Real Estate as an Estate Planning Vehicle – Part 1: The Benefits and Risks of Owning California Real Estate

California real estate appreciates faster than real estate in most other states, and for that reason, it’s more likely to form the largest part of a homeowner’s total estate upon death. However, real estate is vulnerable in ways that other forms of generational wealth are not, and therefore requires more planning and protection. This four-part series will explore those vulnerabilities and provide tips on preserving the value of this precious asset for generations to come.

Say your grandparents purchased a home in California in 1940 for $25,000. With good planning, steady jobs, and a bit of luck, they managed to hold onto that house and pass it to your parents in the mid-‘80s. You grew up in that house, and now your parents are planning to pass it to you and your family. Over the years, that house would have appreciated to about $750,000, 30-times what it was worth in 1940, all while providing shelter and safety to those who reside within it.

Few assets appreciate at the pace of California real estate, and even fewer with the remarkably steady predictability of home prices in this state. Moreover, housing is becoming such a scarce commodity, with immigration drastically ramping up and new constructions lagging, that prices are actually increasing exponentially in some areas, especially coastal communities and high-tech centers.

Getting on the California real property ladder is a smart long-term investment, one that could significantly enhance the size of any estate you pass down to your children and your children’s children. But protecting that investment requires some strategic planning because real estate is vulnerable in ways that other assets like stocks and savings accounts are not.

Let’s take a look at those vulnerabilities.

1. Liability

The first major risk in homeownership is liability. For those without familiarity, liability is essentially a debt you owe someone else for an injury they incurred on your property or because of you. If you hit someone with your car, you are liable to them for their injuries. If you break a contract, you are liable to the other party for any negative consequences they sustained as a result.

Real estate is vulnerable to both “inside” and “outside” liability. Inside liability is liability related to or caused by the property itself. For example, if someone slips and falls while on your property, they could sue you for damages resulting from their injuries. Another common inside risk of owning real estate is a claim made by a tenant for, say, unlawful eviction or water damage to their personal property.

Even risks unrelated to your real estate – “outside” liability – could affect it. Let’s say you get in a car accident and the other driver sues you for more than your car insurance will cover. If you are found liable for that accident, all assets held in your name – your bank accounts, your car, and your home – are theoretically accessible to satisfy the judgment.

Sixty-three million lawsuits were filed in the United States in 2021, and I’m willing to wager that at least 10% of those were filed in California. We live in a highly litigious state that is known for something called “predatory” or “nuisance” lawsuits, in which the value of the suit is in subjecting the defendant to the expenditure of time and money until they settle on a claim that probably wasn’t worth much to begin with.

Given that a California homeowner’s largest asset is likely their home – which represents so much more than just the money it’s worth – liability is a substantial risk that warrants protecting against.

2. Probate

Probate is the court process by which assets are transferred from a deceased person to a living person. It is mandatory in California for any individual who, at death, has more than $184,500 in assets or owns California real estate valued at more than $61,500 – with one notable exception that I will discuss in Part 2 of this series.

Probate is expensive, not least because it’s a court process that your family will have to go through while grieving your loss. Imagine your loved ones having to get an attorney, calculate your net worth, file papers and appear in court, all while in mourning. Not a prospect anyone relishes. And, in California, this process can take up to 2 years.

In addition, because court proceedings and court records in the United States are, with few exceptions, open to the public, your family will lose a great deal of privacy in probate. Without proper planning, your assets, your heirs and how much they inherit will all be exposed to public scrutiny. And unfortunately, there are people who sit in probate court just waiting for the 18-year-old who is inheriting $2 million in order to take advantage of their new-found wealth.

Finally, probate costs a lot of money. On average, the costs and fees associated with probate – filing fees, court costs, attorney’s fees, etc. – amount to 4-5% of a person’s total assets upon death. So, for the average California home – valued at $742,352 – probate would cost $37,118. And these costs must be paid before a single cent is actually received by the deceased’s heirs.

And here’s the kicker: probate costs are calculated based the fair market value of your assets, not taking into account debt. This can be a big problem particularly for real estate because most real estate is backed by a mortgage. So, for example, even if the owner of that average California home holds half its value in debt and half in equity (meaning the bank owns half and the homeowner owns half), probate costs will still be calculated based on the total fair market value of the house. This can lead to the need to sell the house just to pay the costs of probate, particularly if the home is recently purchased or highly leveraged and its fair market value is far higher than any equity the deceased held.

3. Taxes

Most taxes that will affect the value of real estate in a generational transfer scenario are not a problem for the vast majority of Californians. Taxes assessed at death fall into two buckets – estate/gift taxes and generation-skipping transfer taxes (GSTT). Both buckets currently exempt the first $12.9 million of value, meaning that if your total estate plus the gifts you gave during your lifetime are less than $12.9 million, you pay no estate taxes. Same for transfers you make to generations 2 or more below your own (i.e., generation-skipping): the first $12.9 million is tax-free. If this is an issue for you, Part 4 of this series will be very useful for you.

For the rest of us, the primary tax issue that we’ll need to be concerned about is property taxes. Unlike most assets, real estate is taxed on an annual basis, and starting in 2021, the value that is taxed goes up upon a generational transfer. In 2020, California voters passed Proposition 19, which requires that real property be reassessed for property tax purposes upon transfer from parent or grandparent to child. Before Prop. 19, the house purchased for $25,000 in 1940 could have passed from grandparent to parent and parent to child, all while keeping the tax basis of $25,000 – a huge boon for families that hold real estate for a long time. That is no longer the case, and it’s a big problem for heirs that inherit generational properties.

4. Divorce

The final risk that owners of California real estate need to be concerned about is divorce. Because California is a community property state, any property acquired during marriage, either by purchase or inheritance, becomes half the property of each spouse. Therefore, upon divorce, each spouse has a right to take one-half of the interest in the real estate. This division forces sale in many if not most cases. If you’re looking to retain a home in your family for multiple generations, or even just one, you’ll need to consider the distinct possibility that divorce could end up liquidating or splitting the benefit of the property.

Coming up… Part 2: The Basics. In the next installment of this series, we’ll discuss the essential protections that every California homeowner should put in place to preserve the value of their real estate both during their own lifetimes and during generational transfer.

© 2024, Jane Legal PC

This article is a service of Jane Legal PC. We don’t just draft documents; we ensure you make informed and empowered decisions about life and death, for yourself and the people you love. That’s why we offer a free Wealth Planning Session™, during which you will get more financially organized than you’ve ever been and make all the best choices for your chosen family. Begin the process by scheduling a free 15 minute discovery call today.

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking legal advice specific to your needs, such services should be obtained separately from this educational material.

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