Simply Multifamily Episode 3: Prop 19's Impact on Multifamily Investments with Steven Sorell
Updated: Oct 5, 2021
Join us for a discussion with Steven Sorell of Sorell Law Group in Pasadena, CA and Kiran Dhillon, Broker-Associate at KW Commercial on the impact of Proposition 19 on California’s multifamily property owners.
Topics covered include: (1) summary of property tax changes under Prop 19; (2) impact of Prop 19 on the multifamily market, including on family-owned properties; (3) factors to consider when deciding whether or not to transfer your multifamily properties to your children prior to February 16, 2021; and (4) possible alternative solutions to Prop 19 taxation for property owners to consider.
Kiran Dhillon, SIG Commercial (00:02):
Welcome to our series "Simply Multifamily." My name is Kiran Dhillon, I am a Broker-Associate at Keller Williams Commercial specializing in multifamily properties. The purpose of this series is to highlight issues that affect owners of multifamily properties via market updates, investment highlights, and interviews with trusted professionals. Today, we're going to be talking about Proposition 19, which covers property tax transfers and exemptions. To walk us through the effects of Prop 19 on owners of multifamily properties, we have with us today attorney Steve Sorell of Sorell Law Group. Steve brings business experience to business law and the unique perspective of being both a CPA and an attorney. Welcome Steve, thank you for being here today.
Steven Sorell, Sorell Law Group (00:49):
Thank you very much for having me, Kiran. I appreciate this opportunity to share this information. Prop 19 was something of a stealth proposition. During the general election, there was a lot of attention paid to Prop 15, the so-called "Split Role," and it was a very bitterly fought battle and Prop 19 just kind of skated in. It actually had a lot of money behind it from what you may think is an unlikely source, and almost no opposition. Prop 19 makes the most significant changes to the Prop 13 revolution, specifically Prop 58 and Prop 193, which allow properties to be passed from one generation to another. It also has an effect on Props 60 and 90, and I will get out of the alphabet soup of numbers here and talk about these things specifically.
Steven Sorell, Sorell Law Group (01:55):
The Proposition does four main things. The thing that it is most publicly described as doing is making it easy for people over 55 to sell their house, buy a replacement, and keep their existing property tax base. Under current law, before Prop 19, somebody over 55 could sell their appreciated property and keep their low property tax base provided they bought a replacement property for not more than 105% or 110%, depending on how long they waited and provided that the replacement property was either in the same county that their current property was in, or one of 10 counties that have reciprocity agreements. The law was helpful. It enabled many seniors to downsize and carryover their property tax basis. To my mind, one of the biggest weaknesses with the existing law is the very rigidity of the formula: the replacement property could not exceed 105% in the first year or 110% within two years by even a dollar or you lose the carryover basis. It was an all or nothing proposition. Plus, it could be done only once in a lifetime, except for under certain special circumstances.
Steven Sorell, Sorell Law Group (03:32):
Prop 19, what it was advertised as doing is making this easier for our seniors to buy replacement properties. For one thing, they can now get the replacement property anywhere in California. The rigid rule has been changed out for one that says that as long as the property is the same value or less, you have your existing tax base. If it's over it -- so if you sell your house with its $100,000 basis for $750,000 and you buy a replacement property for $800,000 -- instead of losing your basis, you'll carry your $100,000 existing basis over and you'll be reassessed on the $50,000 increase in value. So, your new basis for property tax purposes will be $150,000. Much fairer, less hand wringing involved with it. Plus, one of the big advertised benefits is that you can do it three times. I personally don't know that many people over 55 who look forward to swapping houses multiple times. It's usually traumatic enough the first time, you kind of want to settle in, but it's still there now if you want to do it a couple of more times.
Steven Sorell, Sorell Law Group (04:55):
The law also applies to houses that are lost in declared wildfires and for people who are severely disabled. But, much of that provision was there in the existing law. It really didn't change much. In fact, under the existing law, if you were a victim of a fire, you could get a replacement. Under the new law, it's if you're a victim of a declared wildfire. So, I don't know if that eliminates the existing protection for just plain old fires. So there are, as we'll see as we get on through the discussion, there are many questions that remain to be answered, and that's always the problem that you have with a law that is passed by referendum because they try and make it fairly compact and they can't necessarily come up with all the answers. In fact, as you know, there has been wrangling since 1976 over exactly what Prop 13 means and each one of the successive changes and there is a very large body of law that's been developed. I predict the same thing will happen here.
