basis of $500,000, but present fair market value of $2 million, were transferred by the clients to a limited partnership, and the partnership agreement and the transfer were structured such that the clients' transfer of the property into the partnership fell within the exception of the change in ownership rules. Suppose, then, later that day, or a week later,[28] the clients make gifts of partnership interest to their grandchildren which transfer 40% of the partnership ownership interest. Again, this individual transfer would not constitute a change in ownership. The end result, however, is that the clients have given their grandchildren 40% interest in the property without a reappraisal and corresponding increase in real property taxes (approximately $6,000 annual property taxes for the 40% transferred in this example). While each individual step (the form of the transaction) would not require a reappraisal, the end result (the substance of the transaction) would.
The Shuwa court did indicate that there may be business exigencies which would justify upholding form over substance, but it rejected the business considerations presented by the taxpayers in Shuwa and the last sentence of the opinion states, "We cannot describe with precision exactly which combination of business exigencies would justify upholding form over substance, but we do know this is not such a case."
However, in a footnote the opinion states that after the litigation had commenced, the State Board of Equalization, assisted by the County of Los Angeles, developed a uniform standard governing application of the step transaction doctrine, as follows:
[W]here a taxpayer utilizes a series of transfers or steps to effect a transfer which might otherwise have been accomplished by fewer transfers or steps, we recommend that any steps in the transaction be disregarded if the county assessor concludes that they are not supported by a business purpose other than avoiding higher property taxes.[28]
A case decided before Shuwa (but now decertified for publication) considered the step transaction doctrine but found business purposes which defeated its application. Aden v. Lynch (1990) 270 Cal. Rptr. 174, concerned a corporate dissolution followed by purchase of an interest in the real property formerly owned by the corporation. The "independent economic" business purposes accepted by the court were the corporate dissolution plan and the ultimate transferee's decision to purchase real property rather than corporate shares prior to dissolution because the interest in real property was more valuable. (270 Cal. Rptr. at 182.)
The step transaction doctrine was also applied in Crow Winthrop Operating Partnership v. County of Orange (1992) 10 Cal. App. 4th 1848.
Therefore, it behooves a practitioner to carefully document the business purposes of each step, and also to warn the clients that even if they are successfully able to transfer real property into a legal entity without the assessor determining that the transfer is a change in ownership, and even if making gifts of 50% or less of ownership interest in the legal entity will not ordinarily create a change in ownership, the risk is still there that the assessor will determine the entire transaction to be a "step transaction" and will reassess the percentage of the real property ownership interest which ultimately is transferred. (See, however, discussion at IV.B.3., below re non-application of the step-transaction doctrine where the parent-child exclusion is available.)
Even if a transaction is structured in a way which will create a change in ownership, the real property may still be exempt from reappraisal under one or more available exclusions.
1. Transfers between Spouses. R&TC § 63 states, "Notwithstanding any other provision in this chapter, a change of ownership shall not include any interspousal transfer . . ." and lists several includable examples. This statute became effective July 10, 1979, (Ch. 242, Stats. 1979, AB 1488) with minor amendments made in 1981 (Ch. 1141, Stats. 1981), and it refers to any transfer, not limiting it to real property transfers alone and therefore including transfers of interests in legal entities. However, when Proposition 58 (adopted November 4, 1986) made the statutory spousal exclusion constitutional, it used the phrase, "the purchase or transfer of real property," thus throwing question on whether the spousal exclusion now is limited to only transfers of title to real property. For some time BOE staff questioned the application of this section, but with the updating of the Rules in 1998 and 1999, it is clear that the exclusion applies to transfers of interests in legal entities as well as trusts and transfers of real property. (Much discussion on this issue was contained in the original article as published, but the matter is now favorably resolved with the updated Rules.) (See also Rule 462.220.)
Applicable Dates. The application of the spousal exclusion becomes particularly relevant when structuring any transaction involving legal entities as one must determine whether any prior transfers between original co-owner spouses are to be counted in the cumulative more than 50% change in ownership under R&TC § 64(d) discussed at part III.B., above.
