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.

Death and taxes

"In this world nothing can be said to be certain, except death and taxes." Benjamin Franklin, as quoted in a letter to Jean-Baptiste Leroy in 1789.

Given this certainty, taxpayers respond by engaging in various tactics to reduce, minimize, avoid or evade their inevitable taxation. For example, nefarious individuals peddle phoney trusts as methods to ostensibly shield income from taxation.  Unfortunately, the zealotry to which a person pursues avoiding taxation can lead them to believe these crooked arrangements. A wealthy San Diego nursery owner, via her son, fell victim to this scam. The tale of her account unfolded in court as explained below.

Estate of Young (2008) 160 CA4th 62

The late Irma Young was a wealthy nursery owner who had amassed a number of real estate holdings. Through here attorney, Dennis Burns, she devised an estate plan in 1991 which called for the distribution of her estate to her 4 children equally. One peculiar part of her estate plan was that her son, Charles Parker, was only allowed to take his inheritance if he did not have any tax liabilities at the relevant time. This naturally prompts the response that Charles probably had difficulties with paying his taxes.

Charles began to attend asset protection seminars in 1992-1993 and became convinced that creating a land trust was an instrument that could be used to avoid paying taxes. Attorney Burns told her Irma that he believed that such trusts were not legitimate tax avoidance devices. Nevertheless, Charles convinced Irma to retain the individuals selling these trusts. In turn she, according to the court opinion, "paid approximately $30,000 to several persons to prepare such documents, some of whom took the money and did no work."

A total of 8 "tax avoidance" or "land trusts" were created for the 8 parcels of real property owned by Irma. Furthermore, 5 business trusts were created to hold her business interests. Of note, the drafting attorney for the business trusts was the trustee for 4 of them (Author's comment: this is generally a huge no-no in California).   

Later on in 1995, Irma became aware that these trusts were a facade and approached her old attorney to try to rectify the situation. Attorney Burns "asked her if she had gotten involved in one of Charles's schemes, and she said yes. He then told her that he had advised her against that, but she had not listened to him, and he could no longer help her and she should get another attorney." 

In 2000, Irma became acutely ill and she asked her son Stephen Parker to inquire as to status of her estate. Stephen naturally approached Charles who failed to provide him with the necessary information. Stephen then asked R. Richard Evans, the trustee of Irma's "trusts" for a copy of such and he provided Stephen with a copy of one of the land trusts. 

"Stephen told Irma about this and she said Charles and Evans were crooks. In May 2000, she called her four children to the hospital and told them that her plan was that each should share equally in her estate, and asked Charles to verify that that was her intent, which he did."    

"On July 30, 2000, Young died. Stephen was appointed the administrator of her estate. In that capacity, he formally requested that Charles and Evans supply him with business records relating to trusts, disposition of funds or property, and the original irrevocable land trust dated September 27, 1993. They replied that they did not have any such documents except for the 1991 will and inter vivos trust. The trusts had no cash left." (Author's comment: not good).

Ultimately, Stephen successfully sued for undue influence and fraud in the establishment of the trusts. 

One sad reality of this case is that neither Charles nor Evans knew Irma's tax bracket. Charles nonetheless coerced his mother to engage in very questionable and expensive behavior without knowing what benefits would accrue. One would think that knowing the current situation would be very helpful for future planning. For example, if Irma was a high-income individual who paid a lower tax rate than others, a la Warren Buffet or Mitt Romney, then pursuing such an exotic tax arrangement is baffling. The point of tax avoidance is to have a net gain. Yet with Irma, her son caused her to have a net loss, and a massive one at that.   

Asset Protection Trust

There is nothing illegal, wrongful or unethical about protecting your assets from potential creditors. 

Asset protection is commonly practiced by millions of Americans, including myself in multiple situations. 

The key feature of asset protection is the method used to achieve it. Some methods work in California, while others do not.

For example, a savvy real estate investor will purchase property through a limited liability entity, such as a LLC or a corporation. Thereby the real estate investor's liability, subject to a few exceptions, is limited to the company's assets regardless of whether a judgment, fine or levy against the company exceeds the value of the company's assets. 