Steven Sorell, Sorell Law Group (06:12):
The next element of it strikes at the heart of Props 58 and 193, the ability to pass a house on to your children. Under the current law, a parent can pass to their children their primary residence, regardless of value at their carryover basis, plus a rental property with up to a million dollars of assessed value. Remember we were talking the historical assessed value -- that million dollars of assessed value could have a market value of five, six million by now. It just depends, and that goes to the heart of the changes. It's the revenue raising portion of the new proposition. First of all, the primary residence can be passed on (a) if the children occupy it as their primary residence; they cannot take it and put it into rental like you could under the existing law and (b) even if they do follow that, the carryover basis exists only if the property has not appreciated by more than $1 million. If it has, then you are tagged for the amount over it. This is an interesting concept, the way it's applied. It's not intuitively obvious at first because it mixes historical assessed value with current market value. So, we start out with the simple example of a property that parents paid $100,000 for, it is now worth $600,000 - $700,000. And they leave it to their children. They will get the parents' basis of a $100,000 because the value of the property has not increased by more than $1 million. But again, that is provided that they occupy it as a primary residence, which we'll get to another problem in a minute.
Steven Sorell, Sorell Law Group (08:22):
What if the property has gone up substantially in value, which is certainly not uncommon in California, particularly when you're talking about your parents' house, which they may have owned for 35-40 years or more. So, if we go back to that same example, the property has an assessed value of $100,000 today. Maybe they bought it for $50,000, thirty-five years ago. Now it's inched up to $100,000 and the property is worth $2.5 million dollars. In forty years, it can happen in the right spot. So how much will the property tax be? If the kids take it over as their residence, the property tax will be $100,000 carryover basis from the parents, plus the amount over a million dollars. So since it's worth $2.5 million, it's gone up $1.5 million over the $1 million amount. So their basis will be $1.6 million: $100,000 carryover basis and then the $1.5 million that it's increased over it. The property tax will go from about $1,200 a year to $18,000-$19,000 a year. And if they don't use it as a primary residence, it goes to the full $2.5 million and the property tax on that figure will be a little over $30,000 a year. That's definitely a game changer.
Steven Sorell, Sorell Law Group (10:01):
One of the nagging questions here is that it says that it has to be used by the children. Well, does that mean all the children have to live in there, if there's more than one? We don't know the answer to that. I suspect that there will be some accommodation just as there were adjustments made for Prop 13's language and Prop 58's language, which also referred to children. The last change and the one that is most significant to your audience is that carryover of a million dollars of assessed value for other property, that's simply gone. As of February 16th, when these new provisions kick in for primary residence and other residences, any property that is inherited other than the primary residence is immediately reassessed at the full fair market value. That is a huge change that people really didn't see coming. And I think that as we get onto some of the other questions, we'll see where I think that that's going to go. But those are the primary changes that take place in the law.
Kiran Dhillon, SIG Commercial (11:21):
That's a lot of information to delve into. On the flip side of that, can you just quickly talk about situations where Prop 19 would have no effect on the carryover assessed value? Just so that it's very clear.
Steven Sorell, Sorell Law Group (11:37):
Sure. It's a good question because that hybrid formula of assessed value and market value is not intuitive. It took a while before it sunk in. The cases where Prop 19 will not affect the transfer of property are limited to primary residences where the child or children occupied as their primary residence and where the value of the house is not increased by more than a million dollars. So if the market value of the house that you inherit is under a million dollars, no effect of Prop 19. You'll get whatever basis your parents had. And the "under a million dollar" category certainly covers a lot of property. But in the more urban parts of town, that doesn't cover a lot of property. So there will be a lot of properties where you have to watch out for it. But again, even if the property is worth $600,000 - $700,000, you don't get the carryover basis unless you're occupying it as your primary residence. The way they're going to determine that primary residence is that when you take over title to the property, you'll fill out the Homeowners' Exemption or the Disabled Veterans' Exemption, which asks you a series of questions as to, "Is this your primary residence? When did you take over?" And you sign the application under penalty of perjury. And that is how it gets triggered. This form is supposed to be executed within one year of taking over the property. Under current law, you have three years to apply for the Parent-Child Exemption and get it retroactively. There are a whole series of other rules that take place. If you missed the three-year mark and they catch you, or they don't catch you, how you make it go forward. None of that is stated in Prop 19. It just says you have to apply for it in the one year or pretty much you don't get it at that point.
