When setting up your Estate Plan, how do you instruct your Executor to distribute your property? There is nothing stopping you from naming a beneficiary for each and every asset in your estate, but that would be very tedious and painstaking. You’d need to name a contingent beneficiary for each as well, which adds to your headache.
Instead, you can use a legal stipulation that clearly directs how your property and assets should be distributed. There are several options to choose from. Today we’ll be exploring the difference between a pro rata vs. non pro rata distribution, in which option might be better for you.
What Is Non Pro Rata Distribution?
A non pro rata distribution takes place when beneficiaries will inherit equal proportions of an estate in total, but they won’t necessarily inherit equal proportions of each asset.
For instance, let’s say an individual passes away with an estate worth a total of $300,000, after remaining taxes and debts are paid. They request a non pro rata distribution to each of their three children. This means that when all is said and done, each child will inherit property and assets valued at $100,000 each. However, the inherited items will look different from one beneficiary to the next. Individual property and assets weren’t necessarily divided into thirds.
When is Non Pro Rata Distribution Used?
When a child or children stand to take title to real property passed to them by a parent, they could face some significant property taxes. For example, let’s say that a surviving parent passes away and leaves the family home to one child, valued at $700,000. The other child prefers cash and inherits $700,000 total in cash, retirement savings, and investments. However, these two inheritances are not actually equal in value. This is because different types of assets and property are subject to different tax implications, thus resulting in differing financial obligations for each inheritance.
Because of this, a non pro rata distribution can be used to avoid a property tax reassessment event and create cost savings.
In California, Proposition 13 established base values for real property. Any property that was not sold or undergone construction retains its base value. If a property is sold or re-constructed, it triggers a property tax reassessment event. The owner must pay a much higher property tax based on the property’s current market value.
Luckily, there is a parent-to-child exclusion to this rule. If a parent bequeaths real property to their child through an Estate Plan, it does not trigger a property tax reassessment event. This means that the child gets to inherit the property and can continue paying the locked-in property tax rate that their parent was paying.
Pro Rata vs Non Pro Rata Distribution - What’s the Difference?
A pro rata distribution of estate assets takes place when each heir receives equal portions of each asset in the estate. In review, this is different from a non pro rata distribution, through which each heir receives an equal proportion of the estate in total, but won’t necessarily receive equal portions of assets.
Let’s go through examples of a pro rata vs. non pro rata distribution to demonstrate how non pro rata can help prevent a tax reassessment event.
Pro Rata Example
John passes away and leaves his estate to three adult children. John’s Will includes a stipulation calling for a pro rata distribution of the estate to each child. This means that each asset is divided evenly amongst each child. Included in the inheritance is a home (owned free and clear of debt) with a Proposition 13 base year value of $300,000.
After the distribution is made, each child owns one-third of the home each. Due to the parent-to-child exclusion, a reappraisal event isn’t triggered. However, the children find it impractical to each own one-third of a home. The eldest child, Molly, decides to buy out her two siblings by taking out a new mortgage. However, this transaction is outside of the parent-to-child exclusion and thus triggers a property tax reassessment event. Before the transaction, she could have paid property taxes on the base value of $300,000. After the property tax reassessment, she now has to pay property taxes on the updated $700,000 property value. Because the home was distributed pro rate, Molly’s property tax bill is thousands of dollars more per year.
Non Pro Rata Example
Now, let’s pretend that John passes away and leaves his estate to the same three children in equal shares. The family home has the same base year value of $300,000, but the current fair market value is $700,000. He also happens to leave behind an array of cash, liquid assets, and investments that are worth $1.4 million in total.
Molly wants the childhood home, while the other two siblings prefer cash.
John had placed all his real property and assets into a Trust, and the Trustee performs a non pro rata distribution. Molly inherits the home that is worth $700,000 in today’s market. Her two siblings inherit $700,000 each in cash and other financial assets. Because Molly doesn’t have to buy out her siblings from the childhood home, she gets to keep her father’s base year value of $300,000 and gets to save thousands of dollars per year in property taxes.
Both examples shared the same variables: the asset, the value of the asset, and the number of beneficiaries. However, depending on whether the estate distributed the assets pro rata or non pro rata, two significantly different outcomes were created. Where real property is concerned, using a non pro rata distribution helped the beneficiary avoid suffering from a dramatic increase in property taxes.
Should I Use Pro Rata or Non Pro Rata in My Estate Plan?
When drawing a comparison between a pro rata vs. non pro rata distribution, it’s difficult to say whether one strategy is better than the other.
In this guide, we explored a specific scenario in which a non pro rata distribution created a better outcome for a child inheriting real property. This was a relatively clean scenario in which their siblings didn’t want to stake any claim in the property and plenty of other assets amounting to equal value were available.
However, a different individual’s estate could look entirely different. For instance, they might have an entirely different set of assets and property, along with beneficiaries with complex desires. Different estates require different solutions.
A key takeaway from this discussion to keep in mind is that flexible estate planning solutions and options are available. In this example, property was placed in a Trust, thus giving the Trustee the flexibility to select a distribution strategy that worked best for the beneficiaries. Based on the estate’s specific characteristics, a non pro rata distribution created the best outcome for all beneficiaries involved.
Want to level up your Estate Plan? Consider employing a Trust-based Estate Plan, which instantly expands your control over how your estate is distributed to your loved ones. Because passing on your legacy to more than one person is hardly straightforward, having more options and flexibility is always preferable. At Trust & Will, we’re here to help keep things simple. You can create a fully customizable, state-specific estate plan from the comfort of your own home in just 20 minutes. Take our free quiz to see where you should get started, or compare our different estate planning and settlement options today!
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