Assume that Willis purchased a home in San Francisco’s Sunset District for $400,000 through his company, Winning, LLC. Willis then leased the home to Lionel for 1 year. Sadly, Lionel slipped and fell on a banana peel that Willis had negligently left on the property. Lionel broke his hip, thereby ruining his promising soccer career and successfully sued Willis for $500,000. At this point, if Willis had owned the home personally, Lionel could enforce the judgment against all of Willis’ assets until he collected his $500,000 judgment. However, Willis had prudently decided to own the rental home through a LLC, thereby limiting his liability to the company’s assets. Consequently, Lionel’s recovery would be limited to whatever the company owned, namely $400,000. Even though the LLC did not have the assets to satisfy Lionel’s judgment, California law says that Willis is not personally for the debts of his LLC, specifically $100,000. Corp C § 1710. Thus, Willis would be able to walk away from his lawsuit financially battered and bruised but not ruined.

Now contrast the above example with the case of a person who creates a revocable trust and funds the trust with a rental property and is also the beneficiary of this trust. 

The aforementioned would be an example of a “self-settled” trust. The reason being is that there is a overlapping of positions whereby the settlor, the person who writes the trust, is also the beneficiary. California law is very specific in saying that creditors can reach the assets of a self-settled trust. Prob C § 15304. From the above example, if Willis owned the rental property through his revocable trust, then Willis would have unlimited personally liability for the liabilities arising from the operations of the rental property. Thereby Lionel could enforce his $500,000 judgment against any of Willis’s assets. For instance, if Willis owned another home, Lionel could attach a judgment lien to the home, if Willis had a bank account, Lionel could execute a bank levy on that account, if Willis had a job, Lionel could perform a wage garnishment on Willis’ paycheck.

One of my law books wisely says “if a deal is too good to be true, it is probably not true.” So the next time you hear somebody or some advertisement talk about asset protection, pay attention to how they intend to achieve it. Often times, there is some elaborate procedure discussed involving an exotic location such as the Cayman Islands or the Bahamas, which is usually hype, or worse fraud. There is a correct method to achieve asset protection; the right steps have to be followed however. 

Writing a Will

The following are some commonly cited reasons, some meritorious while others not, as to why a person might engage in estate planning. 

1. Concern about the Estate Tax and other transfer taxes

At an initial client meeting recently, the first words the client uttered were, “I don’t want the government to get any of my money if possible.”

For whatever reason, many clients believe that the Estate Tax or some other transfer tax will affect them when they pass away. This is largely untrue as the Estate Tax has been increased to $5 million. Hence, the portion of the population that will be affected in the future by it will be very small. Granted, there are some who are reading this that will point out the Estate Tax amount was only lifted to $5 million for 2011 and 2012 (inflation adjusted) and thereby the Estate Tax issue will arise again in the not so distant future. However, it is doubtful that the Estate Tax would be lowered to a very small exemption amount come 2013 because such would be characterized as a “tax increase” and voting for tax increases are politically unpopular.

Regardless, many people come into my office with the belief that the IRS will extract a large portion of their estate upon death. So one of the first questions I ask them is, how much do you think your estate is worth? When I hear that their estate is worth $400,000, $1.5 million, $800,000 or $3.2 million, I tell them to not get too concerned about a tax that will most likely not affect them.

2. Avoid probate

Probate is somewhat what of a dirty word to non-lawyers because the process is lengthy and expensive. 

For instance, if Donny Decedent, an unmarried man without children, passed away in Yreka, CA and his entire estate consisted of a single home worth $400,000, probate would take anywhere between 9 – 18 months to complete and the attorney handling the case would be permitted to charge a fee $11,000. Of note, the executor’s fee is the exact same as the attorney’s. 

However, the executor’s fee is often not taken because the executor is often a beneficiary and inheritance is not subject to income tax whereas payment rendered for being an executor is subject to income tax. In light of this, an executor-beneficiary often forgoes the fee because it will result in a larger inheritance for them. Thus, the focus on probate fees is primarily geared towards the attorney’s fee.

Although $11,000 does not seem like a large percentage of the estate, 2.75% percent, it should be noted that probate fees do not take into account any mortgages on the property. So in the above example, if the house had a mortgage of $30,000, then the estate’s value would in reality be $100,000, not $400,000. Yet, the attorney’s fee would still be $11,000 which would represent 10% of the estate. In other words, for every $10 of Donny Decedent’s estate, $9 would be paid to his beneficiaries and $1 to his attorney. Consequently, individuals often write revocable trusts because assets held in a revocable trust are exempt from probate. Prob C §13050(a)(1). 