Kiran Dhillon, SIG Commercial (13:53):
A quick clarifying question: Is it that the parents were living there with the child and then the parents passed away and the child continues to live there, or could it be that the parents were living in that primary residence, they pass away, and immediately the child comes to start living there?
Steven Sorell, Sorell Law Group (14:10):
It is the latter. The only requirement is that it had to have been the parents' primary residence. No language about whether the child was living there. But they have to take over, which hence that one-year window, if they even sincerely want to do it, you know, sometimes it takes time to go through the administration and get the place cleaned out and all that sort of thing. And so the same thing would apply if the parents owned a duplex, let's say, and occupied one unit and rented the other unit. In that situation, if the children took over, they could make half of the duplex a residence like their parents, but half would be a rental property because that's how the parents used it. Even if they chose to occupy the upstairs and the downstairs, only half of that would qualify for the Parent-Child Exemption because only half it was used as their residence.
Kiran Dhillon, SIG Commercial (15:12):
So with larger properties, like a fourplex or a ten unit, the value [of the Parent-Child Exemption] decreases if the children continue to live there.
Steven Sorell, Sorell Law Group (15:25):
Right. If the parents are living in one unit of this ten unit place, yes, one-tenth of it would be eligible, at most, for the carryover. The other ninth-tenths are going to be reassessed at market value -- this could be a game changer. We'll talk about which properties are most affected, things that can be done. I would point out one other thing about it. The proposition says that they have to take it over as their primary residence. It doesn't really say what happens afterwards. So the child steps into the parents' house, lives in it for a year or two, then gets another job somewhere else and has to move or wants a different house. And they put it into rental. Is the exemption revoked? It's not clear. One suspects that that will happen, but it also raises the issue of how that would ever be found out if not voluntarily disclosed, right?
Kiran Dhillon, SIG Commercial (16:36):
For the purposes of our audience today, we can focus on the fact that under Prop 19, essentially any multifamily property that's being passed on to children after the parents' death will be fully reassessed at that time at the fair market value. What kind of an impact do you think this will have on the broader multifamily market and then also on these smaller family owned properties?
Steven Sorell, Sorell Law Group (17:02):
Okay, it's a good question. We're still trying to think our way through it. Even the legislative analyst that prepared the budget forecast for the Proposition, you know, usually they tell you, "Oh, it's expected to raise X millions of dollars or whatever," is so vague. It says tens of millions of dollars increasing potentially to hundreds of millions of dollars per year - pretty vague. The cases where you can see that it's most likely to cause a change is in the family vacation home or second home because there they've owned that family cabin for 40 years and zoom, the value, it jumps up and it's not producing revenue. You know, it's a nice weekend place. You'd like to keep it for your kids, but you're not going to be able to afford to do it because [the property taxes] will go up so much. If we have time, I'll give you an example later on of a property that we were able to prevent that from happening with suitably dramatic results.
Steven Sorell, Sorell Law Group (18:12):
In terms of the regular multifamily place -- so, parents owned a fourplex or a couple of duplexes or something, some additional property that they probably had for a long time -- yes, the property is going to go up in value. The property taxes will jump. If the properties have been managed properly all along, sort of competitive with other properties, then you have to think that it wouldn't necessarily be that much of a change. That is they'll be a lot less profitable, but what's the children's alternative? They sell the property and the new buyer is going to have the same taxes plus financing to carry. So, it'll have to be priced to cover that. In many cases though, of course, you know I call them children, but many times they are quite well into their adult years, right? They often are not well-prepared. They haven't been educated for the transition, really taken into their parents' confidences and the property that was once a cash cow suddenly loses a lot of its cash flow because of the property tax hike.
