The Property Tax Inheritance Exclusion

The Property Tax Inheritance Exclusion MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • OCTOBER 2017 Summary Ownership Changes Trigger Higher Tax Bills. Under California’s property tax system, the change in ownership of a property is an important event. When a property changes hands the taxes paid for the property typically increase—often substantially. Local government revenues increase in turn. Special Rules for Inherited Properties. While most properties’ tax bills go up at the time of transfer, three decades ago the Legislature and voters created special rules for inherited properties. These rules essentially allow children (or grandchildren) to inherit their parent’s (or grandparent’s) lower property tax bill. Inheritance Exclusion Benefits Many but Has Drawbacks. The decision to create an inherited property exclusion has been consequential. Hundreds of thousands of families have received tax relief under these rules. As a result, local government property tax collections have been reduced by a few billion dollars per year. Moreover, allowing children to inherit their parents’ lower property tax bill has exacerbated inequities among owners of similar properties. It also appears to have encouraged the conversion of some homes from owner-occupied primary residences to rentals and other uses. Revisiting the Inheritance Exclusion. In light of these consequences, the Legislature may want to revisit the inheritance exclusion. We suggest the Legislature consider what goal it wishes to achieve with this policy. If the goal is to prevent property taxes from making it prohibitively expensive for a family to continue to own or occupy a property, the existing policy is crafted too broadly and there are options available to better target the benefits. Ultimately, however, any changes to the inheritance exclusion will have to be placed before voters. AN LAO BRIEF SPECIAL RULES FOR INHERITED PROPERTY Local Governments Levy Property Taxes. typically trigger an increase in a property’s assessed Local governments in California—cities, counties, value. This, in turn, leads to higher property tax schools, and special districts—levy property taxes collections. For properties that have been owned for on property owners based on the value of their many years, this bump in property taxes typically property. Property taxes are a major revenue source is substantial. for local governments, raising nearly $60 billion Special Rules for Inherited Properties. In annually. general, when a property is transferred to a new Property Taxes Based on Purchase Price. owner, its assessed value is reset to its purchase Each property owner’s annual property tax bill is price. The Legislature and voters, however, have equal to the taxable value of their property—or created special rules for inherited properties that assessed value—multiplied by their property tax essentially allow children (or grandchildren) to rate. Property tax rates are capped at 1 percent inherit their parent’s (or grandparent’s) lower plus smaller voter-approved rates to finance local taxable property value. In 1986, voters approved infrastructure. A property’s assessed value is Proposition 58—a legislative constitutional based on its purchase price. In the year a property amendment—which excludes certain property is purchased, it is taxed at its purchase price. transfers between parents and children from Each year thereafter, the property’s taxable value reassessment. A decade later, Proposition 193 increases by 2 percent or the rate of inflation, extended this exclusion to transfers between whichever is lower. This process continues until the grandparents and grandchildren if the property is sold and again is taxed at its purchase grandchildren’s parents are deceased. (Throughout price (typically referred to as the property being this report, we refer to properties transferred “reassessed”). between parents and children or grandparents Ownership Changes Increase Property Taxes. and grandchildren as “inherited property.” This In most years, the market value of most properties includes properties transferred before and after the grows faster than 2 percent. Because of this, most death of the parent.) These exclusions apply to all properties are taxed at a value well below what inherited primary residences, regardless of value. they could be sold for. The taxable value of a They also apply to up to $1 million in aggregate typical property in the state is about two-thirds value of all other types of inherited property, such of its market value. This difference widens the as second homes or business properties. longer a home is owned. Property sales therefore 2 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF CONSEQUENCES OF THE INHERITANCE EXCLUSION The decision to create an inherited property the state—have passed between parents and their exclusion has been consequential. Hundreds of children without reassessment. The vast majority of thousands of families have received tax relief properties receiving the inheritance exclusion are under these rules. As a result, local government single-family homes. property tax collections have been reduced by a few billion dollars per year. Moreover, Figure 1 allowing children to inherit Steady Use of Inheritance Exclusion Over Past Decade their parents’ lower property Total Exclusions tax bill has exacerbated inequities among owners of 80,000 similar properties. It also appears to have influenced 60,000 how inherited properties are being used, encouraging the conversion of some homes 40,000 from owner-occupied primary residences to rentals or 20,000 other uses. We discuss these consequences in more detail below. 