Real Property Taxes: Living with the Uncapping Rules

Take-Away: To describe Michigan’s real property tax rules as complicated is a gross understatement. The key To navigate the uncapping rules in search of an exception is to go slow (to the point of moving your lips while you read the key definitions) in order to avoid a taxable value uncapping when title transfers to Michigan real estate. Taking small steps in the search of an exemption from the uncapping rules is often the answer.

Background: Months ago I was asked to provide an overview of Michigan’s real property tax rules. I admittedly procrastinated acting on that request. I do so now reluctantly, since the rules are bewildering on their face, and they are frequently subjected to tortured interpretations by assessors who follow Guidelines created with the sole goal to generate revenues for local municipalities.

Any time there is a transfer of real estate in Michigan, the local property tax assessor is supposed to re-assess (uncap) the real property’s taxable value up to 50% of the real property’s current fair market value. This basic rule that the taxable value is uncapped is complicated by the multiple statutory exceptions to the uncapping of a parcel’s taxable value. This discussion will be restricted to residential real property, since many of our clients have legacy homes that they want to keep in their family to be owned or used by the next generation, but without a dramatic jump in the legacy home’s real property taxes. In order to counsel those clients it is critical to have a working knowledge of what transfers of real property fall within one or more of the statute’s uncapping exemptions.

Definitions: To start you first need to know some of the often counter-intuitive definitions used in Michigan’s real property tax statute and its litany of exemptions.

Transfer of Ownership: The obvious is a conveyance of title to real estate by deed. The not-so-obvious definition of a transfer is a conveyance of a present interest in real property, including a beneficial use of the real property, the value of which is substantially equal to the value of the fee simple (that’s Latin for full marketable title) interest. In plain English that means that a change in a trust beneficiary’s right to possession, use, or enjoyment of the real property held in trust is a possible transfer. Consequently, if a trust by its terms changes its beneficiary upon a specified event, or the present beneficiary’s death, it is possible that the change in present beneficiary of the trust that holds title to real estate will cause an uncapping transfer to occur.
Residential: This is an important exemption. As a generalization, the transfer of residential real property will be exempt from uncapping if the transfer is to a qualifying family member (defined below.) Residential includes platted or unplatted parcels, with or without buildings, condos within or outside a village or city, which are used for, or probably will be used for, residential purposes. Also included within the residential definition are parcels that are used for, or probably will be used for, recreational purposes. Residential real property is technically defined by statute; the converse is that the real property cannot be used or treated as commercial property, i.e. the residence is rented.
Commercial Use: Unclear from what should be a fairly obvious definition of residential real property is if there is some commercial activity on what is otherwise considered to be or used as a residence, since that commercial activity disqualifies the real estate from the statute’s residential Commercial use is defined as a use ‘in connection with any business or other undertaking intended for profit, but does not include the rental of residential property for a period of less than 15 days in a calendar year. Clear Example: The kids inherit the family cottage on Lake Michigan from Mom and Dad. The kids decide to rent the cottage out for the month of June to raise funds to help to pay real property taxes, insurance, maintenance, etc. that goes along with owning the cottage. That rental for the month of June is a commercial use which will cause the taxable value of the cottage to be uncapped. If the kids only rented the cottage for the first two weeks of June, then the cottage’s taxable value will not be uncapped. Not-so-clear Examples: (i) Daughter inherits home from father. Daughter lives in and runs a day-care center out of the home that she inherited. The day-care operation in daughter’s home destroys the residential character of the home (an undertaking for profit) as it as she intends to make a profit. (ii) Son is gifted a home by father; son lives in the home and he day-trades all day on the computer. Son’s day-trading blows the residential exemption if he makes a profit. But how does the local assessor know the son day-trades? (iii) Child inherits the home and chooses to work from that home one day a week. Child is paid wages whether or not he/she works from home one day a week. Does working a wage job one day a week from home fall within intended for profit? (iv) Son inherits home and adjacent 10 acres of hardwood timber. As a hobby, son son on weekends cuts some of the timber and sells firewood in the front yard at $3.00 a bundle. Son intends to make a profit, albeit minimal, from his hobby. Is intent to make a minimal profit enough to be viewed as a commercial use? (v) Will a tupperware party (if they still have them- showing my age again!) conducted in the home be enough? No one knows at what point the level of remuneration activity conducted in the residence causes the residential classification to be forfeited.
Qualifying Family Member: This definition, when coupled with the residential definition, is where most of the exemptions from uncapping takes place that are of interest to us and our clients. Note that only certain family relationships will qualify for the exemption. The key qualifying family member relationships are: spouse, transferor or transferor’s spouse’s mother, father, brother, sister, son, daughter, adopted son, adopted daughter, grandson or granddaughter. Some close family relationships are not covered by this definition, which can lead to inadvertent uncapping traps: for example, adopted grandchildren or sons-in-law or daughters-in-law are all excluded from being a qualifying family member. Also a hot topic in the legal circles these days is that a transfer of residential real estate to an LLC that is owned by qualifying family members is also excluded. Using an LLC to own a cottage is the prime legal recommendation (‘use an LLC to hold title to the family cottage’) in David Fry’s immensely popular book owned by thousands of Michigan cottage owners, Saving the Family Cottage.

