Often a client wishes for one or more of his children to receive the family home or other real property as part of their inheritance, while retaining the parents’ current property tax assessment. This is known as the parent-child exclusion. When a property qualifies for this exclusion it means that the child can assume the parents’ typically very low property tax basis on the parents’ personal residence (of any value) and of other property up to $1 million dollars of the parents’ current assessed value. This is referred to as an “exempt transfer” and often can make a huge difference between a child’s ability to retain the real property and having to sell it.
A problem arises when the parents’ Trust simply states that the entire estate is to be divided equally among the children – sometimes referred to as the “share and share alike” provision. To the assessor “equal” means equal, therefore if one child wishes to receive real property that exceeds their equal share of the estate then the assessor will not recognize the full parent-child exclusion. Instead the assessor will disallow the exemption to the extent the value exceeds the child’s share of the Trust. Moreover, the child who receives the property cannot simply pay the other children the difference, as the Board of Equalization (“BOE”) that oversees assessments has consistently held that the source of funds cannot come from the child who receives the property. Instead in this scenario the Trustee must adjust the value of the assets by encumbering the real property with a note or loan from a third-party lender or another beneficiary. The problem with this post-mortem technique is it can be costly, difficult to obtain a third-party lender and cause delay in distribution.
So, how can this be resolved in pre-planning? One obvious way to pass along the parents’ property tax basis is to give the property as a specific gift to the intended child. However, this could mean that one child receives more value than the others and will likely result in a family rift. The other pre-planning method would be to have a Trust provision that grants your child or children, a “right of first refusal” to purchase only that share of the property which exceeds his or her distributive share. While it is not guaranteed, the BOE has indicated in an opinion letter that a Trust provision to this effect will qualify as an exempt transaction. Furthermore, the BOE opinion letter indicates that this is so even if the funds are received directly from the child and/or includes a personal promissory note from the child.
While the BOE opinion letter indicates that the full exemption would apply if the “right of first refusal” was granted to ALL children, the language in the Trust cannot appear to be a generic right of refusal. In concluding that such rights would be respected, the BOE stated that they would treat the right of first refusal provision as the testator’s specific intent to supersede the general intent of “share and share alike” or an “equal share” of the provision of the trust. As such, the attorney’s file should contain some documentation that such a provision reflects the settlor’s intent and is not boilerplate in nature.
When including a “right of first refusal” in your Trust you should consider the following points: (1) the acceptable source of funds for the purchase (i.e. from the child, a third-party commercial lender, or if acceptable, a promissory note from a child); (2) how the value of the property is to be determined because “costs of sale” are avoided in a private sale; (3) how disputes as to value are to be resolved (since the property not being marketed); (4) how expenses of the transfer are to be allocated; (5) will there be a formal escrow or title insurance; and (6) any time frame associated with the right, required notices, etc.
In this age where estate tax sensitivity may not be a driving force for many clients, the ability to preserve the current assessed value of real property may be the most significant tax issue addressed in your Trust. At Moravec, Varga & Mooney we believe that it’s important to help our clients plan for all contingencies. If you would like to schedule a free consultation to see how we can help you, please give us a call at 626-460-1763 or send us an email.