How the Prop 8 Ruling Threatens Prop 13 (and other future tax reforms)

California's ballot initiative process is vital to Californians and helps ensure that the will of the people is expressed, even when California politicians are uncooperative.  Over the years, ballot initiatives have been proposed and passed that have advanced both liberal and conservative causes.  In each of these cases, the initiative process was the only way to advance these issues as the legislature would not, or could not, pass effective legislation. 

While the recent Supreme Court case on Proposition 8 may have advanced gay marriage, its unintended consequence is to put into question the sustainability and power of future ballot initiatives.  Justice Scalia ruled, in essence, that the defenders of the Prop 8 initiative did not have standing to sue because only the State of California had standing to defend Prop 8 from attacks.  While Gov. Brown and Kamala Harris, the State A.G., put up a begrudging defense of Prop 8 at the trial level, they opted not to appeal the trial court decision finding Prop 8 unconstitutional.  Defenders of Prop 8 then stepped in and decided to appeal.  The California Supreme Court held that clearly, the Prop 8 defenders had standing and could appeal the decision and were essentially representing the interests of the State. 

Unfortunately, Justice Scalia's holding now weakens almost any ballot initiative--especially those that the Governor and Attorney General personally dislike. Consider the following hypothetical.  A homeowner sues alleging that Prop 13 violates their equal protection because their neighbor who bought their home 50 years ago pays much less than they do for their new home, despite the fact the homes are identical and have the same value.  Although merit less, the Governor and state AG could opt to not defend the suit.  All of a sudden, an injunction is issued finding Prop 13 to be unconstitutional.  The State decides it won't pursue an appeal and the defenders of Prop 13 have no standing in federal court to pursue an appeal either.

In a single opinion, Justice Scalia was able to do something many California politicians have been trying to do for year--weaken the initiative process. 

How to Fix the Prop 13 Loophole Without Harming CA Businesses

As of late, much has been written about Proposition 13—the 1978 ballot initiative that keeps property taxes low for landowners, whether they be residential homeowners or commercial landlords.   Under Proposition 13, real property is only to be reassessed when there is a “change of ownership”.  For residential homeowners, the rule is relatively simple to apply—if you sell or transfer your home, the property will likely be reassessed.  However, when property is owned by a business, the rules become extremely complex and contain a gaping loophole.     

This loophole recently gained widespread attention when computer billionaire Michael Dell restructured the purchase of the Fairmont Miramar hotel to avoid triggering a reassessment of the property—a move which saved him an estimated $1 million a year in property taxes.  His strategy involved buying the business that owned the hotel in such a manner so as to ensure that no single person or entity held more than a 50% interest in the business. And so, effectively, Michael Dell, Dell’s wife, and another entity took ownership in the entity, but none of them acquired more than a 50% stake.   This maneuver brought justified outrage—not only from the left, but even the head of the Howard Jarvis Taxpayer Association—the very group that helped ensure Proposition 13’s original passage said that Dell was “gaming the system”.     

Unfortunately, many long-time Proposition 13 critics are using this extreme circumstance to attempt to repeal, or effectively gut, the protections afforded by Proposition 13.  The most common “fix” offered by proponents is to only apply the generous rules of Proposition 13 to residential properties and to carve-out commercial properties, allowing commercial properties to be reassessed each year (a position apparently supported by most of the State's editorial board). 

While this approach may seem tempting to those who yearn for higher tax revenues, when one takes into account that California already has the highest income tax, the highest sales tax, the highest gasoline tax and one of the highest corporate taxes in the Nation, it is apparent that California’s budgetary ills are not wholly attributable to “low” revenues.    

Recently, Assemblyman Tom Ammiano (D-San Francisco) introduced a bill (AB 188) that sought to close the loophole and would require a reassessment if 100% of a business were sold or transferred within three years.   While this bill is a good start, the fatal flaw of this bill, however, is that it can easily be planned around (e.g., one can structure the business sale to take just over three years or acquire up to 99.9% of the business ownership without triggering reassessment).    

 There is, however, a way that the Proposition 13 loophole can be permanently closed so that the tax rules are applied fairly across the board while at the same time ensuring that businesses are not hit with increasing property taxes as property values increase.    

This can be accomplished by amending the applicable statutes to provide that when an original owner or owners of a property transfers, either in a single instance or cumulatively, more than 50% of his or her or their business, then all real property owned by that business will be reassessed.  From that point forward, those owners will then be considered the original owners and whenever more than 50% of the business interests are again transferred there will be another reassessment. 

Believe it or not, this “original owner” rule already exists in the Proposition 13 implementing statutes, but for some reason, it only applies if the property was originally transferred to the business by the owners (essentially as a capital contribution).  Thus, if a business buys the real property from a third party, then the “original owner” rule, as currently written does not apply (which is why it did not apply in the Dell transaction).  Thus, by slightly altering the existing “original owner” rule to capture all cumulative transfers of more than 50% of a business’s interests, it will ensure that businesses are given a break on property taxes and also ensure that reassessments do happen when it is clear there has been a change in a business’s ownership.  This slight change is something that the most ardent supporters and opponents of Proposition 13 should be able to agree on.    

Proposition 13: Buying Property Without Reassessment of Property Taxes

Recently, Michael Dell has been in the news quite a bit as the result of his purchase of the Fairmont Miramar Hotel for $200 million.  In fact, the LA Times  reported to its chagrin that while Michael Dell had bought the hotel, he was able to exploit a "loophole" in Proposition 13 that allowed him to keep the property tax base as if the property was only worth $86 million.  By doing this, he was able to save over a million dollars a year in property taxes.  When the LA County Assessor's Office read the Times article they conducted a review of their own.  While LA County attorneys informed the assessor's office that Mr. Dell's transaction was not a change of ownership, the Assessor's Office challenged the transaction anyways.  Recently, an LA Superior Court judge ruled in Mr. Dell's favor, holding that under plain language of the law, there was no "change of ownership" and could be no reassessment.  

