Forms of Ownership: Entity Ownership

A legal entity is an artificial legal person and it has legal capacity like an individual. It can:

1. Enter into agreements or contracts;
2. Assume obligations;
3. Incur and pay debts and loans;
4. Sue others and can be sued;
5. Be held responsible for its actions; and
6. Contract for purchase, sale, or lease of real property.
Just like a real person, a legal entity’s interests in real property may be owned individually, owned by another legal entity, or held in trust. Some of the most common examples of legal entities holding title to real property in California are:

1. Corporations,
2. Partnerships,
3. Limited liability companies,
4. Joint ventures,
5. Massachusetts business trusts, and
6. Real estate investment trusts.

Change in ownership for legal entities

In general, transfers of corporate voting stock, partnership ownership interests, LLC membership interests, or ownership interests in other legal entities are not changes in ownership of the real property owned by the entity.

The above general rule does not apply to three exceptions:

1. A transfer of an ownership interest in a legal entity that shifts control of the entity;
2. A transfer of an ownership interest in a legal entity by an original co-owner resulting into a cumulative transfer of more than 50 percent of all the interests held by original co-owners; and
3. A transfer of shares in a cooperative housing corporation.
In general, there are two types of transfers involving legal entities that result in a change in ownership for the purpose of Property Tax in California:

1. The transfer of interest in real property to and by a legal entity; and
2. The transfer of ownership interest in a legal entity that owns real property.
The first type of transfer involves a transfer of an interest in real property between legal entities i.e. between a corporation, partnership, LLC, or other entity, etc. The transfers also include transfers between a legal entity and its shareholders.
The second type of transfer involves transfer of ownership interest in a legal entity. The real property is in ownership of the legal entity before and after this type of transfer. Only the ownership interests of the legal entity change.

Both type of transfers trigger a change in ownership of the real property owned by the legal entity. Therefore, the property held by the legal entity attracts reassessment based of change in ownership.

Illustration

Mr. Arthur Andrews, Mrs. Ava Andrews, and their daughter Ashley Andrews owns 51%, 39% and 10% shares in a legal entity. The legal entity owns a real property worth $660,000. Who owns the legal entity? Who controls it? Who owns the real property? And who controls the real property? 

What should Mr. Andrews do if he wants to shift the control of the property to his wife, Ava?

The situation is best explained using a diagram:

Diagram 01

Mr. Andrew Arthur 51% Shares Mrs. Ava Andrew 39% Shares Miss Ashley Andrew 10% Shares	----	Family of Mr. Andrew Arthur owns the legal entity.
­ I
Ownership of legal entity
­ I
Legal Entity	----	The legal entity owns the real property
­ I
Ownership of Real property
­ I
Real Property	----	The real property to be assessed for Property Tax.

Arthur Andrews, his wife, and his daughter owns the legal entity as shown in the diagram. However, effective control on the administration of the legal entity requires ownership of more than 50% share. Therefore, Mr. Andrews controls the legal entity; he has 51% shares in ownership of the entity.

If Mr. Andrews wants to shift the control of real property to his wife, Ava, he will have to transfer 12% or more of his shares in the legal entity to her. Mrs. Andrews will have more than 50% shares in the legal entity then and she will effectively control the property owned by the legal entity. In such transfers of control as transfer of ownership of a legal entity, there is no change of ownership of a real property in strict sense of such a change. However, effective control of the real property changes hands from one person to another, namely from Arthur Andrews to his wife Ava Andrews.
The legal entity owns the real property, but it has its own owner controlling it – Mr. Andrews. Thus, Mr. Andrews controls the property without having a direct ownership of the property.

The county assessor understands this possibility of control through legal entity. The Revenue and Taxation Code allows the county assessor to treat this type of indirect control and its transfer as ownership and change in ownership respectively.

Illustration

Zara owns 60% of the voting stock of the Asian Logistics Corporation. The Asian Logistics Corporation owns three warehouse in California worth $3.0 Million, $3.2 Million and $2.0 Million. The current fair market value of these warehouses is about ten times more than the acquired values of the warehouses in 2007. Zara wants to leave the country after selling voting stock to her husband, Smith, and one of her business fellow, Nathan. Nathan and Smith already have 30% and 10% voting stock of the corporation. Which of the following options will not trigger reassessment of the underlying property of the corporation: 

1. Zara transfers 60% voting stock to Nathan?
2. She transfers voting stock to Smith and Nathan 30% each?
3. She transfers 45% voting stock to Smith and 15% to Nathan?

