(Note: This article is general in nature and is geared towards California properties. Seek professional legal and accounting advice before making any decisions.)
It used to be that rental properties could be passed down for generations, as a wealth transfer technique. But now, our California government has changed the property tax aspect of that approach with the passage of Prop 19. This law has potentially severe financial consequences for children who inherit real property from their parents, because it considerably limits the availability of the parent-child exclusion for purposes of real estate tax assessments and resulting property-taxation.
Before and After Prop 19
Prior to Prop. 19, which took affect in 2021, parents could transfer a rental property with up to $1 million of the assessed value being exempt from the increase in property taxes. This was regardless of the property's use by the children.
For generations, California families used this law to build family wealth that could be passed on to future generations. Apartment buildings, townhomes, and single family homes were often purchased, refinanced, and more properties acquired, generating rental income as well as increased net worth.
However, while these wealth building strategies can still effectively take place from a capital gains tax perspective, the impact of property taxation has changed dramatically. (Note: From a capital gains tax perspective, current law still is unchanged by Prop 19. Estates of decedents who die during 2025 have a basic exclusion amount of $13,990,000, which generally means no capital gains will be applied if the estate is less than that amount. If the home is sold, capital gains taxes are only due on any gains made since it was inherited.)
Property Tax Increase
While a primary residence might possibly be exempt from value reassessment due to the "Intergenerational Transfer Exclusion," this does not apply to rental properties. When a rental property is inherited, it is reassessed at its current market value, which can lead to a significant increase in property taxes. This can make it difficult for children to keep inherited rental properties.
For example, if the parents purchased a rental property in 1990 for $150,000, and the value of the rental property is more than $1 million when it is transferred upon the parents' death to a child, the parents' tax basis doesn't pass on to the child. Since the child will now have to pay property taxes based on the assessed fair market value, it can make cash flow negative and impact the child's decision to keep or sell.
Potential Strategies
There have been efforts to repeal the Intergenerational Transfer Exclusion but so far with no success. So, what can be done?
Your heirs will likely decide upon one of these choices:
- Keep it and pay the higher property taxes. Depending on the cash flow, your tax situation (i.e., depreciation and tax write offs), overall investment portfolio, and potential property value growth, it can make sense to keep the rental property. Of course, finances and taxes aren't the sole reason to sell or keep property, but they typically are key drivers.
- Sell the property. This might happen in any case, if heirs would rather have the cash (which might be excluded from capital gains). Further it might be the only viable option if heirs cannot afford any significant negative cash flow.
- Convert it to an LLC. The rules applicable to LLCs under the California Revenue & Taxation Code can provide a potential loophole for avoiding higher property taxes. However, the implementation of this strategy depends on when the property was acquired, appreciation, ownership structure of the LLC, rent control, and numerous other factors and rules that might apply.
- Make it your primary residence. This would be part of a fairly complex process, including evaluation of tax implications (especially for depreciation deductions), Section 121 exclusion (involving how long you've lived in a property and capital gains), what will be done with your existing primary residence, etc. However, this strategy can make sense in certain circumstances, such as downsizing, a more suitable location as you age, and if your rental property might be better suited to avoid any increase in taxes because it fits within the parameters of Prop 19's exemption for primary residences. On top of all these considerations, in order for your child to take advantage of your property taxes (i.e., the primary residence exemption allowed under Prop 19's Intergenerational Transfer Exclusion), your child would need to occupy the home as their primary residence within one year of inheritance.
Each of these strategies can be evaluated with your estate planning attorney, so that your estate plan can be optimally structured to meet your personal goals.
Experts in Estate Planning for Real Estate
At Mortensen & Reinheimer, PC we've crafted estate plans that have involved literally thousands of real estate properties! Let us put that experience to work for you in simplifying what can be a very complex process. We look forward to helping you! Please contact Mortensen & Reinheimer, PC at (714) 384-6053 to make an appointment, or use our online contact form.
About the author:
Tamsen R. Reinheimer, Attorney, is a Certified Specialist in Estate Planning, Trust & Probate Law (The State Bar of California Board of Legal Specialization). She has significant experience in all aspects of estate planning, trust administration, and probate. Contact Tamsen at tamsen@ocestateplanning.net.