Subparagraph (i) to § 2 of Article XIIIA of the Constitution was also added by Proposition 58, and it then read, ". . . [A]mendments to this section shall be effective for change of ownerships which occur . . . after the effective date of the amendment," (that is, November 4, 1986). Proposition 90 adopted by the electorate on November 8, 1988, gave us the text of § 2, subparagraph (i), as it reads today:
. . . [A]mendments to this section adopted prior to November 1, 1988, shall be effective for changes in ownership which occur . . . after the effective date of the amendment. . . . [A]mendments to this section adopted after November 1, 1988, shall be effective for changes in ownership which occur . . . on or after the effective date of the amendment.
Until there is further legislation or case law decides the issue, it would appear that:
- For transfers up to July 1, 1979, the provisions of R&TC § 63's predecessor statute applies, and it had excluded only "any interspousal transfer to create or terminate a community property interest or joint tenancy interest" (see endnote 31).
- For transfers from July 1, 1979, through July 9, 1979, it appears there was no legislative spousal exclusion as the new R&TC § 63 was not effective until July 10th (although one would want to present arguments pressing for application).
- For transfers between July 10, 1979, through November 4, 1986, all interspousal transfers of any kind should be excluded from constituting a change in ownership under R&TC § 63.
- For interspousal transfers after November 4, 1986, pursuant to Rule 462.220, any interspousal transfer of either real property or an interest in a legal entity which owned real property will be excluded from being a change in ownership.
2. Trusts. R&TC § 62(d) provide an exclusion from "change in ownership" for transfer to certain trusts, particularly revocable trusts. Rule 462.160(b) list exclusions from change in ownership for transfers to a trust upon the creation of a trust and Rule 462(d) list exclusions upon termination of a trust, both of these including the spousal exclusion referred to above. When a trust is revocable, there is generally no change in ownership upon transfer of the real property to the trust, or upon return of the interest in the real property back to the individual trustor-transferor.[44] In certain situations, interests in real property may need to be returned to the trustors in order to form the legal entity, and there will be no change in ownership upon doing so.[45]
3. Parent/Child Exclusion. Proposition 58 referred to above and adopted on November 4, 1986, excluded from a change in ownership certain transfers of real property between parents and children. It added subparagraph (h) to § 2 of Article XIIIA of the Constitution, as follows:
. . . [T]he terms "purchased" and "change of ownership" shall not include the purchase or transfer of the principal residence of the transferor in the case of a purchase or transfer between parents and their children, as defined by the Legislature, and the purchase or transfer of the first $1,000,000 of the full cash value of all other real property between parents and their children, as defined by the Legislature. This subdivision shall apply to both voluntary transfers and transfers resulting from a court order or judicial decree.
The same provisions of § 2(i) concerning effective dates of these amendments to Article XIIIA discussed at paragraph IV.B.1. apply here.
R&TC § 63.1 also states the exclusion, and the legislative history adopting R&TC § 63.1 (Ch. 48, Stats. 1987) states that the Legislature intended § 63.1 to be liberally construed in order to carry out the intent of Proposition 58. The two exclusions are discussed under § 63.1 as follows:
a. Transfer of the Transferor's Principal Residence. "Principal residence" is defined at § 63.1(b)(1) as dwelling for which a homeowner's or disabled veteran's residence exemption has been granted in the name of the transferor, and includes only that portion of the land underlying the principal residence which consists of an area of reasonable size which is used as a site for the residence. (Therefore, a ranch cannot be included under this first provision.)
b. Transfer of the First $1 Million Full Cash Value of All Other Real Property. Each individual has a $1 million exemption accumulated during life, and includes real property in all California counties combined. Where there is more than one eligible transferor, exemptions may be combined. R&TC § 63.1(b)(2). Thus, husband and wife together can exclude $2 million of the value of one parcel upon its gift to a child. However, in certain circumstances where the transferor held the property in joint tenancy as set forth in R&TC § 63.1(b)(2), this exemption does not apply.