In option 1, the control of the corporation will be transferred to Nathan and the warehouses owned by the corporation will be reappraised. Since, the fair market values of these warehouses are about ten times larger than there acquisition values in 2007, Property Tax increase will also be huge.

The Option 2 will also produce the same results.
In Option 3, the control of the corporation will be transferred to Smith, her spouse, the change in ownership will qualify for inter-spousal transfer exclusion.

Illustration

Three brothers, Joseph, Jose, and Jeremy created a partnership for starting a retail store in a rented building. Subsequently, the partnership purchased the store’s land and building. Joseph owns 51%, Jose owns 48%, and Jeremy owns 1% of the partnership. The partnership has a continuing clause so that the partnership does not terminate if any of the brothers dies. 

After two years, Joseph died in an accident. Upon death, his will gave 10% interest to his brother Jose, and 41% interest to his son David. 

Will the property owned by the partnership be reappraised by the County Assessor?

The control of the partnership has shifted from Joseph to Jose. This change in control is sufficient to constitute a change in ownership and to trigger reassessment of the underlying land and building of the store by the County Assessor.

California Property Tax: Change in ownership and Proposition 13

Property Tax in California 

If you own taxable property on January 1, you become an assessee and are liable to pay property tax. The property tax amount you have to pay is based on the value of your property, or more accurately on its assessed value. The assessed value of your property is the value determined by the County Assessor of your county for property tax purposes. It is shown on your property tax bill (see a typical property tax bill below). The assessed value of your property is likely to be the prior year’s assessed value adjusted for inflation by up to 2%. Hence, you normally do not expect a large increase in your property tax bill. You will receive a property tax bill with a normal increase in amount payable unless there is a change in ownership.

If there has been a change in ownership of your property, its assessed value no longer remains the prior year’s assessed value adjusted for inflation. Its new assessed value will be its market value after it has changed ownership. The date of change in ownership is also important to ascertain the effective year of change in assessed value. Since, your property tax is calculated on the assessed value of your property, the change in ownership and its effective date can have a major impact on your property tax bill.

This section will explain to you the two primary factors that affect your property tax bill, as well as how change in ownership can be another dominant factor that results into higher assessed values and property tax bills.

A property tax bill gives you important information including the name of the owner, assessed value of the property, and property tax rate.

Property Tax Bill

Two primary factors which increase your Property Tax Bill

Your Property Tax on real property depends on two primary factors:

1. The taxable value (assessed value) of your real property; and
2. The tax rate.

One of the other factors that affects your property tax liability is change in ownership. It is a dominant factor which increases your property tax by increasing the assessed value of your property. As the assessed value increases, it causes your property tax to increase as a result. 

When a change in ownership occurs, the County Assessor assigns a new assessed value to your property. The technical term for assigning a new taxable value to your property is reappraisal or reassessment. 

In California, reassessment based on change in ownership can very often account for major increases in property taxes each year. The reappraisal or reassessment of property due to change in ownership is one of the major driving forces behind higher property tax bills and increases in public revenue.

Let us examine how property taxes are calculated and how the changes in ownership increases the payable amount shown on a property tax bill. It is important to keep three items in focus throughout the coming text. The three factors are assessed value and increases in it; rate of property tax, and change in ownership.

You cannot calculate property tax without assigning a value to your property

You cannot calculate the annual property tax on your real property simply by punching the number of rooms, shops, apartments, and swimming pools into a calculator! You need to know the value that has been assigned to your specific property. Once you know this value, the process of calculating your property tax liability is simple and straightforward. You need to multiply the value by the tax rate to get the amount of property tax payable. That is:

Property tax = property value X tax rate

The value on which you calculate the property tax of your real property is the first primary factor that affects amount payable shown on your property tax bill. A county assessor will call it the assessed value (taxable value) of your property, i.e., the value on which your property tax liability is computed. The higher the value of your property, the higher will be your property tax bill. That is why owners of properties strive to keep the assessed value of their properties by adopting all possible legal measures.

The California Revenue and Taxation Code and Property Tax Rules spells out a precise procedure to determine this assessed value of your real property based on its size, location, improvements (houses, garages, fences, etc.), and other factors.

Note the underlying arithmetic:

The higher the assessed value of your property, the higher the tax liability on your real property will be.

The County Assessor may increase the assessed value of your property each year in order to adjust for inflation.

In summary, the assessed value of your property will be reappraised by the County Assessor based on any new construction, as well as change in ownership. It will also be adjusted for inflation in addition to any reappraisal.

