Christopher Karachale, Senior Counsel at Hanson Bridgett in San Francisco, advises businesses and individual on a wide range of tax issues, including federal, state and local tax issues.
This presentation discusses California property tax issues and both reviews the general rules, but also provides an update on current issues for each particular topic.
As a threshold matter, California state property tax law is one of the most confusing areas of tax law. Indeed, there are a number of instances where the rules seem simply nonsensical and perversely counter intuitive. Most importantly, there is a fundamental tension between the property tax rules and income tax rules under the R&TC or the IRC. Clients who are familiar with income tax rules often miss or are uninformed about the property tax ramifications of their transactions.
Hello. My name is Christopher Karachale. I am senior counsel at Hanson Bridgett here in San Francisco. I advise businesses and individual on a wide range of tax issues, including federal, state and local tax issues.
Today I’m going to discuss California property tax issues. I’ve tried to create a presentation that both reviews the general rules, but also provides an update on current issues for each particular topic as well as my own comments on what I am seeing in my practice.
As a threshold matter, I want to point out (as you already know) that California state property tax law is one of the most confusing areas of tax law. Indeed, there are a number of instances where the rules seem simply nonsensical and perversely counter intuitive. Most importantly, there is a fundamental tension between the property tax rules and income tax rules under the RT&C or the IRC. Clients who are familiar with income tax rules often miss or are uninformed about the property tax ramifications of their transactions. However, there is an odd beauty to the rules and I hope I can point some of that beauty out in the next 50 minutes.
Today we are going to discuss 5 topics
Establishing base year value under Prop 13 and changes of ownership
Next we’ll discuss the largesse of Prop 8 where the property tax rules allow property owners a “do over” in assessing values
Third we’ll discuss when the base year value is set
Fourth we’ll consider the important distinction – especially for businesses – between the property taxation of personal property and real property
Finally we’ll address the rules of reassessment in new construction and supplemental assessments
So let’s begin with base year value
As Jon Coupal just discussed, on June 6, 1978, California voters approved Prop 13, an amendment to the California Constitution which changed the manner in which property was taxed. Previously, California would assess tax against property at its current market value on a yearly or other regularly reassessment regime.
Prop 13 changed that by rolling back most local real property assessments [click] to their 1975 market value levels. Under Prop 13, properties can only be reassessed to current market value upon [click] (1) a change in ownership or (2) the completion of new construction. We’ll discuss each of these.
Prop 13 also limited the property tax rate to 1% of the assessed value of the property, plus the rate necessary to fund local voter-approved bonded indebtedness.
So let’s discuss base year value under Prop 13
If a property has not been sold or undergone new construction since February 1975, it has a 1975 base year value (against which tax can be assessed)
For example [click]
Let’s say you have owned a building since 1970. [click] the base year value is set as of that 1975 current market value – for example $100,000.
Now if the property is sold in 2012 – that is a change of ownership occurs- the base year value resets [4 clicks] to the FMV. Say to $2 million.
Let’s discuss change of ownership:
A few important concepts to bear in mind, especially in the business context:
Under R&TC section 64(c), when an entity acquires direct or indirect ownership or control of more than 50 percent of the voting stock of any corporation or a majority interest in any partnership, the purchase or transfer of the stock or other interest is a “change of ownership” of the real property owned by the corporation or partnership.
This change of control rule can lead to some unexpected results. Consider a tax-free reorganization under IRC section 368 where one entity acquires control of the stock of any other corporation. The exchange is tax-free to the shareholders of the acquiring and acquired entity for federal income tax purposes. However, FOR PROPERTY TAX PURPOSES, this indirect change in ownership of the entity represents a change in ownership and the underlying property of the acquired entity may be subject to reassessment.
So need to be careful: what may be a tax-free income tax event may not be a tax-free California property tax event.
This could be true in the partnership context too. Generally, a transfer if property to an LLC in exchange for an interest in that LLC is tax-free for income tax purposes under IRC section 721. However, for PROPERTY TAX purposes, that transfer is a change of ownership under R&TC code section 60. That means a taxpayer who transfers a highly appreciate piece of property to a partnership may end up losing his low base year value – and costing the partnership more money in property taxes.