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Many Have Taken As a Share of All Property Transfers Advantage of 12% Inheritance Rules 650,000 Inherited Properties in Past Decade. 8 Each year, between 60,000 and 80,000 inherited properties statewide are exempted from reassessment. As Figure 1 4 shows, this is around one-tenth of all properties transferred each year. Over the past decade, around 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 650,000 properties—roughly 5 percent of all properties in www.lao.ca.gov Legislative Analyst’s Office 3 AN LAO BRIEF Many Children Receive Figure 2 Significant Tax Break. Counties With More Older Homeowners Typically, the longer a home Had More Inheritance Exclusions is owned, the higher the Inherited Properties as a Share of All Transfers, property tax increase at the California Counties (2010-2014) time of a transfer. Many 18% inherited properties have been 16 owned for decades. Because 14 of this, the tax break provided 12 to children by allowing them 10 to avoid reassessment often 8 is large. The typical home 6 inherited in Los Angeles 4 County during the past decade had been owned by the 2 parents for nearly 30 years. Least Owners Over 65 Most Owners Over 65 For a home owned this long, Share of Homeowners Over 65 the inheritance exclusion reduces the child’s property Significant and Growing Fiscal Cost tax bill by $3,000 to $4,000 per year. Reduction in Property Tax Revenues. The Number of Inherited Properties Likely to widespread use of the inheritance exclusion has Grow. California property owners are getting had a notable effect on property tax revenues. We older. The share of homeowners over 65 increased estimate that in 2015-16 parent-to-child exclusions from 24 percent in 2005 to 31 percent in 2015. This reduced statewide property tax revenues by around trend is likely to continue in coming years as baby $1.5 billion from what they would be in the absence boomers—a major demographic group—continue of the exclusion. This is about 2.5 percent of total to age. This could lead to an increasing number statewide property tax revenue. This share is higher of older homeowners looking to transition their in some counties, such as Mendocino (9 percent), homes to their children. This, in turn, could result San Luis Obispo (7 percent), El Dorado (6 percent), in an uptick in the use of the inheritance exclusion. Sonoma (6 percent), and Santa Barbara (5 percent). Recent experience supports this expectation. As Figure 3 reports our estimates of these fiscal effects Figure 2 shows, during the past decade counties by county. that had more older homeowners also had more Greater Losses Likely in Future. It is likely the inheritance exclusions. This suggests a relationship fiscal effect of this exclusion will grow in future years between aging homeowners and inheritance as California’s homeowners continue to age and the exclusions which could lead to a rise in inheritance use of the inheritance exclusion increases. While exclusions as homeowners get older. the extent of this increase is difficult to predict, if 4 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF Amplification of Figure 3 Taxpayer Inequities Fiscal Effects of Inheritance Exclusions Inequities Among Estimated Reduction in Annual Property Taxes (2015-16) Similar Taxpayers. Because Share of Revenue Millions of Dollars a property’s assessed value Los Angeles greatly depends on how Orange long ago it was purchased, San Diego Santa Clara significant differences arise San Mateo among property owners San Francisco solely because they purchased Alameda Contra Costa their properties at different San Bernardino times. Substantial differences Sonoma Santa Barbara occur even among property San Luis Obispo owners of similar ages, Ventura incomes, and wealth. For Sacramento Marin example, there is significant Monterey variation among similar Riverside homeowners in the Bay El Dorado Fresno Area. Looking at 45 to 55 Santa Cruz year old homeowners with Placer San Joaquin homes worth $650,000 to Mendocino $750,000 and incomes of Solano $80,000 to $100,000 (values Stanislaus Humboldt characteristic of the region), Butte property tax payments in Tulare 2015 ranged from less than Nevada Napa $2,000 to over $8,000. Imperial Inheritance Rules Merced Amplify Inequities. Yolo Kern Inheritance exclusions Sutter exacerbate underlying Lake Kings taxpayer inequities. This Yuba is because inheritance San Benito exclusions effectively Sierra lengthen the amount of time 10 $250 a property can go without being reassessed. To see how the relationship suggested by Figure 2 is true it is this happens, consider an example of two identical possible that annual property tax losses attributable homes built in the same neighborhood in 1980: to inheritance exclusions could increase by several hundred million dollars over the next decade. www.lao.ca.gov Legislative Analyst’s Office 5 AN LAO BRIEF • Home 1 is purchased in 1980 and owned to grow. By 2060 home 1’s bill will be one-sixth as continuously by the original owners until much as home 2’s bill. their death 50 years later, at which time the Unintended Housing Market Effects home is inherited by their child. Many Inherited Primary Residences • Home 2, in contrast, is sold roughly every Converted to Other Uses. Inheritance exclusions 15 years—around the typical length of appear to be encouraging children to hold on to ownership of a home in California. their parents’ homes to use as rentals or other We trace the property tax bills of these two purposes instead of putting them on the for homes over several decades in Figure 4 under sale market. A look at inherited