You need a rate to calculate property tax on the value of your property.

The assessed value of your real property is not sufficient alone to determine your property tax liability. You also need a property tax rate to multiply by this value to determine property tax payable. The rate of property tax is the second primary factors which increases or decreases your property tax in a given year.

Arithmetic is simple:

The higher the rate of property tax rate in your county, the higher your tax liability will be.

A lower tax rate is good for saving property owners money and a higher tax rate is good for tax collectors.

The power to tax

This Article is about locally assessed real property. Locally assessed personal property and state-assessed properties are not subject of this Article/eBook.

The local government has power to tax real property. Primarily, the government exercises the power to tax by imposing tax at specified rates and subsequently changing the rate of tax annually or after a suitable period.

The government increases tax by increasing assessed value and rate of property tax

Because the amount of your property tax bill depends on the assessed value of your property, it changes as the assessed value of your property changes. In addition, if rate of tax changes, your property tax also changes. Therefore, in addition to other measures, the government can increase property tax amount on property by changing both the primary factors which determine your property tax.

The government can increase your property tax by:

1. Increasing the assessed value of property; and
2. Increasing the property tax rate.

Prior to 1978, annual assessments for real property were based on current fair market value. In addition, it was not possible for the County Assessors to annually assess property due to financial and human resource constraints. Therefore, they assessed property on a cyclical basis after every three to five years. Between these reappraisal cycles, county assessors would often apply interim value increases based on trending factors such as inflation.

If the County Assessor of your county uses the market value as the assessed value of your property, your property tax bill will increase or decrease with the changes in the market value of your property. In turn, the market value of your property changes based on the market forces that drive the real estate market. Therefore, the tax on your real property is subject to both market forces and the government. If real estate prices are soaring, property tax bills will also show higher payable amounts. Before 1978, the government was on the receiving side of these benefits because of ever-increasing real estate prices. However, the assessed value was no longer allowed to increase based on market values of property after 1978.

Prior to 1978, there were no prescribed limits on assessing initial assessed value at a base year values, increasing the assessed value from year to year, or increasing the rate of property tax. The passage of Proposition 13 in 1978 prescribed these limits and curtailed many of the methods of the government to tax real properties.

Proposition 13 has limited the government’s power to tax

In June 1978, California voters approved Proposition 13 to change property taxation in California. The passage of Proposition 13:

1. Limited the property tax rate applied to assessed values to 1 percent plus additional rates to retire bonded indebtedness;
2. Placed explicit limitations on the power of the government to impose additional property taxes; and
3. Limited increases in assessed values.

Proposition 13 limited the power of the government to assign values to properties by fixing base values for properties at market values of 1975 in general. After its passage in 1978, the assessment procedure of real properties for property tax has dramatically changed. Real property values for property tax purposes are now rolled back to their March 1, 1975, values before any increase in them and before calculating property tax on these values.

In addition to fixing the base values, Proposition 13 further limited the government’s power to tax by placing strict upper limits on annual increases in assessed values. The assessed value of a property cannot increase by more than 2% in any given year. This means both the initial assessment of a property and its yearly increase are now limited.

After Proposition 13, a County Assessor annually assesses all real property in California annually on January 1. Under the Revenue & Taxation Code, two values are compared, and the greater of the two is assigned as the assessed value for the property:

1. Base Year Value as of March 1, 1975 plus adjustment for inflation; and
2. Base Year Value as of the date of recent change in ownership.

Base Year Value as of the date of new construction is also relevant because new construction also triggers reassessment. However, reassessment based on new construction is beyond the scope of this article/eBook.

Thus, Base Year Value of March 1, 1975 plus adjustment will be the assessed value of your property unless there is new construction on your property, or the property is transferred through sale. Therefore, any new construction or transfer is likely to result in a higher assessed values for your property.

A base year value is the full cash value or fair market value of the property. The base year value is adjusted for inflation at a specified rate. Since Proposition 13 placed a limit on the annual increase in assessed value, the base year value cannot be increased by more than 2% in a year, unless the property is transferred or new construction takes place.

The law defines fair market value as the full cash value of real property or its equivalent. It is the amount of cash that the seller of the real property would expect to receive on the open market if neither party were under an exigency to enter into the transaction and both parties were fully informed about any advantages or disadvantage associated with the property.

After the passage of Proposition 13, the value of real property in California, for property tax purposes, does not necessarily increase to keep pace with its current fair market value. However, a change in ownership can result in the assessed value being increased to the current market value, regardless of its previous assessed value.