R&TC § 63.1 applies to both transfers from parents to children, and from children to parents, and includes step-children, adopted children, and daughters- and sons-in-law. R&TC § 63.1(c)(1) and (2).
As R&TC § 63.1 restrict the parent/child exclusion only to transfers of title to real property, there is generally no application to transfer of interest in legal entities. R&TC § 63.1 uses the term "real property" both as to "real property which is the principal residence" (§ 63.1(a)(1)) and as to "the first one million dollars ($1,000,000) of full cash value of all other real property" (§ 63.1(a)(2)). § 63.1(c)(6) in defining terms, states, "'Real property' means real property as defined in Section 104. Real property does not include any interest in a legal entity." R&TC § 104 defines "real estate" or "real property" as "the possession of, claims to, ownership of, or right to the possession of lands" plus mineral rights, timber, improvement, etc.
However, there may be one exception to restricting the application of the exclusion to transfers of title to real property only: opinions have been expressed that the exemption should apply to step transactions.[46] The enabling legislation provides that step transactions involving entities are within the broad purpose of the exclusion and should be allowed (§ 2 of Ch. 48, Stats. 1987), and this has also been affirmed by Board of Equalization Correspondence dated July 10, 1989.
The medium of an inter vivos or testamentary trust for the transfer of the real property may be used. R&TC § 63.1(c)(7).
In order to obtain this exclusion, a properly completed claim must be filed within three years after the date of the purchase or transfer of real property, or subsequent transfer of the real property to a third party, whichever is earlier. R&TC § 63.1(d). (Note that 1992 legislation [Ch. 1180] added to § 63.1(c)(1) that the date of transfer "under a will or intestate succession shall be the date of the decedent's death, if the decedent died on or after November 6, 1986.")
SB 675 (signed by the Governor in October of 1993) gives clients a second chance when claims have not been timely filed for transfers occurring on or after November 6, 1986. Under this law R&TC §63.1 was amended to reflect that a claim is considered timely filed if it is filed within six months after the date of mailing the notice of supplemental or escape assessment. Thus, if title to property is not transferred upon death and the assessor is not otherwise notified of the death but later discovers the death (and thus change in ownership) three years later (for example), the surviving child will have an additional six months from the time the notice of supplemental or escape assessment is mailed to file the claim. The law as signed includes transfers through a probate estate and also allows the claim to be signed by the transferee's legal representatives.
4. Leasehold Interest. Any transfer of a lessor's interest in real property subject to a lease with a remaining term (including renewal options) of 35 years or more is excluded from reappraisal. To say the same statement another way, if a person transfers the leased fee interest in property where more than 35 years remains in the lease term (including options to renew), there is no reassessment as to the transfer of the leased fee interest. The explanation is that where more than 35 years remain in the lease term, the lessee (not the lessor/owner of the fee) is treated as the "property tax owner" whose interest is substantially equal to the fee; and consequently, the remainder interest of the leased fee estate is not deemed substantially equal to the fee and so transfer of those interests are ignored for property tax change in ownership purposes.
Homes eligible for the homeowners' exemption (other than mobile homes) located on leased land are conclusively presumed to have a renewal option of 35 years or more. R&TC § 62(g).
This exemption pertains to transfer of "real property" so will apply to making gifts of interest in real property, or to transfer of the real property into the legal entity, but will not apply as to transfer of ownership interests in a legal entity.
