Asset Protection for California Real Estate

By Robert J. Mintz, J.D Ll.M (Taxation)

Many of our California clients are seeking an asset protection plan to protect substantial equity in their homes or investment properties. This is particularly true in the costliest areas of the San Francisco Bay Area, Los Angeles and San Diego.  What is the best asset protection strategy for protecting a residence in California?  How should ownership of investment properties be structured to create the highest level of asset protection?

In a number of respects protecting California real estate presents legal challenges. Proposition 13 looms over every transfer of property and must be successfully navigated to avoid sometimes disastrous property tax increases. The California Homestead Exemption is low compared to home values, often exposing a significant portion of the equity in a home to potential judgment liens.  Traditional  LLC’s, often used for ownership of California investment properties, are subject to veil piercing, foreclosure and relatively high state taxes.

In this article we will address the impact of Prop 13 on asset protection for California real estate.  We will highlight the key issues and the legal solutions which can be effectively employed. In subsequent articles on California asset protection we will dig in greater detail into the advantages and dangers of LLC’s for protecting investment  property.

Goals of Real Estate Asset Protection

Asset protection for a residence, or a rental property, usually involves a change in the manner of holding title to a property. The property may be transferred into a specially  designed trust intended to hold that specific property. Or, other entities such as Limited Liability Companies, Family Limited Partnerships or corporations may be the best vehicle, depending on the specific legal and tax considerations of the client.

Trusts and other entities are intended to create particular legal and business advantages for the property owner through favorable tax treatment, estate planning advantages and a reduction in liability exposure. In addition to legal entities,  there are contract arrangements such as leases, mortgages, options and other security interests which may legally alter  or transform ownership rights in an effective manner.  The ability to legally convert the nature of ownership rights while retaining the requisite degree of control and enjoyment is at the heart of asset protection planning for real estate.

Impact of Prop 13 on California Asset Protection Planning

And that’s where we bump into Prop 13.  It is precisely because asset protection involves a change in an owner’s legal relation to a particular property that California’s Prop 13 must be considered. If that change is too significant it will not work for purposes of Prop 13. Not enough change and the asset protection benefits may be endangered.

In general, Prop 13 limits annual property taxes to approximately 1%  of the assessed value of a property.  Broadly speaking, the assessed value is the value at the time the property was purchased (plus allowable increases of approximately 2% per year).   The property’s current market value is not considered. Appreciation in value is not subject to tax.

For example, an individual who purchased a property in California in 1980 for $100,000 has annual property taxes of about $1,000 (  plus certain allowable increases). Even though the market value of the property has increased over the years, a reassessment based on this  increasing value is specifically prohibited by Prop 13. That’s what the law was intended to accomplish. It is only when there is a change of ownership on the property that the property is permitted to be reassessed at the current value.  If the property in this example is sold in 2018 for $1 million, the annual taxes can then be increased based on the market value.  For this buyer taxes would increase from $1,000 to about $10,000 per year*.  Since the 2018 Tax Act limits the deductibility of state and local taxes to a maximum of $10,000, the actual cost of increased property taxes is that much more painful.

What is a Change of Ownership?

Certainly a sale of property is considered to be a change of ownership, permitting a reassessment of the property value to market value. However, a challenge in asset protection planning for California real estate is that the law considers many transfers of property- other than outright sales- to be a change of ownership subject to reassessment.  Transfers to a trust or LLC or other legal entity may constitute a change in ownership. The   same is true with a  gift of property or granting to others a significant beneficial interest. Similarly, a change in control over a property or a shift of  economic interests, far short of an actual sale, may be a legal change in ownership for purposes of Prop 13.

