Are You Missing Out On The Tax Benefits Of Prop 19?

As of April 1st, 2021, Prop 19 allows that if you are over 55 years old and purchase a new home anywhere within California within two years of the sale of the original home, you can transfer the tax basis to your new home.With Prop 19 you can actually do this three times. Prior to Prop 19, you were able to only transfer the cost basis once and even then you could only do it within the same county as defined by Prop 60 or to another county that accepted inter-county tax basis transfers, as defined by Prop 90.

There is another element of Prop 19 that is particularly relevant in Sonoma County and probably a lot less well known which benefits victims of wildfires. Under Prop 19, if your primary residence is substantially damaged or destroyed by a wildfire, you can transfer the tax basis anywhere in California. This applies if you either purchase or buy some land and then construct a primary residence, as long as it is completed within 2 years of the sale of the original home or land.

Before diving into Prop 19 in more detail, it is probably worth giving some context to the propositions that preceded Prop 19. Back in 1978, Proposition 13 was passed by the California Legislature because it wanted to stimulate the real estate sales market because of the economic benefit to all the industries that feed off the property market such as lenders, insurers, contractors, hmes stores etc. The belief was that high property taxes were preventing some people from purchasing a home or from trading up to a more expensive home.  

Proposition 13 had three components:

1. It limited property taxes to 1% of the  assessed value of the property

2. It limited the property tax increases to 2% yearly based on a consumer price index adjustment

3. It also only permitted property taxes to be reassessed for a change in ownership or due to new  construction

In 1986 Proposition 60 was introduced which allowed the one time transfer of the tax basis of a primary residence within the same county and then in 1988 Proposition 90 was introduced which permitted the transfer of the tax basis to another county that accepts intercounty tax transfers. This gave more flexibility but there were only a relatively small number of counties which would accept the lower taxes that this would inevitably lead to. 

So How Do You Calculate the Cost Basis?

One of the keys to applying Prop 19 is to be able to determine the cost basis of a home which varies based on whether you are buying or selling and whether or not the property is inherited or gifted. 

Calculating the Cost Basis For a Purchase

The cost basis is calculated by taking the assessed value plus additional fees such as title fees, legal fees, survey fees, any transfer taxes paid by the buyer and costs paid by the buyer to the seller. If we look at a few different scenarios for calculating the cost basis for a seller, an inherited property and a gifted property. 

Calculating the Cost Basis For A Sale 

If John, a single person, bought a house in 1996 for $400,000 and sold it for $1,000k in 2022 then the sale proceeds might be $1m minus $60k of selling costs so the sale proceeds would be $$940,000.

The cost basis would be the purchase price plus any fees associated with the purchase so $400k plus $20k fees but also including any improvements, say $80k. This would give a cost basis of $500k.

The capital gain would then be calculated by taking the $940k sale proceeds, subtracting $500k cost basis giving a $440k but then subtracting the capital gain allowance for a single person of $250k making the taxable gain $190k.   

Calculating the Cost Basis For An Inherited Property

The cost basis of a gifted property is the fair market value (FMV) as the date of death.

Calculating the Cost Basis For A Gifted Property:

The basis depends on any gain or loss when you sell the property. When there’s a gain, the basis is the donor’s adjusted basis. When there’s a loss, the basis is the lesser of the donor’s adjusted basis, or the fair market value at the time of the gift.

Calculating The Cost Basis When One of the Co-Owners Dies

One of the benefits of California law is the ability to hold a property as a community property.  If a spouse dies the surviving spouse’s tax basis is increased to 100% of the assessed value at the time of death. When a property is held in joint tenancy with the right of survivorship when the owners are not married, there are several possible outcomes, as follows:

If the joint owner who died paid for the entire property, the full value of the property is included in the deceased owner’s estate. The property receives a 100 percent step-up in basis. For example, if Mrs. A owned real estate, put it in joint tenancy with her daughter, and subsequently died, the full value of the home would be included in Mrs. A’s estate. Her daughter would then inherit the property with a 100 percent step-up in basis.

If both joint owners contributed to the value of the asset, the value of the deceased joint owner’s share is included in his or her estate. That portion of the property receives a step-up in basis. If Mrs. A and her daughter bought a property for which Mrs. A paid 60 percent and her daughter paid 40 percent, then 60 percent of the value of the home would be included in Mrs. A’s estate and would receive a step-up in basis.

If the joint owners received the property by gift or inheritance, only the decedent’s portion is included in his or her estate. For example, if three children inherited real estate from a parent and the property was jointly held by all three, one-third of the value of the property would be included in the estate of a child who dies. This one-third interest would receive a step-up in basis.

The True Benefits of Prop 19

The great thing with Prop 19 is that you can transfer this tax basis three times anywhere within the state as long as the purchase is completed within a two year period. However, if you are trading up to a more expensive home which is greater than the cash value of the original home, the difference in the full cash values will be added to the transferred factored base year value. 