5. Other Exclusions. The following other exclusions may apply to an estate planning practice in transferring real property, but have no application to transfers of ownership interests in legal entities.
a. Disabled Child. Transfer of an eligible dwelling from a parent or guardian to a child who has been disabled for at least the preceding five years, and where the adjusted gross income of both parents and child do not exceed $20,000 may be excluded. R&TC § 62(n).
b. Replacement Property. R&TC § 68 grants an exemption for replacement property applicable to eminent domain proceedings, acquisitions, or judgments of inverse condemnations. (It does not appear clear to me that this provision necessarily excludes legal entity owners of real property.)
c. Employee Benefit Plan. R&TC § 66 and Rule 462(m)(4) provide an exemption for contribution of real property to, or distribution from, an employee benefit plan.
d. Value of Interest Transferred. Except for transfers of certain joint tenancy interests, when total cumulative interests in real property transferred during one assessment year (now January 1 to January 1) have a market value of less than 5% of the value of the total property and this value is less than $10,000, the property will not be reappraised under R&TC § 65.1, confirmed by Board of Equalization Letter to Assessors No. 80/180, December 9, 1980.
e. Partitioning of an Appraisal Unit. R&TC § 62(a)(1) allows for instances where partitioning of land will not result in a change in ownership. A good discussion is contained at 2 Crawford, et al., California Taxes 2d Ed. (CEB May 1992 Update) § 1.81, but for our purposes here, if several owners own parcels appraised by the county assessor as one appraisal unit (such as a large ranch) and only a portion of the property and/or some of the owners desire to contribute the real property to a legal entity, a partitioning action which is exempted from reappraisal may enable a later transfer of title to the name of a legal entity to also fall within this exemption from reappraisal.
For analysis as to whether a change in ownership occurs, the transferor, and sometimes the transferee, is not necessarily the person(s) whose names appear on title.
1. Agent. Obviously when one is acting in an agency or fiduciary capacity the principal, and not the agent or fiduciary, is the transferor or transferee. Thus the conservatee, not the conservator, is the transferor; and the decedent, and not the executor, is the transferor.
2. Trust. Where real property is donated to a trust, generally the transferor is the settlor/trustor and the transferee is the present beneficiary of the trust. R&TC § 62(d), Rule 462.160(b)(1)(A). (See R&TC § 62(d) concerning when a change in ownership occurs as to real property held in a trust.) When an event occurs in which new persons become present beneficiaries of a trust (which event usually creates a change in ownership, cf. Rule 462(b)(1)(A)), the transferor remains the original trustor/settlor and is not the prior beneficiary. Board of Equalization Correspondence 3691D dated November 5, 1991.[47] For example, Husband's will establishes a testamentary trust for the benefit of Wife for her life. Husband dies, later Wife dies, and the trust corpus is distributed to their Children. The transferor is Husband, not Wife (her interest is characterized as a life estate), and the transferees are Children. (For parent/child exclusion purposes, therefore, there is only Husband's $1 million exclusion available, and not $2 million for both Husband and Wife.)
3. Joint Tenancy. When property anticipated to be transferred is held in joint tenancy one must ask, who were the original owners of the property prior to the creation of the joint tenancy? If an original owner is now one of the joint tenants, there would not have been a change in ownership at the time of creation of the joint tenancy. Under R&TC § 65(b) and Rule 462.040, that owner is termed an "original transferor" for purposes of determining the property to be reappraised upon subsequent transfers. In addition, under R&TC § 65(e) and Rule 462.040, it is rebuttably presumed that where a joint tenancy was created on or before March 1, 1975, that each joint tenant then on title is to be considered an "original transferor."
When joint tenancy property is then transferred to a legal entity (thus terminating the joint tenancy), to the extent the transferor to the trust or partnership is the "original transferor" of the joint tenancy interest, and to the extent this "original transferor" retains an interest in the transferee entity, generally there is no change in ownership as to that respective ownership interest (unless some other provision comes in to play, such as failing to structure the legal entity transfer to avoid a change in ownership under R&TC § 62(a)(2)). R&TC § 65(c) and (d), and Rule 462.040. But where the transferor is other than the "original transferor" of the joint tenancy interest, there will be a reappraisal of such respective interest. R&TC § 65.1(a). (For all joint tenancy questions, Rule 462.040 provides additional rules and examples.)
