Estate, Gift, Income, and Property Taxation & Planning Tax Returns Articles
Property Taxes – Trust Transfer Analysis

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Non Pro Rata Distribution of Trust and Estate Assets

A trustee or executor can make a transfer of trust or estate assets to beneficiaries in other than pro rata fashion among the beneficiaries, without causing a change in ownership for California property tax purposes and thereby a reassessment of the real property in question.

Most Trusts and Wills, as well as the default California law provide for the ability to make non pro rata distributions of real property to beneficiaries. As a result, California law provides for an exclusion from reappraisal for transfers between parents and children and, in certain cases, between grandparents and grandchildren.

One common form of family transfer is by inheritance when a parent dies and leaves the property to a child(ren). The two most common forms of inheritance, other than by intestate succession where there is no will or other documents, are by trust or by will.

A pro rata distribution of the assets of an estate means that each beneficiary receives an equal portion of each asset in the estate.

A non pro rata distribution means that each beneficiary  receives an equal proportion of the entire estate but not necessarily of each asset.

Under California law, trustees have non pro rata distribution powers for the assets of a trust. The use of non pro rata distribution by a trustee can have a significant impact on the property taxes to be paid by a child or children taking title to the real property in an estate.

Example 1

Jane Smith, surviving parent, dies and leaves the family vacation home, which she has owned for 40 years and has a Proposition 13 base year value of $100,000, to her three children. The home is free of debt. Jane’s living trust provides for distribution in equal shares, i.e. pro rata, with each child inheriting one-third of the home. The transfer by inheritance from Jane  to her three children is covered by the parent-to-child exclusion and there is no reappraisal. After the estate is distributed, Jane’s son decides to buy out his two brothers by taking out a new mortgage for two-thirds of the $900,000 current market value of the home. The son will keep his  mother’s low, Proposition 13 base year value as to one-third of the home’s assessed value. However, the buy out between siblings is not parent-to-child and is therefore subject to reappraisal. The reappraisal will be based on two-thirds of the current market value of the home at the time of the buy out and will add approximately $400,000 in new assessed value, raising the purchasing son’s tax bill from the mother’s old amount of approximately $1000 per year (including direct charges) to approximately $10,000 per year.

Example  2

Joan Smith, the surviving parent, dies and passes her estate through a trust to her three children in equal shares. The estate, after all expenses are paid, consists of the family vacation home, which he has owned for 30 years and has a Proposition 13 base year value of $150,000 and brokerage accounts in the amount of $600,000 each. Her son, George, wants the vacation home and his two sisters each want only liquid investments. The trustee does a non pro rata distribution wherein each daughter gets $600,000 in cash and George gets the home which is worth $600,000 in today’s market. George is entitled to a complete parent-to-child exclusion because the non pro rata trust distribution by the estate is not considered “buying out” his sisters. George  keeps his mother’s Proposition 13 base year value thereby saving approximately $4,000 per year in property taxes.

Trusts and estates can borrow money against the real property to be distributed if there are insufficient other assets in the trust in order to qualify for a non-pro rata distribution. The child who wants the real property takes it subject to the loan. However, the child who takes the real property cannot be the lender because the loan funds are distributed to the siblings which constitutes a sibling buyout.

Transfers Through Medium of Trust

Transfers through the medium of a trust require looking through the trust to determine the beneficial owner of the property. For example, a transfer to a revocable trust that becomes irrevocable on the death of the deceased spouse or registered domestic partner will be excluded under the trust exclusion in Rev & T C §62(d) and the interspousal transfer exclusion in Rev & T C §63 or domestic partner transfer exclusion in Rev & T C §62(p)–(q) if the surviving spouse or partner enjoys the exclusive right to trust income, regardless of the trustee’s power to distribute principal. Property also will be transferred to the spouse or partner to the extent that the spouse or partner has a power of appointment over trust principal.

NOTE: The power of the trustee to distribute principal among spouse and issue does not destroy the interspousal transfer exclusion because issue do not share a present interest with the income beneficiary; the issue’s interest is a “mere expectancy.” See Estate of Johnson (1961) 198 CA2d 503, 510; Estate of Canfield (1947) 80 CA2d 443, 451.

If the trustee has the power to sprinkle income to the surviving spouse or registered domestic partner and issue, the trust may not qualify if “issue” includes grandchildren who have at least one living parent, but the trust will qualify under the interspousal or domestic partner and parent-child exclusions if the sprinkle power is limited to the spouse or partner and children. 18 Cal Code Regs §462.160(b)(1).

Notice: If you are concerned about property tax increases following the death of the first spouse, when taxes could create a material financial burden, and the bypass trust will own real property, the surviving spouse should have the sole income interest in the bypass trust. This objective is inconsistent with the federal transfer tax planning goal of minimizing the survivor’s estate by granting the trustee a “sprinkle” power over income. To reconcile this goal, consider allocating the real property to the QTIP trust.