The Big Move: I bought my home for $30,000, but now it’s worth almost $3 million. How can I avoid a massive tax bill?

Sincerely,

Preparing in Palo Alto

‘The Big Move’ is a MarketWatch column looking at the ins and outs of real estate, from navigating the search for a new home to applying for a mortgage.

Do you have a question about buying or selling a home? Do you want to know where your next move should be? Email Jacob Passy at TheBigMove@marketwatch.com.

Dear Preparing,

It’s never too late or too soon to strategize the best way to leave a sizeable inheritance to your loved ones. And your dilemma, in particular, clearly illustrates the challenges many longtime homeowners face when it comes to leaving their home to their heirs.

You’ve benefited from longstanding tax arrangements that have made it feasible to own a home as expensive as yours in a pricier coastal real-estate market. And it seems clear from your letter that your children wouldn’t be able to afford the property taxes that would come with such a property if they were to buy it themselves today.

Before I begin to answer your questions, I want to commend you on remaining clear-eyed about what your children will do with your home upon your passing. Too often parents assume that their children or grandchildren will want to inherit the family home to live in it. The reality is, especially if your children are grown, they likely have homes of their own and have no need to take another on, even as an investment property. If the past two, pandemic-ridden years have taught us anything, it’s not always easy being a landlord.

So I’m glad that you’re considering all possibilities — what the property-tax picture would be if your children did keep your longtime home, and what would happen in terms of capital gains taxes should they sell it after you pass.

Property taxes just got more complicated in California

Now, let’s address your first question. For those who live outside of California, a quick primer: Proposition 13 is a constitutional amendment in California that limited increases to the property taxes on homes throughout the state. Notably, a property could only be reappraised for tax purposes when a change in ownership occurred, when new construction was completed or if the market value declined.

But last year, another amendment that was approved by California voters, Proposition 19, changed key components to the taxation policy. While it allowed older or disabled homeowners or people displaced by natural disasters to transfer their existing tax assessed value to a new home even if it was more expensive, it limited the ability to transfer these tax benefits among family members. Notably, in the past, a child could inherit their parent’s tax assessed value along with the home, but it is not so straightforward now.

The good news is that converting your home into a rental property won’t necessitate a reappraisal of the home for property tax purposes. However, it could make a difference if and when your children inherit the home.

“The Prop. 19 rules say that you can pass a principal residence to your children, so long as it was the primary residence of the parents before, and it’s the primary residence of the child thereafter,” said Yin Ho, a California-based senior associate on the real estate team of international law firm Withers. Because the home is now a rental home, if you were to pass away now, your children wouldn’t be entitled to this benefit.

Ho noted though that if you were to change your mind in the future and resume living in the home yourself, you could preserve that benefit. However, your children would need to plan to live in the home after you died — if they didn’t, again, they would not be eligible.

The deadline to transfer property to one’s children proactively to retain the property-tax assessed value was back in February, so you’ve missed that window of opportunity. But such a transfer wouldn’t have been advantageous from a capital-gains tax perspective, because it would have nullified your kids’ ability to receive the step-up in basis.

Similarly, if the property had been owned by an LLC all along, it might have continued to qualify for this tax break, Ho said, but because it wasn’t that strategy won’t help you here.

Rental homes can still receive a step-up in basis when inherited

When it comes to the step-up in basis, you’re fine there. Rental homes qualify for that the same as primary residences, Ho said. So long as your children are able to sell the home quickly when you die, they should face little in the way of capital-gains taxes. At one point some Democratic lawmakers were considering reducing or eliminating this tax benefit as part of the Build Back Better social-spending package, but those proposals went nowhere.

Nevertheless, there are reasons why you may want to consider creating an LLC or trust to own the home. An LLC could offer legal and financial protection should problems ever arise with one of your tenants in the future. And a well-designed trust can keep property out of the probate process, allowing it to pass onto your kids more quickly after you die. That could help them sell the home more quickly and avoid a larger tax bill.

As I suggest to many readers who write into The Big Move, an accountant or lawyer well-versed in estates and property ownership will prove extremely vital in helping you to determine the best path forward to ensure your children get the most out of your home. Hopefully this information will be a useful starting point for you as you explore what options are still at your disposal. Best of luck.

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