For example, Husband and Wife own property and change the vesting to Husband, Wife, Daughter, and Son-in-Law, all as joint tenants. Husband and Wife are the "original transferors" and Daughter and Son-in-Law are "other than the original transferors." Husband, Wife, Daughter, and Son-in-Law now transfer title to Husband and Wife solely as trustees of their revocable living trust of which Husband and Wife are the sole present beneficiaries. As such sole present beneficiaries of the revocable trust transferee, Husband and Wife in effect gain back 100% interest in the property; as the "original transferors" there is no change in ownership.
Suppose instead, however, Husband, Wife, Daughter, and Son-in-Law record deeds terminating the joint tenancy interest by making a gift of 50% of the fee interest in the property to Daughter and Son-in-Law, with Husband and Wife retaining the remaining 50%, all held as tenants in common. Husband's and Wife's remaining 50% is not reappraised as they were the joint tenant "original transferors," but Daughter and Son-in-Law's 50% will be a change in ownership as they were not "original transferors" when the joint tenancy was created -- notwithstanding the fact their names were on the deed prior making the gifts and changing the vesting to tenants in common. (Of course, reappraisal of this 50% interest may be excluded under the parent/child exclusion.)
Therefore, attempts to avoid reappraisal by changing title to joint tenancy immediately prior to contribution of the property by the new joint tenants to a partnership (where the joint tenants are all the partners of the partnership) will not work.[48]
4. Legal Entities. In an analysis similar to that for the holders of title in joint tenancy, when either transfers are to be made of real property presently held in the name of a legal entity, or when changes in ownership and control of the legal entity are made (as discussed at part III., above) one must determine who the original owners of the property were and whether, when the property was originally transferred to the legal entity, it was excluded from reappraisal. If it was excluded, one needs to account for the cumulative more than 50% ownership interest under R&TC §64(d) and Rule 462.180(d)(2) since the date of contribution, identifying every change of ownership interest in the legal entity since the contribution of the real property in order to tell at the present point in time what percentage interest remains with the "original co-owners." (Of course, one need go back no further than the 1975-76 tax assessment year for Prop. 13 purposes.)
1. Recorded Instruments. Generally, the county assessors will use the date the deed is recorded as the date of transfer, and thus the effective date of the reappraisal (Rule 462.260(a)(1).), which states that its purpose is to select the date to be used "for purposes of reappraising real property as of the date of change in ownership of real property." For transfers to legal entities and making gifts of real property the rebuttable presumption is that the date of gift is the date of the instrument of transfer (Rule 462.260(a)(2).)
Many times use of the recordation date is not a problem for property tax purposes, although from the standpoint of gift taxes and legal conveyance (especially if the client should die after signature on the deed but prior to recordation, in which case the rebuttable presumption that delivery has not occurred must be overcome) the transfer is effective the date the deed is signed. However, it can be a problem when there is a significant time lapse between the date of deed execution and date of recording and some event occurs which makes a significant change in the value of the property.
This can also be a problem when deeds pertaining to the same transaction, though executed the same date, are recorded on different dates. The assessor will consider each recording date a separate change in ownership and this could cause a change in ownership when none was intended (or require an unplanned utilization of the parent/child exclusion).
For example, three individuals sign a partnership agreement and contribute their one-third interest in real property into the partnership by signing three separate deeds on July 1st. This transaction will normally not result in a change in ownership. However, if two deeds are recorded on July 10th and the third deed is recorded on July 18th, then as of the July 10th recording date the third person had gained a one-third partnership interest in the undivided two-thirds of the real property now owned by the partnership (as the third person is a partner by signature to the agreement on July 1st), and the prior two-thirds ownership interest held by the other two individuals has been proportionately reduced. As discussed under transfers to legal entities in part II., this will then remove the transfer from the R&TC §62(a)(2) exemption of transfers to legal entities where the parties retain the same proportionate ownership interests before and after the transfer, and will result in a reappraisal of the entire interest transferred, i.e., the two-thirds interest contributed to the partnership. (One might think common sense might override the technicality of the recording date, but this has not been our experience.)