3. Ensure familial harmony/continuity

Parents often write estate plans primarily out of concern for their children, or a minor in legal speak. 

Since minors are legally incompetent, they are protected by laws until they have reached the age of majority in California, 18. In particular, if a minor were to become parent-less prior to reaching the age of 18, a guardianship of both their estate and person would need to be established. In a guardianship of the minor’s estate, somebody would need to be appointed by a court to supervise the minor’s finances. Whereas in a guardianship of the minor’s person, somebody would need to be appointed by the court to supervise the minor’s schooling, medical needs and other child-rearing activities. 

It should be noted that a revocable trust established by a child’s parents will not solve both guardianship problems in case it is needed. A revocable trust can only manage the minor’s estate because a revocable trust is merely a legal document that spells out how a child’s inheritance is to be distributed to them. Whereas a guardianship of the minor’s person requires a natural person to supervise since one could not ask a writing, which is basically what a revocable trust is, to make medical or school decisions for the minor. Thus if a minor loses both of their parents, a guardianship of their person will be needed.

4. Prevent mismanagement of inheritance

One of primary concerns in estate planning is that a designated family member will be unable, as either the trustee or executor, to distribute the estate’s assets. 

People would like to see that their assets go to their beneficiaries in an expedient and affordable procedure. However, this is often not the case as once the individual has passed away, typically a surviving spouse parents, the designated child often times has no idea what to do and gets lax with their duties. A principal advantage in writing a trust is that it allows an estate to avoid probate, yet this attribute is a double-edged sword. 

Since a trust is not subject to court supervision, a trustee may easily make numerous legal mistakes in the trust administration process. Compounding this is the fact that by the time a beneficiary realizes that the trustee has committed a breach of trust, the damage is often irreparable. For example, I received a call last spring and the person, a beneficiary of this trust, said that the trust estate had been depleted and the trustee was personally broke as she had spent the bulk of the trust money on vacations and beauty products. Since a vacation and beauty products would qualify as “perishables” there was little if anything she could recover from the trustee as damages. Naturally, she was not very pleased when I told her that court action would be largely ineffectual.

In short, the selection of who distributes your estate, whether it be a trustee or executor, is probably the second most important question facing clients in estate planning. Naming beneficiaries is the most important question in case you are wondering.

5. Asset protection

Some people have the misconceived notion that revocable trusts are asset protection devices. A revocable trust is not an asset protection device because assets in a revocable trust are subject to creditor claims. Prob C § 15304. 

For instance, Larry Leadfoot, a California resident is up watching late-night television and sees an advertisement for an asset protection trust in California. Knowing that his driving is a serious liability, Leadfoot calls the number and speaks to a representative who mails him the advertised documents. Leadfoot receives the packet and follows the directions exactly. Following this, Leadfoot heads off to the local bar to celebrate the fact that he thinks that his assets are immune from creditors. Leadfoot then drinks to the point of inebriation and proceeds to drive home drunk wherein he crashes into a fellow motorist, Isue Freely. Freely naturally files and wins a massive judgment against Leadfoot for damaging his antique 1974 AMC Gremlin. 

In order to recover this judgment, Freely compels Leadfoot to attend a debtor’s exam at the local courthouse so Freely can figure out if Leadfoot is a judgment-proof defendant. At the hearing, Leadfoot exclaims, under oath, that he has no assets to his name as he transferred his estate to an asset protection trust for his own benefit. The judge, upon hearing this, informs Leadfoot that he is sadly mistaken as California law does not allow a person to shield assets from creditors through a revocable trust. The judge then allows Freely to attach his judgment to Leadfoot’s “trust.”

6. Disabled family member

Since a person with a disability receives needs-based assistance from the federal and state government, an inheritance would seriously jeopardize their ability to receive future benefits. In light of this, parents often draft a “special needs trust” for their disabled child. This special needs trust will allow the disabled child to receive an inheritance, subject to certain restrictions, while at the same time retaining their eligibility for government benefits such as Supplemental Security Income (SSI) and Medi-Cal.