For example if the tax basis of the original home is $500k with a cash value of $1m and the owner purchases a home with a cash value of $1.7m then the tax basis would the $500k tax basis transferred plus $700k which is difference in the cash value of the original home and the new home. This would give a tax basis of the new home of $1.2m compared to $1.7m in the absence of applying Prop 19. In this scenario, the property purchased to transfer the property tax basis must be of equal to or less than 100% of the ultimate cash value of the property that is sold if the new property is purchased prior to the sale of the existing property. 

If the replacement property is purchased within 1 year of the sale, it must be equal to or less than 105% of the cash value of the sale. If the replacement property is purchased after 1 year, but within 2 years of the sale, it must be equal to or less than 110% of the cash value of the sale. The replacement property must be purchased within 2 years of the sale.

If the replacement property is above the values stated above, it can be purchased, but prorated accordingly. Example: If a property with a tax basis of $100,000 is sold for $1,000,000, and then a new property is purchased after 1 year and within 2 years for $1,500,000, the property tax basis on that will be $500,000 (the $100,000 for the first $1,100,000 (110% of the property sold) and the remaining $400,000 overage of the purchase price).

Proposition 19 Removes Some Of the Benefits Of Passing A Tax Basis Within Families

Proposition 58, which was passed in 1986, excluded transfers of property from parents to children from reassessment, and also excluded the first $1 million of assessed value for any type of property transferred to children—including commercial and industrial properties—not just the family home.

Parents could then pass on their tax breaks to their kids on their residence, of any value. 

For other properties that aren’t the residence, two parents could combine their assessment exclusions to equal $2 million in assessed value being transferred to the children – even though the property might be worth $10M or more. In certain cases, grandparents could also transfer Prop 13 caps to grandchildren.

However with the introduction of Proposition 19 changed the provisions of the parent-child and grandparent child exclusions taking away some of the benefits. As of Feb 2021, a limit was placed on the value of the benefit that could be transferred to the current taxable value plus $1m. The other change that was introduced was to exclude any property that was not a principal residence or family farm. 

But how does this work in practice? If a home that is being transferred to a child has a taxable value (or a factored base year value (FBVV)) of $600k and a fair market value of $2.5m this is how the calculation would work:

Firstly we calculate the value of the excluded amount by adding together the taxable value ($600k) plus the Prop 19 allowance of $1m to get $1.6m

Since the fair market value of $2.5m is more than the excluded amount, we calculate the difference between the fair market value and the excluded amount to get a difference of $900k ($2.5m minus $1.6m)

This leads to a new taxable value of $1.5m by taking the taxable base value of $600k plus the difference of $900k. While this doesn’t seem a huge benefit it is the difference between being taxed on a $2.5m home versus a $1.5m which at a property tax rate of 1% saves $10,000 per year of net income. 

In Summary

For anyone who is over 55 years old, a veteran or subject to a wildfire it is definitely worth looking into whether Prop 19 will benefit you particularly given you can now transfer the base three times and more importantly can now move anywhere within California. As with all tax schemes, it is important to make sure that in arranging your property affairs specifically to take advantage of Prop 19 you don’t miss out a greater benefit that you may get by taking advantage of a 1031 Exchange or don’t fall foul of triggering a large capital gain which may otherwise not have been triggered. 

Anyone looking to take advantage of any tax rules should work directly with their CPA or a qualified tax professional.

Frequently Asked Questions: 

1. What is Prop 19, and what does it allow for individuals over 55 years old in California?

Proposition 19, effective since April 1st, 2021, allows individuals over 55 years old to transfer their tax basis from their original home to a new one within California within two years of selling the original property. This transfer can be done up to three times.

2. How can victims of wildfires benefit from Prop 19?

Under Prop 19, if your primary residence is substantially damaged or destroyed by a wildfire, you can transfer the tax basis anywhere in California. This applies if you purchase land and construct a primary residence, as long as it's completed within two years of the sale of the original home or land.

3. How do you calculate the cost basis for a property purchase under Prop 19?

The cost basis for a purchase includes the assessed value plus additional fees like title fees, legal fees, survey fees, transfer taxes paid by the buyer, and costs paid by the buyer to the seller.

4. What changes did Proposition 19 bring to parent-child and grandparent-child property transfers?

Proposition 19 introduced limits on the value that can be transferred to the current taxable value plus $1 million. It also excluded properties that are not a principal residence or family farm from benefiting from parent-child or grandparent-child transfers.

5. How many times can the tax basis be transferred under Prop 19, and are there restrictions?

Prop 19 allows the tax basis to be transferred three times. However, if you're trading up to a more expensive home, the difference in the full cash values will be added to the transferred factored base year value, and there are specific rules depending on when you purchase a replacement property relative to selling your original one.