Deeds executed chronologically but recorded in the wrong order can also create an unintended change in ownership. If Father makes a gift of real property interest to Son on July 5th (intending to exclude this transfer under the parent/child exclusion), then Father and Son sign a partnership agreement and two separate deeds on July 15th, but the partnership deeds are recorded on July 16th and the gift deed is not recorded until July 30th, then the assessor will reflect that prior to the July 16th recordation date the property was solely owned by Father, but as of the July 16th deeds Son has gained an ownership interest in the real property through the partnership interest and a change in ownership has occurred (and the parent/child exclusion cannot be utilized for partnership interests). As the entire property was contributed to the partnership, 100% of the interest will be reappraised (not just the proportionate interest given to Son; see part II).
Both of the outcomes of these examples would be reversed by successfully overcoming the recording date presumption. The Preliminary Change of Ownership Report form has a place (Part II, item A) to state a date of transfer if other than the recordation date, and we always list the date the deed was executed here as future evidence of our opinion of the effective date of transfer (should it be required) for gift tax or other purposes. When important, we have also talk with personnel at various assessors' offices to persuade them into using this date instead of the recordation date; however, we have yet to succeed in having any assessor acknowledge any date other than the recording date. To rebut the presumption, therefore, will require more than representation on the P.C.O.R. form and oral discussion with the assessor's office.
To be safe, therefore, one need be sure that (a) every deed pertaining to the transaction is recorded as soon as possible after the signing, (b) deeds pertaining to a series of transfers are recorded in the correct order, and (c) all deeds pertaining to a single transfer are recorded the same date.
2. Unrecorded Changes in Ownership. If the transfer is pursuant to an unrecorded document, the date of the transfer document is rebuttably presumed to be the date of ownership change (Rule 462.260(a)(2)). This is consistent with R&TC § 64(c) concerning change of control of a legal entity which states, "When a . . . person obtains control [of a legal entity] . . . such purchase or transfer of such stock or other interest shall be a change of ownership of property . . . ." It is also consistent with R&TC §64(d) concerning accumulation of change of ownership of more than 50% of the original co-owners' interests, which states, "The date of reappraisal shall be the date of the transfer of the ownership interest representing individually or cumulatively more than 50 percent of the interests in the entity."
3. Trusts. Transfers to a revocable trust are not effective until the date in which the trust becomes irrevocable (Rule 462.260(d)(1), which is usually the date of death of the trustor). Transfers to irrevocable trusts occur on the date the property is placed in trust (Rule 462.262(d)(2)), i.e., the date the deed is recorded.
1. Avoiding R&TC § 64(d). In a situation where reassessment may occur in any event in a transaction, one may want to structure the transaction so that the accrual of cumulative ownership interest changes by the original co-owners under R&TC § 64(d) is avoided (so that reassessment will only occur upon change of control of the entity under §64(c)). For instance, if two people purchase property (reassessment) and then contribute it to a partnership, it may be preferable for them to form the partnership first and the partnership purchase the property (reassessment) and thus avoid R&TC § 64(d).
2. Additional Taxes. Some transfers to legal entities may require payment of the Documentary Transfer Tax, and different counties have adopted different rules. The state law provisions are at R&TC §§ 11911, et seq. § 11923(d) provides for an exemption to the tax when the deeds are to make effective any plan of reorganization or adjustment, "Whereby a mere change in identity, form or place of organization is effected." In some situations additional personal property taxes may be assessed (particularly if the transfer requires reappraisal of the real property and the appraiser discovers previously unidentified taxable assets). Income tax consequences of the transaction must also be considered. Finally, there may be local taxes to advise the client about, such as the Los Angeles City Real Estate Transfer Tax.
