November 14, 2013

Parent-Child Exclusion and Rental Property

The parent-child exclusion can be enormously beneficial to children who seek to maintain ownership of inherited real estate. In short, the parent-child exclusion essentially allows a parent to transfer to their child the property tax basis of their primary home plus up $1M in assessed value of other real property. This can be a boon to children because property purchased many decades ago has a low property tax basis which makes keeping the home desirable. 

For example, one client I represented a few years ago inherited a home from his late mother who purchased her home in the 1960s. Since the transfer qualified for the parent-child exclusion, the son was able to "inherit" his mother's property tax basis, which was minimal. Hence, his property tax payments were around $600 whereas without the benefit of the parent-child exclusion his property tax payments would be around $5,000. While this does not seem like an eye-popping discrepancy, this payment is annually made. Therefore, the property tax savings are magnified given that the son can reap the benefits for years to come.      

One dilemma though that parents face when deciding how to structure their estate is with rental property. While rental property fits within the "other real property" parameters of the parent-child exclusion, the issue of personal liability remains. That is, if a person owns rental property in their individual name, they are personally liable for the debts of the rental property. For instance, if the tenant slips and falls, the tenant may sue for redress of injury in hopes of obtaining a judgment against the landlord/owner. If successful, this judgment can be then be attached to the rental property, and more importantly, the individual himself. Thus, the personal assets of the individual, e.g. bank accounts, stocks, bonds, mutual funds, etc., are subject to attachment. 

One way to shield oneself from personal liability in this situation is to create a business entity to own the real estate. Under this scenario, the landlord/owner would ordinarily not be personally liable for any judgments that arise from ownership of the rental property. It would be reasonable to say that at least thousands of Californians have established LLCs for this purpose, i.e. own rental property to avoid personal liability. 

The problem is that the California code does not permit real estate owned through a business entity to be eligible for the parent-child exclusion. Penner v. County of Santa Barbara (1995) 37 CA4th 1672. In Penner, a parent's unsuccessful  attempt to transfer real estate to her children via a limited partnership resulted in the property taxes being increased from $337,276 to $2,300,000 because it did not qualify for the parent-child exclusion. The court noted that "property must be transferred from one natural person to another" to qualify for the parent-child exclusion. Since the partnership, a business entity, was not a natural person, it failed to qualify for the parent-child exclusion.

A parent owning rental property is thus faced with two competing issues, (1) the parent-child exclusion and (2) liability protection. In this case, a parent cannot have their cake and eat it too seemingly. Either the parent can keep the rental property in their individual name and risk personal liability, or they can transfer the rental property into a business entity, typically an LLC, but lose the potential benefit of the parent-child exclusion. One solution to this dilemma is to purchase umbrella insurance for the rental property and keep the rental property in the individual's name. This method maintains eligibility for the parent-child exclusion and minimizes the effects of personal liability because of the availability of insurance proceeds. The problem is the potential cost of an umbrella policy and the policy limits for an umbrella policy. In law, much like life, there is no perfect solution.