One final point on importance of change in ownership rules. We are here to talk about property tax. However, a recent case decided by a California Court of Appeals may have important implications for the change of control rules in the context of the documentary transfer tax. Remember that under R&TC code section 11911, cities and counties can impose a tax when “realty is sold.”
In 926 North Ardmore Avenue LLC v. County of Los Angeles, decided on September 22, 2014, a California Court of Appeals ruled that the change of ownership rules could be applied in the transfer tax context and the transfer tax could be imposed upon a change of control in a partnership holding real property.
There are a number of exceptions to the change in ownership rules. We will discuss two that frequently occur and that I get questions about regularly in my practice
The first is the transfer of property between a parent and child or grandparent and grandchild.
RT&C section 63.1 excludes from the change of ownership rules transfers of real property between parents and children and transfers of real property from grandparents to grandchildren, providing that all the parents of the grandchildren who qualify as children of the grandparents are deceased as of the date of transfer.
Two types of transfers excluded:
Transfers of primary residences (no value limit)
Transfers of the first $1 million of real property (other than the primary residences).
Note that this is an exclusion that can be gradually used up
One important consideration in the parent/child exclusion. It generally does not apply to transfers of interests in legal entities. This is something we see a lot. So, where a parent transfers property to a partnership with her children, that transfer is not excluded under R&TC section 63.1. The property will likely be reassessed since the transfer was to the partnership, rather than directly to the children (notwithstanding their status a partners)
Don’t forget the a claim for reassessment exclusion must be filed with the appropriate assessor’s office within 3 years of the transfer.
Another important exclusion from change of ownership – especially in San Francisco – involves a transfer rather than an exclusion. Propositions 60, 90 now codified at R&TC section 69.5 allow individuals over the age of 55 to transfer their base year value of their home to a replacement dwelling of equal or lesser value, provided the replacement home is acquired within 2 years after the sale of the original property.
Note that a replacement residence generally need to be acquired in the same county. Prop 90 was supposed provide reciprocity among counties. However, as of September 2013, only 9 California counties have allowed for inter-county base year value transfers. In the Bay Area, that includes San Mateo, Santa Clara, and Alameda, but not San Francisco.
Some important considerations for this transfer rule:
R&TC section 69.5(b)(7) provides that the transfer can only be used once. Homeowners need to be very careful about the cost of the replacement home. This is where I have seen issues.
In general, “equal or lesser value” means 100% or less of the “market value” of the original property. Note that the market value of a property is not necessarily the same as the sale or purchase price. The assessor will determine the market value of each property. If the market value of your replacement dwelling exceeds the "equal or lesser value" test, no relief is available.
Finally, once the property’s base value is set, how can it increase?
Under Prop 13, the base value may be annually increased at a rate “not to exceed 2% of any given year as shown in the consumer price index or comparable data for the area under taxing jurisdiction”
So – at least in theory – this is how a home’s adjusted base year value could increase: Refer to slide
However, recently, given the issues with low inflation, this 2% cap has not always been met.
Each year the BOE provides notices the applicable adjustment factor. In most years, inflation has exceeded 2%. In fact, before 2011, there had been only 5 years (since the passage of Prop 13) in which the adjustment factor dropped below 2%. However, for 2010-11, 2011-12 and 2014-15, the inflation factor announced by the BOE has been less than 2%, given the reduced inflation.
What does this mean – your clients need to check to ensure that their base value has not increased beyond the Prop 13 limit. For 2014-2015, the inflation factor is forty-five one-hundredreths of a percent.
Let’s talk next about a topic that, until 2008 didn’t really affect very many taxpayers. In November 1978, voters passed Proposition 8, which allows a temporary reduction in assessed value when a property suffers a “decline-in-value.” We have now pretty much recovered from the 2008 depressed real estate market, but Prop 8 will be a real benefit to taxpayers again if we suffer another real estate market correction.
So how does Prop 8 work:
When the current market value of a piece of real property is less than the current assessed factored base year value as of the lien date, then Prop 8 allows a temporary reduction in the assessed value.