3. Other Tax Risks. Converting client's real property assets to personal property assets (i.e., ownership in a legal entity) may mean the loss of Internal Revenue Code § 2032A farm valuation at the time of a client's death. Estate of Maddox v. Comm'r, 93 T.C. 228 (1989). Additionally, if the new legal entity is not actively involved in the business but only receives rents, the Internal Revenue Code § 6166 installment payment option upon the client's passing may be lost as to these properties as the legal entity receives only passive income.
4. Payment of Taxes. Where the property is leased and the client is the lessor, the lease agreement may contain provisions providing that the lessee pays the real property taxes. If, therefore, a reappraisal should be required with the transaction, the property tax burden may fall upon the lessee and not the client. (Of course, in another situation where the client is the lessee, this can work adversely to your client and some protection should be written into the lease agreement.)
5. Inability to Avoid Reassessment. If it appears a change in ownership may occur in a particular situation notwithstanding all efforts to avoid it, before proceeding with the transaction talk with an appraiser at the county assessor's office to see if there are zoning changes or other factors unknown to you which will affect valuation, and try to get an idea of the range of what reappraised values might be for your client. Then informed your client of the tax consequences before proceeding with the transaction.
6. Rental of Property. Planning must ensure that the transfer of property to the legal entity qualifies as a "bona fide sale for an adequate and full consideration in money or money's worth" (IRC § 2036(a) and Reg § 20.2036-1(a)), so fair market rental value of the real property must be paid to the legal entity to avoid inclusion of the property, or portion thereof, in the clients' estates. (See also Rev. Rul. 70-155; W. Douglas Estate, 31 TCM, Dec. 31,802(M), T. C. Memo 1973-2.)
7. Other Contracts Affected. If there is a mortgage on the land and title is assumed by the legal entity, the lender may call the loan pursuant to a due-on-sale clause. Transfer into the name of the legal entity may also affect a county agricultural preserve ("Williamson Act") contract, contracts for water rights, or other private contracts.
1. Upon contributing real property to a partnership, make sure each partner has the same percentage ratio of capital account (ownership interest) and right to profits and losses as each had in the real property prior to transfer. If the partners desire varying rights as to distributions, priorities, contributions, or other variations of interests, have an initial agreement among the partners that their rights in capital and profits will be proportional to their previous interests in the real property. After the transaction, amend the partnership agreement to add the special terms the partners desire--however, in so doing, avoid creating a change of more than 50% control under R&TC §64(c); also note that this later change may begin the accumulation of changes by the "original co-owners" toward such time as a change of more than 50% under R&C § 64(d).
2. If more than one parcel of real property is to be contributed to a partnership, make sure all the partners have the same relative ownership interests in every such parcel. If they do not, there may be less of a property tax consequence by selling or gifting the varying interest(s) first. The sale or gift will result in a change in ownership only as to the percentage then sold or gifted, rather than a reappraisal of 100% of all real property contributed to the partnership if disproportionate interests are contributed. If there is no other solution, have a separate partnership for each parcel of real property.
3. If assets other than real property are to be contributed to the legal entity, contribution of non-real-property assets must be made in values proportionate to each owner's respective ownership interests in real property.
4. If interests in legal entities (corporate stock, partnership interests) are to be contributed, (a) determine if the transaction will result in a change of majority interest or control of each legal entity (whether gained by a single individual or a family as in Rain Bird), and (b) trace the percentages of interest changed over the years (and check the dates of each transfer to determine applicable law at that time pertaining to exclusions) in order to calculate what percentage of the "original co-owners'" changes in ownership interests have accumulated so that the new transaction does not exceed a change of more than 50%.
5. Be sure every partnership agreement (both general and limited, and every partnership in a chain of ownership by other entities) provides that the partnership will continue and not dissolve upon change of a general partner.
6. Review the list of exemptions to see if any will apply in a situation where a change in ownership cannot otherwise be avoided. However, do not assume an exemption for a transfer of real property to be applicable to a transfer of an ownership interest in a legal entity.