Common Uncapping Transfer Examples: Where you will encounter an uncapping transfer, absent one of the statutory exemptions, are the following:

Deeds between unrelated third parties;
Sales of real property;
Land contract sales;
Leases, if the lease term is greater than 35 years or there is a bargained-for purchase option as part of the Lease terms;
Cooperative housing transfers as to the ownership interest conveyed; and
Qualified agricultural land if it is removed from the qualified agriculture classification and placed under a separate tax parcel number.

Common Excluded Transfer Examples: Transfers that are expressly exempt from uncapping in the Michigan real property tax statute include the following:

Forfeiture or foreclosure of a mortgage or land contract;
Redemption;
Court order or judgment if no consideration (money) is mentioned in the order or judgment;
Discharge of a security interest in real estate;
Tax-free organization of an entity that holds title to real estate;
Most qualified agricultural property transfers;
Most qualified forest property transfers; and
Conservation easements.

Common Examples: When we advise clients, e.g. gifts of real estate, or we administer trusts that hold real estate, we need to be mindful of these uncapping rules and exemptions to assist to avoid an inadvertent uncapping:

Joint Ownership: This exemption got a lot of attention 5 or 6 years ago with the Supreme Court’s 2011 Klooster decision. If I add my wife’s name to the deed as a joint owner of real property with rights of survivorship, the transfer is protected. If my wife and I dissolve our jointly owned real estate, that transfer is protected.
Example: If my wife and I add our son’s name to the title as a joint owner with full rights of survivorship with us, that transfer is protected; that is because my wife and are treated as original owners. A helpful way to understand the original owner concept is that when my wife and I bought the real property from a third party years ago, the taxable value was uncapped at that time of our purchase (a transfer between unrelated parties.) The last time the taxable value was uncapped was when my wife and I acquired title, making us the new original owners, i.e. the last time the taxable value was uncapped. So long as there is an original owner holding title as one of the joint tenant, there is usually no uncapping when another person’s name (family member) is added to the title. Consequently, adding my son’s name to the title does not result in an uncapping since my wife and I continue to be original owners in the chain of title. Assume, my wife and I die; no uncapping occurs on our deaths. My son, as the sole surviving joint owner, decides then to add his daughter’s name to the title as a new joint owner with him. Adding the daughter’s name as a joint owner results in an uncapping of the real property’s taxable value since my son, who made the transfer into joint ownership, was not an original owner at the time of that transfer, even though his daughter satisfies the qualified family member definition as it relates to my son. Solution: If my wife and I add both our son and his daughter as joint tenants with full rights of survivorship to the title, upon our deaths there will be no uncapping transfer, and thus the taxable value of the real estate will remain what it was while my wife and I were alive. Note, this applies to all real estate, not just residential exempted real estate. However, any transfers by my son and his daughter later will cause an uncapping since neither my son nor his daughter are original owners.
Into a Trust: Assume that I transfer title to real estate to an irrevocable Trust. A transfer to the Trust will result in an uncapping unless: (i) the sole present beneficiary of the Trust is me, my spouse, or a qualifying family member (defined earlier) AND (ii) the real property is residential with no commercial use. Transferring a cottage to an irrevocable trust will have to satisfy all of these requirements to avoid an uncapping.
Out of a Trust: Similarly, a transfer from the Trust will result in uncapping unless: the distribute/grantee is either (i) the sole present beneficiary of the Trust or (ii) the sole present beneficiary’s spouse, or (iii) the distribution to a qualifying family member (defined earlier), AND the (iv) the real property is residential with no commercial use. Again, all of these requirements must be met to avoid an uncapping.