Importantly, the temporary reduction does not reset the base year value of the property. The decline in value is a one year temporary adjustment. If the property increases and is equal to or greater than the factored base year base year value, then the factored base year value is reset and the annual increase in base year value will again be limited to 2%.
This is confusing so let’s do an example. Assume in year 1 that a property has a FMV and an adjusted base year value of $500K.
[Click] assume in year 2, the market value increase to $550K.
[Click] that is good!
[Click] under normal Prop 13 rules the adjusted base year value can only increase 2%, or to $510K
[Click] that is okay.
[Click] Now assume in year 3, the market value falls dramatically to $480K
[Click] that is bad!
[Click]However, under Prop 8, the base year is temporarily reset to the decline in value, or $480K
[Click] that is good!
Finally, Let’s move to year 4
[Click] Assume, the market value has increased again, now to $540,000 (or $10,000 less than the $550,000 it was in year 2)
[Click] that appreciation is good
[Click] Now the 2% cap under Prop 13 kicks in again. The maximum year 4 adjusted base year value can be no more than 2% of what would have been the year 3 value if the property had continued to appreciate (and Prop 8 had not imposed the reduced value)
[Click] that is good!
So what are the takeaways here: when market values are depressed, Prop 8 provides relief to homeowners. The assessors are supposed to check Prop 8 declines in value, but homeowners can also apply directly to the assessor to request a reduced value assessment.
Next we’ll discuss when property, either personal or real, is subject to property tax.
January 1 sets the assessed value of property. On that date the factored base year value is compared with the Prop 8 (decreased value) of the property and the lesser of those two values is subject to tax. The person “owning, claiming, possessing, or controlling the property on the lien date” is subject to the 1% tax allowed by Prop 13.
Of course, as with so much else in the California property tax area, it is not so simple – this value is set for the “fiscal year” which runs from July 1 though June 30 of the following year. So everything is delayed by 6 months.
There are a number of other dates that are important for assessment. The most important is the appeals process (if a property owner disagrees with the assessed value). It runs from July 2 to September 15, or July 2 to November 30, depending upon the county in the property is located.
Now let’s say the assessor missed certain property as part of his or her assessment from July 1 through June 30.
R&TC section 531 requires the assessor to immediately add an escape assessment and any applicable penalty and interest to the roll prepared, or being prepared, in the current assessment year.
Generally an escape assessment will be imposed because of (1) an error in value judgment, (2) clerical or calculation errors, or (3) errors caused by the failure of property owners to correctly report a change in ownership.
Finally, let’s discuss the statute of limitations for assessments.
If the assessor fails to properly assess value (though his or her own error) then the SOL is 4 years after the assessor’s fiscal year.
The same 4 year statute of limitations rule applies to escape assessments.
However, if the property owner failed to file the necessary change of ownership forms with the assessor, the statute of limitations is 8 years. This is where we see the issue come up.
Going back to the example of a tax-free reorganization under IRC section 368, I have seen entities reorganize but not file the necessary change of ownership forms (including BOE-100-B). Often the particular assessor will not realize that there has been a change in ownership. However, in such a case, the assessor has 8 years to make a reassessment, plus a variety of penalties.
Next we’ll discuss the difference between real and personal property.
This is a key distinction since real property is subject to the limits of Prop 13, while personal property is reassessed each year under the pre-Prop 13 regime.
So what is real property for property tax purposes:
[Click] Land [click]
[Click] Improvements [click] including buildings and structures
A few points about fixtures. Fixtures generally include property which was originally personal property, but has been physically or constructively annexed to realty with the intent that it remain annexed definitely. The example here is an air conditioning unit.
Also, there are some distinctions between fixtures and other kinds of real property. There are some important subtleties: for example – fixtures are considered a separate “appraisal unit” when determining the Prop 8 declines in value – that is they are separately appraised.
In contrast to real property, personal property is generally subject to property tax, but without the benefits of Prop 13. By statute, personal property is anything that is not real property.