7. Make sure that every deed pertaining to the transaction is recorded as soon as possible after the signing, that deeds in a series of transfers are recorded in the correct order, and that all deeds pertaining to a single transfer are recorded the same date. If not, and the assessor determines that a change in ownership has occurred, submit documentation and opinion letter to the county assessor demonstrate that the date the deeds were executed was the date of transfer to overcome the presumption that the recording dates are the dates of transfer for change in ownership purposes.
8. If a series of steps are involved in the transaction, document the business purpose or independent economic significance of each separate step, and, if possible, separate each step by a reasonable period of time.
9. If a change in ownership is not able to be avoided, have the change of ownership statement prepared with the transaction documents, signed by client (or other transferee) at the same time the transaction documents are signed, and then file the statement immediately, in no event later than 45 days, in order to keep the statute of limitations for reassessment down to four years instead of eight. (In marginal cases, possibly file "protective" statements to run the statute even though the statements will contain your opinion that no change in ownership has occurred.)
10. When in doubt, request an opinion from the State Board of Equalization (advisory only), and/or from the local county assessor, who is the one to make the determination as to whether a transaction constitutes a change in ownership requiring reappraisal.
Notes
[28] The three transfers of real property involved in each step of the Shuwa case, above, were accomplished on the same day.
[44] 9 Witkin Summary, supra, § 94, p. 147, with cites.
[45] See also 1 Crawford, et al., California Taxes (CEB 5/92 update) § 1.60, p. 61. This principle is also followed by California Personal Income Tax Law which now substantially conforms to the Internal Revenue Code in not treating a revocable trust as a separate taxpayer. Internal Revenue Code §§ 671-679; 1 California Taxes, supra, § 2.31(a), p. 45.
[46] For example, in the formation of a partnership, the partnership must have two or more "persons" to be valid (California Corporation Code § 15502(1)). Additional, to conform to federal income tax laws, general partners of a limited partnership must have an ownership interest in the limited partnership. Sometimes, therefore, trustees of a revocable trust may revoke a 1% interest in the real property, and the spouses then contribute that interest to the limited partnership in exchange for a general partnership interest in their names individually. As trustees of their revocable trust they contribute the remaining 99% interest in return for a 99% limited partnership interest owned by the trust. While not resulting in a change in ownership for property tax purposes, it does, however, run the risk of a probate being required of the 1% general partnership interest now not vested in the spouses's individual names. Alternatively, a separate revocable trust could be established to own the 1% general partnership interest.
[47] Crawford, et al., 1 California Taxes 2d (CEB May, 1992 Update) § 1.69 and § 1.80. Also, based on the Board's uniform standard governing application of the step transaction doctrine (adopted after commencement of the Shuwa litigation) which recommends "that any steps in the transaction be disregarded," it stands to reason that the exemption will apply as disregarding the step of transfer to the partnership would result in conveyance of real property, not the partnership interest, to the children. However, our queries on this issue to local assessors thus far have been met with denials.
[48] My correspondence with the Santa Barbara County Assessor's Office requesting an opinion also set forth this interpretation.
[49] This recommendation is suggested as a "Planning Note" in 4 California Taxation 2nd (Matthew Bender, March 1992 Update) § 88.162, but it is incorrect under the reasoning behind the joint tenancy rules pertaining to "original transferors." The position set forth in this article was confirmed to me in a telephone conversation with Mr. Carl Bessent, Tax Counsel, Real Property Division, State Board of Equalization, on September 10, 1992, in response to our written request for an opinion. The transaction will also likely be found to be a step transaction and fail to be excluded from a change in ownership on that basis as well.
The contents of this publication are for information purposes only and are not meant nor should be construed to be legal advice. Note, also, the date of the document. Laws are constantly changing, and are subject to differing interpretations. We, therefore, urge you to do additional research or to contact your own legal or tax counsel before acting on the information contained herein.
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