The Times, article, however, doesn't go into the details of how this was orchestrated and the law that applies.  Generally, when there is a change of ownership, property is reassessed for property taxes.  Now, when the property is owned by a legal entity, there are additional rules and complexities.  Under the law, the general rule is that the mere transfer of an ownership interest in a legal entity does not constitute a change of ownership of the property in the entity.  However, there are two main exceptions to this rule.  The first is the "change in control" exception which provides that if a single person (or entity) acquires more than 50% of the entity, then there will be a reassessment.  The second exception is called the "original co-owner" exception and provides that if the original owners of the entity cumulatively transfer more than 50% of their ownership interests in the entity to others, there will be a reassessment.  However, this second exception only applies if the entity acquired the property after March 1, 1975 in a transaction that was not considered a change of ownership because the property was used to capitalize an entity.  It was this curious requirement that worked in Dell's favor.

In particular, Dell's attorney's advised him that instead of buying the real property outright, he should instead by the LLC that owned the hotel.  In particular, they had Michael Dell form a limited partnership that bought 42% of the LLC, they had Michael's wife set up a trust for her to buy 49% of the LLC and then the remaining 8.5% was bought by an investment entity owned by Dell's investment managers.  Ordinarily, this transaction would easily fall under the "original co-owner" exception because you had the original owners of the LLC transfer 100% of there interests away.  However, because the hotel had been purchased by the LLC (or potentially was capitalized before 1975), this exception could not apply and so there could be no reassessment.  That left the Assessor's office relying on the first exception and so they argued that even though no single person owned more than 50% of the LLC, that there had been a change of ownership because Dell's interest and his wife's interest should be viewed as a single unit.  Dell's attorney's countered that this would violate the plain language of the law and that husband-wife transfers have never constituted a change of ownership.  The court ended up ruling in favor of Dell, which the Assessor's Office is expected to appeal.

The take-away is that if a buyer is interested in acquiring a property that has been owned by an entity since before 1975 (or purchased by the entitty thereafter), there are ways to structure the transaction so as to keep the low assessed value for property tax purposes.

What the Passage of Prop 30 Means for You

Proposition 30 was passed on Tuesday carrying about 54% of the vote.  Here's what it means.

There will be an across the board sales tax increase from a base rate of 7.25% to 7.5% for the next four years.  This will have an impact on all consumers.

In addition, there was a significant increase in marginal rates for those making more than $250,000, which will be retroactive to the beginning of 2012 and last for seven years. 

Under Prop 30 the new brackets for single filers will look as follows:

             In excess of $250,000----10.3% (up from 9.3%)
             In excess of $300,000----11.3% (up from 9.3%)
             In excess of $500,000----12.3% (up from 9.3%)

Proposition 30 will keep California in first place for having the highest state sales tax in the nation and should move California from second (behind Hawaii) to first place in state income tax. 

The biggest question I have, however, is will this seven year "temporary" tax increase be enough or will Governor Brown and his new super-majority legislature push for additional tax increases. Also, is Proposition 13 also soon to be on the chopping block?  Time will only tell. 

Homeowners See Jump in Property Taxes--what happened to prop 13?

Many California homeowners, while owning properties worth less than what they paid for, are at least getting some benefit by paying lower property taxes.

While many homeowners are familiar with Proposition 13 (which caps the tax assessed value on properties to a growth rate of no greater than 2%) they are most likely unfamiliar with Proposition 8 (the other one).  When Proposition 13 was passed in 1978, Proposition 8 was also passed. 

When your property declines in value, it is actually Proposition 8 which kicks in and allows you to claim a lower taxed assessed value on your property.  The tricky part is that once the housing market rebounds, the cap on Proposition 13 doesn't kick in until you reach a value essentially equal to your purchase price of the home.  In other words, if values rebound over night, the property's tax assessed value will be allowed to increase at more than the 2% rate until the purchase price value is met.  So surging home values could mean surging property taxes as well. 

While most homeowners are faced with depressed values, there are a few counties where property values are increasing and homeowners are getting assessed additional property taxes. For instance, some 37,000 residents in Santa Clara County received notice that their property taxes were increasing this year as a result of rebounding housing values:

"It's a double-edged sword,'' said Kreshel, a senior manager at eBay. "The value is going up and so are my property taxes, even though it's still below what I had to pay for it,'' she noted with a sigh. "It's part of being a homeowner.''

It is really only a matter of time before home values start to recover state-wide and homeowners realize that the property taxes will increase dramatically as result.

Williamson Act Threatened in Fresno County

The Williamson Act, a unique property tax provision which allows certain farmlands to have a tax assessed value even less than their proposition 13 assessed value, will be cut back, and potentially even dropped in Fresno County.

Under the Williamson Act, farm land values for tax purposes were significantly reduced if the owner/farmers agreed to maintain the land as farmland and not sell out to developers.  In the past, while counties received less in property tax revenues for properties under the Williamson Act, the difference was made up by the the state. 

However, there are no longer state reimbursements which forces counties to either eat the difference or minimize the tax benefits under the act.  As a result, the Fresno County Board of Supervisor's recently announced that they plan to cut the tax benefit by approximately 10%, which means that many Fresno County farmers will see an increase in their property taxes.