ADUs – One Way to Address Prop. 19’s Inheritance Tax Basis Increase
By Mercedes Shaffer I Published in AOA Magazine
The recent passage of prop 19 eliminates the parent-child and grandparent-grandchild exclusion from reassessment for properties other than a “family home.” As of February 16, 2021, if you transfer your property to your children (or, grandchildren, if the parents are deceased), via any means (gifts, sale, hybrid, estate plan after your passing, etc.) that property will be reassessed to full market value for annual property tax purposes.
Prior to Prop. 19’s passage, a parent could transfer the parent’s primary residence of unlimited value, and up to $1,000,000 of assessed value of other property - vacation home, commercial property, rental properties, investment properties and so on - to their children and such properties would retain the low adjusted base year value for property tax purposes. Meaning that the property taxes would stay substantially the same after the transfer to children. Now, unless both the parent and the child will use the property as his or her primary residence, the exclusion is terminated.
Thus, children inheriting property from their parents (other than the primary residence), are very likely to see a substantial increase in property taxes on such inherited property. Your children will no longer inherit your “prop 13 basis” as had been California law for nearly 25 years. Many families fear that this tax increase, which can be quite substantial if a family has owned their property for a long time, will force the children to sell a family treasure or disassemble a real estate portfolio that took a lifetime to build.
The exception to the new rules is if your heir(s) take a home as their primary residence, but even then there’s a limit of up to one million dollars above the current assessed value. Anything beyond that is re-assessed and added to the tax basis. As such, even if a parent transfers his or her primary residence to their child who also uses it as a primary residence, there could still be a crippling tax increase depending on the assessed value of the property. All investment property, even if the child plans to live in it, will be reassessed to full current market value upon transfer. This is potentially the largest property tax increase in California history.
This could mean that your children will need to sell the home they were born and raised in, sell a treasured vacation house that has been in the family for generations, or be forced to liquidate a portfolio of investment properties that was carefully amassed over a lifetime. This will hurt families financially and emotionally, as many of these homes house childhood memories and longstanding family traditions, and/or are an important source of income for heirs.
The hope amidst this government tax increase could be in the new rules around Accessory Dwelling Units (ADUs). ADUs are small, secondary residences built on a residential-zoned single-family home or multi-family building, and could be the solution to keeping real estate in the family. An ADU can be a stand-alone or attached structure that is added to a property, or the conversion of an existing space such as a garage, storage room, basement or attic.
While the impetus for the state allowing ADUs to be built is to try to create more affordable housing, this relatively new law could also help the heirs of property owners to offset the increased tax basis by allowing them to add rental income to the property.
By adding an ADU to your primary residence, secondary vacation house or investment property, you have the opportunity to create additional income that could offset tax increases and add value to the property.
Part of this good news is that you don’t need to rent out the ADU if you don’t want to. While you may not need this additional income right now, and you may not want a tenant renting an ADU at your primary residence, by taking advantage of the current law and creating a permitted ADU on your home you are opening up the option for your kids to be able to derive extra income from the property when they inherit it.
Future generations would even have the option of living in the ADU and renting out the home or even having one sibling living in the primary residence and one in the ADU. Same for a secondary vacation house that perhaps has been passed down from one generation to another. Converting a space into a rental or adding an ADU allows for (additional) income from the property which could make it financially feasible for the heirs to keep the property.
Families have worked hard to acquire their real estate portfolio, and many parents take joy in knowing that their properties will be passed down to their children. Building an ADU is one way that parents can offset the increased tax bases so that the kids aren’t burdened by taxes that they may not be able to afford.
Mercedes Shaffer is an agent with Pacific Sotheby's International Realty and specializes in investment real estate and 1031 Exchanges. For help with buying or selling investment property, Mercedes can be reached by phone at 714.330.9999, by email at InvestingInTheOC@gmail.com or visit her website at www.InvestingInTheOC.com. DRE 02114448.