Steven Sorell, Sorell Law Group (19:31):
And there may be more impatience: 'Gee, I'm not willing to settle for a small cash return and hold out for future appreciation. Let me get the money now.' Whereas a new buyer comes in expecting a very low cash on cash yield and is buying for the long term. But I think you'll see a lot of transition occasioned by that. Where it could really be messy is, let's take a situation where maybe the parents hadn't so aggressively managed the rent because it was inexpensive, they didn't have any debt left on the property, and property taxes were low. So, they were a little lazy about raising rents. Most of the state is subject to various forms of rent control. So now the children may not be able to raise the rent right away. Even a new buyer may have trouble with it, depending on what city it's in. That could have quite a negative impact on the property because if parents have underpriced it for a long time, and now the property taxes have gone up tenfold and they can't pass it through, it could turn into a money loser. And then maybe you tell me what happens? It becomes a candidate for redevelopment, I guess. What you can do is to try and knock it down and start over with something.
Kiran Dhillon, SIG Commercial (21:02):
Or you have the opportunistic buyers who can get in at the right price. If you can't afford to keep it anymore and you have to sell it, you'll just have to sell it for less. And that's something I see all the time. So many situations where it's been owned by the family for a long time and the parents kept rents low, just like you said, because it was profitable for them. Previously the situation was that it wouldn't be for the new buyer, but now it might not even be [profitable] for their own children.
Steven Sorell, Sorell Law Group (21:35):
Right. And, so depending on how far out of whack it is and how rigorous the rent control is in the particular area, you know, it could have very serious implications I think.
Kiran Dhillon, SIG Commercial (21:51):
So, given that Prop 19 goes into effect on February 16th, 2021, should parents be thinking about transferring these investment properties to their children, or are there other considerations that counterbalance Prop 19 that they need to think about?
Steven Sorell, Sorell Law Group (22:08):
I'll answer that two ways. One is based on the existing law. And then I'd like to sort of briefly touch on some alternatives we're exploring, but are not fully cooked yet. Under existing law, knowing what we're facing with Prop 19, the tradeoff is going to be, 'Do I give the property away now so that the children get the carryover property tax basis?' But then they lose the step-up that they would get on death. Property that they bought for $50,000 thirty years ago is now assessed at $100,000 at 2% a year. And its basis for capital gains is a $100,000, but it may be worth $2 million. So, do I give it to them now, so they get the same $1,200 a year property tax? Or do they wait to hold on till I die, the property tax goes up tenfold or higher, but the basis for capital gains purposes also goes up, meaning that they can sell it after death and not pay any tax in most situations. Then we get into the overall limits on estate tax. So, that's one consideration.
Steven Sorell, Sorell Law Group (23:30):
For the most part, the tradeoff between the reduced property tax and getting the step-up in basis after death is quite dramatic. That is, you have to hold onto the property for twenty/twenty-five years before the economics started to come together where the property tax basis difference would really pay off. So, where's that likely to happen? Well, certainly if the family has their nice little cabin somewhere in the woods that's been in the family forever and everybody expects it to stay in the family and there's no desire to sell it because their children want to pass it on to their kids and so forth. That's a good candidate for maybe early gifting now because we don't care about not getting the step-up. We want to be able to afford to keep it.
Steven Sorell, Sorell Law Group (24:32):
But it's less clear of a deal with the more valuable properties. Primary residence becomes another issue. In fact, I am dealing with one client now where they want to do a trade, parent and child trade houses so they can take advantage of the basis. Now there are some possibilities that we're looking at -- this is all new to us -- of ways that we can try and continue to get this benefit past the February 16th cutoff date. One of them is the use of a common estate planning technique called an Intentionally Defective Grantor Trust, which sounds like a bad thing, but it's generally a good thing. And what that does, it involves putting property into an irrevocable trust. So it is a completed gift for estate tax purposes. The property comes out of your estate, but it's an incomplete gift for income purposes. So, the income from the property still goes back to the original owner. With an apartment building, for example, the property would now be owned by the trust for the benefit of the children, but the parent would still be collecting the rent and paying the expenses, paying the tax on it. It gives you an opportunity to then get the property transferred within the timeline, but not lose control of it, and still get a carryover of the tax. It's not clear how well that would work after February 16th. One possibility is to combine it with an LLC, so that that stabilizes it.