homes in Los the assumption that the homes appreciate at Angeles County during the last decade supports historically typical rates for California homes. By this finding. Figure 5 shows the share of homes 2030, home 1’s bill would be one-third as much that received the homeowner’s exemption—a as home 2’s bill. In the absence of the inheritance tax reduction available only for primary exclusion, when home 1 passes to the original residences—before and after inheritance. Before owner’s child it would be reassessed. This would inheritance, about 70 percent of homes claimed erase much of the difference in property tax the homeowner’s exemption, compared to about payments between home 1 and home 2. With the 40 percent after inheritance. This suggests that inheritance exclusion, however, the new owner of many of these homes are being converted from home 1 maintains their parent’s lower tax payment. primary residences to other uses. Over the child’s lifetime, the difference in tax It is possible that this trend arises because payments between home 1 and home 2 continues people intrinsically make different decisions about inherited property regardless Figure 4 of their tax treatment. A Inheritance Exclusion Amplifies Taxpayer Inequities closer look at the data from Los Angeles County, however, Property Tax Bill of Two Hypothetical Identical Homes (2016 Dollars) suggests otherwise. Figure 6 $12,000 Home 1 is owned continuously by breaks down the share of the same owners until their death in 2030 and is then inherited by primary residences converted 10,000 their child. to other uses by the amount Home 2 is sold roughly every Home 2 15 years. of tax savings received by the 8,000 child. As Figure 6 shows, the Home 1 Without 6,000 Inheritance Exclusion share of primary residences converted to other uses is 4,000 highest among those receiving the most tax savings. A little Home 1 2,000 over 60 percent of children receiving the highest tax 1980 1990 2000 2010 2020 2030 2040 2050 2060 savings converted their 6 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF inherited home to another Figure 5 use, compared to just under Inherited Primary Residences half of children receiving the Being Converted to Other Uses least savings. This suggests Share of Homes Claiming Homeowner's Exemption that the tax savings provided Los Angeles County, 2007-2014 by the inheritance exclusion 70% may be factoring into the decision of some children to 60 convert their parent’s primary Inherited Homes residence to rentals or other 50 uses. Contributes to Limited 40 Other Home Sales Availability of Homes for 30 Sale. The conversion of inherited properties from 20 primary residences to other uses could be exacerbating 10 challenges for home buyers created by the state’s tight Before Transfer After Transfer housing markets. In many parts of California, there is a very limited supply of homes for sale and buying a home is Figure 6 highly competitive. Figure 7 Higher Tax Savings May Encourage Conversions (see next page) shows that the inventory of homes for sale Share of Inherited Primary Residences Converted to Other Uses Los Angeles County, 2006-2016 is consistently more limited in California than the rest 60% of the country. This limited inventory—a consequence 50 of many factors including 40 too little home building and an aging population—has 30 driven up the price of housing in California and made the 20 home buying experience 10 more difficult for many. When inherited homes are Least Savings Most Savings held off the for sale market, www.lao.ca.gov Legislative Analyst’s Office 7 AN LAO BRIEF these issues are amplified. Figure 7 On the flip side, the shift of Limited Availability of Homes for Sale in California inherited homes to the rental Number of Homes for Sale as a Share of All Single Family Homes market could put downward pressure on rents. The data 3% we reviewed, however, does not allow us to determine how many properties are being converted to rentals as 2 U.S. opposed to other uses—such as vacation homes. On net, the shift of homes from California 1 the for-sale market to the rental market likely results in fewer Californians being homeowners and more being 2010 2011 2012 2013 2014 2015 2016 2017 renters. REVISITING THE INHERITANCE EXCLUSION It has been decades since Californians voted to to occupy a particular home—the scope of the create the inherited property exclusion. Since then, existing inheritance exclusion is far too broad. this decision has had significant consequences, Reasons the Existing Policy May Be Too Broad yet little attention has been paid to reviewing it. Moreover, indications are that use of the exclusion Property Taxes May Not Be Big Barrier to will grow in the future. In light of this, the Continued Ownership. One potential rationale Legislature may want to revisit the inheritance for the inheritance exclusion is to prevent property exclusion. As a starting point, the Legislature taxes from making it prohibitively expensive for would want to consider what goal it wishes to a family continue to own a particular property. achieve by having an inheritance exclusion. Is the The concern may be that if a property is reassessed goal to ensure that a family continues to occupy a at inheritance the beneficiary will be unable to particular property? Or to maintain ownership of a afford the higher property tax payment, forcing particular property within a family? Or to promote them to sell the property. There are reasons, property inheritance in and of itself? however, to believe that many beneficiaries are in Different goals suggest different policies. If a comparatively good financial situation to absorb the goal is to unconditionally promote property the costs resulting from reassessment: inheritance, maintaining the existing inheritance • Children of Homeowners Tend to Be exclusion makes sense. If, however, the goal is more More Affluent. Children of homeowners narrow—such as making sure a family continues tend to be financially better off as adults. 