(Note: This article is general in nature and is geared towards California properties. Seek professional legal and accounting advice before making any decisions.)
Introduction
For generations, vacation homes have been cherished by family members. Since this property is quite often intended to pass on to the next generation, it might not be viewed as a wealth generator but simply as a family heirloom. In fact, many vacation homes generate negative cash flow, even on a tax basis. So, financially, vacation homes are typically thought of as a luxury asset whose primary value is enjoyment.
Importantly, in terms of estate planning, the property tax considerations of vacation homes have changed dramatically with the passage of Prop 19. This law has potentially severe financial consequences for children who inherit real property from their parents, because it considerably limits the availability of the parent–child exclusion for purposes of real estate tax assessments and resulting property taxation.
Before and After Prop 19
Prior to Prop 19, which took effect in 2021, parents could transfer a vacation property with up to $1 million of the assessed value being exempt from the increase in property taxes. This was regardless of the property’s use by the children.
Now, under Prop 19, when a vacation home is inherited, it is reassessed at its current market value, which can lead to a significant increase in property taxes.
This can make it very difficult for children to keep these properties: the property might be running at a loss anyway (unless heavily rented), so the additional expense of increased property taxes might just be enough to force the sale of the property. This is especially sad for cherished family vacation homes that hold great memories and were hopefully going to be used for generations to come.
For example, if the parents purchased a vacation home in 2000 for $350,000, and the value of the property is more than $1 million when it is transferred upon the parents’ death to a child, the parents’ tax basis doesn’t pass on to the child. Since the child will now have to pay greatly increased property taxes based on the assessed fair market value, it can negatively impact the child’s decision to keep or sell.
From a capital gains tax perspective, current law is unchanged by Prop 19. Estates of decedents who die during 2025 have a basic exclusion amount of $13,990,000, which generally means no capital gains will be applied if the estate is less than that amount. If the home is sold, capital gains taxes are only due on any gains made since it was inherited.
Potential Strategies
Given the impact of Prop 19, there are several strategies to evaluate with your estate planning attorney, so that your estate plan can be optimally structured to meet your personal goals. Here are a few:
- Sell your current home and move into the vacation home – This could make sense if you spend more time there and would prefer living there during retirement. It could also help avoid a tax increase for heirs if the property fits within Prop 19’s exemption for primary residences. However, your child would need to occupy it as their primary residence within one year of inheritance to keep your property tax benefits.
- Keep your current home as a rental and move into the vacation home as your primary residence – This is logistically challenging and has tax complexities, especially around capital gains exclusions for primary residences. You cannot have two primary residences at once in California.
- Sell the property – This might happen if heirs prefer cash or cannot afford negative cash flow.
- Keep it and pay the higher property taxes – This works only if heirs have significant assets and income.
- Convert it to an LLC – In certain cases, California Revenue & Taxation Code rules for LLCs may help avoid higher property taxes, but this depends on timing, appreciation, and ownership structure, among other factors.
Experts in Estate Planning for Real Estate
At Mortensen & Reinheimer, PC, we’ve crafted estate plans involving thousands of real estate properties. Let us put that experience to work for you in simplifying what can be a very complex process.
Contact Mortensen & Reinheimer, PC at (714) 384-6053 or visit www.ocestateplanning.net.
About the author
Tamsen R. Reinheimer, Attorney, is a Certified Specialist in Estate Planning, Trust & Probate Law (The State Bar of California Board of Legal Specialization) with significant experience in estate planning, trust administration, and probate.
Contact: tamsen@ocestateplanning.net
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