Steven Sorell, Sorell Law Group (26:32):
And that brings me to the next idea that we're looking at very seriously. All these rules we've talked about with transferring a property and keeping the assessed value and a Parent-Child Exemption are based on transfers of interest in the fee property, in the underlying real property. However, if the property is held in an entity like a limited liability company, there are a different set of rules. The Parent-Child Exemption doesn't apply because that only applies to transfers of real property and ownership of a limited liability company is not ownership of the real property, even though the LLC just has the one property in it. So it's governed by a different set of rules, which before Prop 19, you tried to steer clear of because they were not as favorable as the Parent-Child rules, but now that Prop 19 has pushed in the other direction, these rules start looking a little bit better.
Steven Sorell, Sorell Law Group (27:39):
So, one possibility is to put appreciated property into an LLC. The parent can then give 50% of the property away without a change in the assessed value. And that would be effective regardless of when the property is put into the LLC or when the gift is done. It's not dependent on that. Well that gets a half a loaf. When the parent dies or gives the other 50%, you could have a reassessment. So we're looking at a possibility of a -- I haven't come up with a clever tax name yet -- but the parent would transfer it out to everybody back in their own names as tenants in common, and then immediately put it back into a second LLC, which if it works, would let the parent then transfer the second half at the parent's death without a change. And you get the extra bonus of getting a step-up in the basis for capital gains on that half. It sounds complicated, it is. But if it works, it will be a pretty clever work around and it will be more simply explained. I can draw this out diagrammatically much easier than I can explain it. I hesitate to go into any greater detail on it yet because you know, we still haven't worked out the details. It's one of those things that work in theory, but we're not sure. There's a critical inflection point in that second contribution where I believe that it will reset the clock, so to speak, but we don't know.
Kiran Dhillon, SIG Commercial (29:30):
That's still really neat that you're already thinking ahead and coming up with all of these solutions. So in terms of the people who are listening to this today, I'm sure it's a very diverse group of people, somebody who owns one small property, people who own hundreds of units and everyone's situation will be very different, right? So what do you recommend that everyone do now to make sure that they are prepared for these upcoming changes with Prop 19?
Steven Sorell, Sorell Law Group (30:04):
It's a good question. I think that the first thing you have to do is try not to panic because there is this sense of urgency that's been created, 'I've only got six weeks left or 10 weeks left to do this thing and then everything changes.' Well, maybe it does. Maybe it doesn't. The first thing to do is assess what properties you have, what the difference is in their appreciation -- that is, if they're highly appreciated versus properties that haven't appreciated that much -- and think carefully about what your gifting plans are, anyhow. Maybe your children aren't ready to get the property, you're not ready to give away complete control, maybe you need the income still. So you have to really try and assess where you are without being unduly influenced by the change in law, because you want to have the reality of this guide you and not be driven by the tax side of it alone.
Steven Sorell, Sorell Law Group (31:09):
That's a serious mistake when people rush in and make important decisions based just on the tax consequences: 'I've got to avoid paying extra taxes!' Well, if it's not the right thing, it's not the right thing. So maybe if you need the income, but you're otherwise able to let go of some of the property, then the Intentionally Defective Grantor Trust is the right solution. If you are thinking about that more farsighted lead and you can let go of some of the property and the income, then the LLC, because those we know we can do for sure. And we can do the LLC even after February 15th and at least get half the solution done. And then you look at what's the tradeoff between keeping it around so that there's a step-up at death, which of course that may change too under the new administration, versus preserving the property tax basis. It's simple enough to pencil that out on a spreadsheet we built where we can drop in the numbers, come up with the appreciation factors that we expect will happen, and you'll start seeing where the decisions start to cross over. Because that fourplex, you know, maybe it does make sense to transfer because by golly, you have owned it forever and your kids are going to own it forever and let's get it in their hands now while we can keep that up property tax basis and not worry about the capital gains down the road.