Change of Trust Beneficiary: If the sole present beneficiary of the trust ever changes, the taxable value of the real property held in the trust will be uncapped unless: (i) the succeeding present trust beneficiary is the spouse of the prior present trust beneficiary or (ii) a qualifying family member (defined earlier) AND (ii) the real property is residential with no commercial purpose.
Example #1: I create an irrevocable Trust for my son’s benefit for a period of 20 years that holds title to the family cottage; no uncapping occurs on that transfer. After 20 years my son ceases to be the sole beneficiary of the Trust and my nephew becomes the next sole present beneficiary of the Trust for his lifetime. There is an uncapping after 20 years because my nephew is the new present beneficiary and he is NOT a qualifying family member under the statutory definition as it relates to me.
Example #2: I transfer title to a cottage from my irrevocable Trust to my son and his wife as tenants by the entireties. The taxable value is uncapped with that transfer, as my daughter-in-law is NOT a qualifying family member as it relates to me to me. Solution: Three deeds are required: Deed #1: If held in my revocable grantor Trust for probate avoidance purposes, I convey title to the cottage from the revocable Trust to myself. No uncapping per the statute, as I was the sole present beneficiary of the Trust and the deed is to me, the former sole present beneficiary of the Trust. Deed #2: I personally deed the cottage to my son. That transfer is exempt because my son is a qualifying family member as it relates to me. Deed #3: My son adds his wife’s name to the title to the cottage. That transfer is exempt because my son’s spouse is treated as a qualifying family member as it relates to him (but not to me.) [See what I mean when I say you have to ‘go slow’ and ‘move your lips’ when you read the definitions in search of an uncapping exemption?]
Example #3: I transfer title to my cottage to my Trust. I die. My Trust has a provision that directs the title to the cottage is to be distributed to my son upon my death. My son approaches the Trustee and says ‘hey, I have my own Trust, why don’t you just deed the cottage directly to my Trust as a convenience to me.’ Trustee deeds the cottage to the acting trustee of son’s Trust (probably my son.) The taxable value of the cottage is uncapped. My son’s Trust is treated as a nonqualifying family member. Thus, an accommodation to the trust beneficiary, deeding the cottage directly to his Trust, causes the taxable value of the cottage to be uncapped. Solution: Two deeds are required. Deed #1: The trustee of my Trust deeds the title to the cottage directly to my son. That transfer is exempt because my son is a qualifying family member as it relates to me. Deed #2: My son’s subsequent transfer of title to his own Trust is exempt because he is the sole present beneficiary of his Trust.
Estate Administration: A transfer of title to real estate from a probate estate will cause the taxable value of real estate to be uncapped unless: (i) it is transferred pursuant to a Will or by intestate succession; (ii) to a spouse or qualifying family member; and (iii) it is residential property with no commercial use.
Example #1: A distribution is made from an estate to an adopted grandchild. An adopted grandchild does not fall within the qualifying family member definition, so the transfer is not exempt from uncapping. Solution: File a motion with the probate court that seeks an order for the distribution directly to the adopted grandchild. Recall that court orders and judgments that order the transfer of title are normally not subject to uncapping so long as no money changes hands as part of that court order.
Example #2: The decedent’s Will devises a cottage to the decedent’s two children. The children are qualified family members, so that transfer from the probate estate by personal representative’s deed is not an uncapping transfer. But, assume that one child lives in California and will seldom use the cottage, and that child agrees to sell their inherited interest in the Michigan cottage to their sibling who lives in Michigan and the sibling’s spouse. With this second transfer to the Michigan sibling and his/her spouse, the real property taxes will be uncapped, since the Michigan sibling’s spouse does not satisfy the qualified family member definition. Solution: The siblings approach the personal representative and ask that the title to the cottage be distributed ‘in kind’ from the probate estate to the Michigan sibling, with the California sibling agreeing to take assets of equivalent value from the estate (assuming there are sufficient other assets to equalize the distribution.) The transfer to the Michigan sibling is exempt from uncapping because the Michigan child satisfies the qualified family member. The Michigan sibling can then add his/her spouse’s name to the title to the cottage; that second transfer will also be exempt, since a transfer to a spouse is exempt.