Examples of taxable personal property include:
[Click] equipment [click] and
[Click] supplies [click]
The distinction between real property and personal property can’t be emphasized enough:
Personal property is subject to the same basic tax regime (that is, it can be taxed at a maximum of 1% of the full cash value of the personal property). However, there are a number of distinctions.
Most importantly, personal property is appraised at market value annual. It is not assigned a base year value.
Like real property, a number of types of personal property are exempt from property taxation:
[click] business inventory [click] meaning all items of personalty that become part of or are themselves a product that is held for sale or lease in the ordinary course of business.
[click] personal effects [click] this includes household furnishings and pets; and
[click] intangible personal property [click]
There are a number of rules regarding the taxation of intangible property generally that are beyond the scope of this presentation but should be kept in mind.
Finally, don’t forget about the BOE Form 571-L.
Since personal property is assessed yearly, the assessor needs to obtain values. Business personal property is generally assessed with the BOE Form 571-L sent by each assessor.
The statement allows taxpayers to declare all taxable business property (including real property) located within the county on January 1 (the lien date).
Failure to file a BOE 571-L can subject the taxpayer to penalty of 10 percent of the assessed value of the business property.
Our last topic will review issues related to reassessment on newly completed construction
Recall the basic Prop 13 rule for reassessment: the base year value is set either when there is a change of ownership or the property is “newly constructed.”
So what is new construction:
(1) Any substantial addition to land or improvements, including fixtures.
(2) Any physical alteration of any improvement, or a portion thereof, to a "like-new" condition, or to extend its economic life, or to change the way in which the improvement, or portion thereof, is used.
(3) Any substantial physical alteration of land which constitutes a major rehabilitation of the land or changes the manner in which it is used.
(4) Any substantial physical rehabilitation, renovation or modernization of any fixture that converts it to the substantial equivalent of a new fixture or any substitution of a new fixture.
With newly completed construction, a new base value is established only for that portion of the property which is newly constructed, whether it is an addition or alteration. The taxable value of the total property is determined by adding the full value of the new construction to the taxable value of the preexisting property.
So let’s do an example:
[click] assume a home was built in 1970, at which time its base year value was set, let’s say at $150,000.
[click] In 2014, the owner undertakes an addition with a value of $75,000.
[click] Upon completion, the total base year value of the home is the sum of the original base year value, plus the base year value of the new addition, or $225,000.
An important distinction exists between new construction and normal maintenance. The former is subject to reassessment while the latter is not.
This seems like a pretty straight forward distinction, it is clearly something the BOE is worried about. In Letter to Assessors No. 2014/039, dated August 28, 2014, the BOE helped clarify what constitutes normal maintenance. Previously, the BOE had taken the position that routine kitchen or bathroom remodels did not constitute new construction. After the publication of a new Assessors Handbook regarding newly constructed property, there was some concern about whether that rule still applied.
The letter makes clear that “remodeling activity consists of replacing or substituting an item that is fundamentally the same type or utility for an item that is exhausted, worn out, or inadequate. Replacements made under these circumstances are considered normal maintenance which do not make the improvement, or a portion thereof, substantially equivalent to new and are not considered assessable new construction.” This is good news for homeowners undertaking remodels.
Let’s consider a property that is still not finished on January 1. In that case,
[click] the property is appraised at its full cash value, even if not completed. This value is not the base year value, just a temporary value until the property is completed.
[click] then, on the date of completion, the entire property is reappraised at its full cash value.
[click] note that the date of completion generally means the date when the property is available for use by the owner. "Available for use" means that the property, or a portion thereof, has been inspected and approved for occupancy.
Finally, let’s discuss supplemental assessments.
Upon a change of ownership or completion of new construction, the assessor must determine a new base year value for the property. Remember that normally the base year value is set on January 1. On the change of ownership or completion of construction, the new base year value is set usually by the current market value (under Prop 13 principles). [click]
At that time, the assessor will send one or more supplemental assessments. [click] The supplemental assessment just takes into consideration the additional base year value arising from the new current market value of the property.
Current California Property Tax Issues
PRESENTAT ION TO
CalCPA Real Estate Conference
Property Tax: Case Study
Christopher Karachale, Hanson Bridgett LLP
October 29, 2014