Steven Sorell, Sorell Law Group (32:45):
There's one other category of people that should be looking at things. And that is, I have some clients that have quite substantial estates, they're well over today's generous level of $11.5 million per person. There may be a surviving widow, who's got $11 million or $14 - $15 million of exemption left because of a carryover and owns $25 million of property, and expects the exemption level to go down. Certainly if we have the Democrats win Georgia, you can expect very quick dramatic changes to the estate tax law. Even if they don't, you can still expect changes, it just won't be as dramatic or as quick. I don't like forecasting, but I'd say that there's a pretty good likelihood that something will change. If nothing else, the higher limits today do sunset in 2025. But there's a good chance that they will be reduced sooner and that the rates will go up. And so for people with large estates, it makes sense to start gifting property now, even if they lose a step-up. They want to get their estate tax base, their estate size down so that they minimize the estate tax that will be due when they die, regardless of what happens to the exemption. And certainly if they expect some decrease in it. And that is another category of owners that we've been able to help.
Steven Sorell, Sorell Law Group (34:29):
I want to close with just one final example of how the right kind of planning can help. I represented a couple of families that were related to each other that bought a piece of property on the beach, on the strand in Newport many years ago for the then exorbitant sum of $525,000. And we were able to show that it was bought initially as a partnership. And so each side was able to pass it down to their children, and to their children, and now the third generation. They're paying taxes based on a $700,000 or $800,000 valuation. They're paying $9,000 - $10,000 a year in property tax. The property is worth about $12 million. So if it gets reassessed, the taxes go up to like $150,000 a year for a vacation house. That would be a problem. However, because we are relying on partnership law, entity transfer laws, it doesn't matter what happens with Prop 19 as long as they keep it owned in this partnership and it never changes from 50/50, they can keep passing it down from generation to generation and the property taxes will go up 2% a year. That's it. So there are ways with foresight and planning that you can tame the beast.
Kiran Dhillon, SIG Commercial (36:13):
Got it. Well, that's great. Thank you for sharing that. It seems like there are a lot of moving pieces. We have property taxes, we have capital gains taxes, we have estate taxes, and the question of how are you going to hold the property. So I would highly encourage everyone who's listening to this to reach out to Steve, reach out to your CPA, whoever your trusted advisors are and just get educated on this issue because like you said, if you have the proper planning, you can avoid a lot of these issues down the road. Steve, if anyone has questions about their particular situation and they want to reach out to you, what's the best way for them to do that?
Steven Sorell, Sorell Law Group (36:50):
The best way is to either call or email. Telephone number is (626) 792-8600 or email firstname.lastname@example.org. We are here, we are in the office every day. And thank you very much for making this available, giving me this opportunity to share. I hope people are now a little bit more aware of some of the issues and the choices that they have available. As I said, this was something of a stealth campaign. I started off mentioning that Prop 15, the Split Roll Initiative, had over $50 million spent by each side, promoting and defeating it. And it was narrowly defeated, 51 to 49. That close, you can bet it'll be back in some other form. Prop 19 proponents spent over $50 million and the opponents of it spent $320,000, which in California is enough to reach what a dozen people? Sadly, one of the leading supporters of Prop 19 was the California Association of Realtors. While they will sometimes say that they supported this because it makes it easier for the over 55 generation to change properties, their own website actually says differently. The CAR website says Prop 19 will open up tens of thousands of housing opportunities, making homes more readily available for first time homeowners in California. And, so they are counting on the fact that the disruption to the parent-child transfer will cause a lot of people to sell their properties. That is really what's behind this.
Kiran Dhillon, SIG Commercial (39:20):
Well, thank you so much, Steve, again for coming on and sharing your knowledge. This has been really great.
Steven Sorell, Sorell Law Group (39:30):
Well thank you so much. And, you know, I am sure that your clients can reach out to you also to get a hold of me. You are a total wealth, a source of all kinds of information and fount of wisdom in this marketplace. And I know from my workings with you, how knowledgeable and dedicated you are to your clients. So, I'm happy to be associated with you and try and help you and your clients out.
Kiran Dhillon, SIG Commercial (40:01):
Thank you so much. I appreciate that.