8 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF Data from the Panel Survey of Income Many Children Not Occupying Inherited Dynamics suggests that Californians who Properties. Another potential rationale for the grew up in a home owned by their parents inheritance exclusion is to ensure the continued had a median income over $70,000 in occupancy of a property by a single family. Many 2015, compared to less than $50,000 for children, however, do not appear to be occupying those whose parents were renters. Beyond their inherited properties. As discussed earlier, income, several nationwide studies have it appears that many inherited homes are being found that children of homeowners tend to converted to rentals or other uses. As a result, we be better off as adults in various categories found that in Los Angeles County only a minority including educational attainment and of homes inherited over the last decade are homeownership. claiming the homeowner’s exemption. This suggests that in most cases, the family is not continuing to • Many Inherited Properties Have Low occupy the inherited property. Ownership Costs. In addition to property taxes homeowners face costs for their Potential Alternatives mortgage, insurance, maintenance, and If the Legislature feels the existing policy is repairs. These costs tend to be lower too broad, it has several options to better focus the for properties that have been owned exclusion on achieving particular goals. In addition for many years—as is true of many to better aligning the policy with a particular inherited properties—largely because their objective, narrowing the exclusion would help mortgages have been paid off. According to minimize some of the drawbacks discussed to American Community Survey data, in in the prior section. Below are some options the 2015 just under 60 percent of homes owned Legislature could consider. These options could be 30 years or longer were owned free and adopted individually or could be combined. Any clear, compared to less than a quarter of all changes ultimately would have to be placed before homes. Consequently, monthly ownership voters for their approval. costs for these homeowners were around Limit to Homes Used as a Primary Residence. $1,000 less than the typical homeowner One option is to limit the exclusion to homes that ($1,650 vs. $670). Because most inherited are occupied by the family member following homes have been owned for decades, inheritance. Inherited homes used as rentals or children typically are receiving a property second homes would be subject to reassessment. with lower ownership costs. Such a change could possibly cut in half the • Property Inheritance Provides Financial property tax losses resulting from the existing exclusion. Flexibility. In addition to lower ownership Apply Means Testing. Another option is to costs, an additional benefit of inheriting require means testing to determine eligibility for a property without a mortgage is a the exclusion. The Legislature could set an income significant increase in borrowing capacity. threshold under which a child’s income would have Many inherited properties have significant to fall to be eligible for the inheritance exclusion. equity. This offers beneficiaries the option Phase In Property Tax Increase. A third of accessing cash through financial option is to phase in over several years the property instruments like home equity loans. www.lao.ca.gov Legislative Analyst’s Office 9 AN LAO BRIEF tax increase resulting from the reassessment of short-term relief. The interim period during which an inherited property. This change would reduce the increase is phased in could provide the family the overall financial benefit provided by the member time to make financial arrangements to exclusion—in recognition of the relative affluence accommodate the ongoing ownership costs of their of many beneficiaries—while still providing some inherited property. CONCLUSION When a property changes hands the taxes In light of these consequences, the Legislature paid for the property typically increase—often may want to revisit the inheritance exclusion. substantially. This is not true, however, for We suggest the Legislature consider what goal it most inherited property. Three decades ago, the wishes to achieve with this policy. If the goal is to Legislature and voters decided that most inherited prevent property taxes from making it prohibitively property should be excluded from reassessment. expensive for a family to continue to occupy a This has been a consequential decision. Many have home, the existing policy is crafted too broadly benefited from the tax savings this policy affords. and there are options available to better target Nonetheless, the inheritance exclusion raises some the benefits. Ultimately, however, any changes to policy concerns about taxpayer equity and adverse the inheritance exclusion would have to be placed effects on real estate markets. before voters. 10 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF www.lao.ca.gov Legislative Analyst’s Office 11 AN LAO B R I E F LAO Publications This brief was prepared by Brian Uhler, and reviewed by Jason Sisney. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This brief and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 12 Legislative Analyst’s Office www.lao.ca.gov