Transfers to Trusts

.For example, the law states that a transfer of property to a trust is a change of ownership at the time of the transfer. However, certain transfers such as to a revocable trust, which do not impact the beneficial ownership of the property  are exempt from the rule. Transfers to an irrevocable trust  which create present interests in beneficiaries will be a change of ownership.  Further exemptions can apply to transfers to irrevocable trusts based on the type of property and the relationship with the beneficiaries**

Transfers to Legal Entities

As with trusts, the general rule for transfers to legal entities is all inclusive. The transfer of any interest in real property to a corporation, partnership, limited liability company, or other legal entity is a change in ownership of the real property interest transferred. Relief is provided in the exceptions which permit a transfer to an entity if the property owners maintain their same proportionate interests after the transfer. A and B are equal co-owners of an investment property and they transfer it to an LLC. As long as A and B each own 50% of the membership interests in the LLC after the transfer the property will not be considered a change in ownership. If instead, A and B receive 49% each and C receives 2% the entire property will be reassessed. Similarly, a change in ownership occurs if an individual or entity acquires a greater than 50% interest in the LLC.

California Asset Protection Strategies – Residence and Investment Properties

Because of the impact of Prop 13, asset protection strategies for California real estate are usually designed to avoid the change of ownership rules.  Depending on the particular circumstances, transfers to a trust or legal entity must fit within the stated legal exemptions to avoid a reassessment.

Protecting a Personal Residence

A  Personal Residence Trust is a popular asset protection strategy for protecting the client’s home from liability risk.  If the property has appreciated since the date of purchase, a reassessment to current value will cause an increase in property taxes. For this reason, the PRT must be designed to allow the client to maintain a sufficient beneficial interest to avoid Prop 13 while limiting ownership rights for asset protection purposes. This can be accomplished by providing that the client retains control and occupancy of the property. Rights and restrictions can be varied based on the client’s needs and whether the PRT is intended to create estate tax savings in addition  to asset protection.

A Personal Residence Trust can be qualified for tax purposes or non-qualified. A qualified PRT  (QPRT) is often used as an estate planning strategy to gift  interests in the residence to family members. The goal in the QPRT is to avoid estate taxation on future appreciation in the property but the grantor’s rights over the enjoyment of the property are limited by restrictions in the Internal Revenue Code. A non-qualified PRT (NPRT) is used when the client’s estate is less than the exemption amount so that no estate tax savings are necessary. In these cases the transfer to the NPRT will be designed so that the transfer is not considered a completed gift for estate tax purposes and the grantor will be permitted to maintain substantially greater freedom over the property. For income tax purposes the PRT is treated as a Grantor Trust and all items of income and expenses are reported directly on the tax return of the grantor. None of the tax benefits which are still available for mortgage interest, property taxes and gain exclusion will be affected by the PRT.

Protecting Investment Properties

Family Savings Trusts and Private Retirement Plans are often used in conjunction with Limited Liability Companies and Family Limited Partnerships to protect investment properties. The trusts for investment properties utilize the Prop 13 exemptions by carefully delineating the beneficiaries to avoid non-exempt beneficiaries. Alternatively, the term of the trust can be limited so that the client retains a substantial reversionary interest as in a term trust or a Private Retirement Plan.

LLC’s  and FLP’s are legal entities are the most likely vehicles for holding real estate investment property. As noted, the transfer into the entity will not be considered a change of ownership if the entity is owned in the same proportions as the property.  From an asset protection standpoint advantages are created by transferring property into an LLC or FLP.  California law generally protects LLC members and limited partners from liabilities arising inside the entity. Further, California law prohibits a creditor of a partner or member from seizing the property owned by the entity. Instead, the remedy of the creditor is a charging order or foreclosure of the ownership interest. To protect ownership interests in an entity from charging order or foreclosure ownership interests can be transferred to an asset protection type of trust such as a Family Savings Trust as long as the Prop 13 exemptions are built into the trust.

*The stakes involved are significant. Despite periods of steep price declines, in most parts of the state, prices for residential and commercial real estate have climbed relentlessly. In 1977, one year before Prop 13 was passed by the voters, the median home price in California was $47,000. As of  2018 that amount had grown to $655,000.

**An exclusion applies for transfers to children (or from children to parents) of a primary residence of any amount and for other property not to exceed a lifetime amount of  $1 million. Also, grandparents may transfer properties subject to these limitations to grandchildren under certain conditions. Unlimited transfers between spouses are permitted.