Ladybird Deeds: As a gross generalization, the creation of a ladybird deed will normally not result in an uncapping if family members are involved. A ladybird deed is described as a transfer of title to real estate in which the transferor (also an original owner) retains: (a) a life estate in the transferred real property; and (b) a power to convey, sell, mortgage, or gift, often described as a general power of appointment, over the same real property which permits the transferor to unwind the earlier deed later in time if the power is exercised. Recent statutory amendments have expanded uncapping exemptions to include life estates and ladybird deeds. Consequently a transfer of ownership of cottage real property will not result in an uncapping if it is residential real estate that is subject to a retained life estate or life lease, i.e. a ladybird deed, or the transfer is a result of the termination of a retained life estate or life lease, so long as (i) it is residential property; AND (ii) transferred to a qualifying family member; AND (iii) and there is no commercial use of the real property. If these requirements are not met, then the taxable value of the real estate is uncapped on the expiration of the life estate interest;
Example #1: I convey title to my cottage to my son, but I retain in the conveyance deed both (i) a life estate; and (ii) a general power of appointment over the real property. The taxable value of the real estate will not be uncapped when I create this deed. Nor will the cottage’s taxable value be uncapped upon my death when my life estate is extinguished and my son becomes the sole title holder to the cottage. My son is a qualified family member. He just cannot lease the cottage or convert it to commercial use after he becomes titleholder.
Example #2: Same facts as above except that after I transfer title to my son, at his request I exercise my retained general power of appointment to re-execute the deed, making a gift at that time, where I add my son’s wife as the other owner of the cottage with him but at his request, saving a future deed. This second transfer results in an uncapping because my daughter-in-law does not meet the qualified family member definition as it relates to me. Solution: I deed the cottage to my son and there is no My son then adds his wife to the title to the cottage with a second deed.
Leases: Some leases, if they also have an option to purchase attached, will not be exempt from uncapping as they will be viewed as a sale. Most sales of real property will usually result in an uncapping.
Example #1: Suppose I purchase an Ann Arbor condo for my daughter and her friend to live in while she attends UofM. I lease to condo to my daughter and her roommate, and I include in the lease agreement an option to purchase the condo after my daughter graduates if she wants to continue to live in Ann Arbor, but the purchase will be at a discounted price (after all, she is my daughter.) If the option price reflects a discount then the lease will cause the taxable value of the condo to be uncapped. The option price at a discount is viewed as a form of sale for consideration which results in an uncapping.
Example #2: Mom and Dad gift their cottage to their children, but Mom and Dad take back a Lease from the children so they can continue to live in and use what they continue to view as their cottage but with the goal to shift some of the annual maintenance expenses onto their children who want to keep the cottage in the family for the next generation. In short, the classic gift-lease back estate planning strategy is used. The deed to the children will result in an uncapping since the lease-back is a commercial use of the cottage, since Mom and Dad plan to rent the cottage more than 14 days in a year. Possible Solution: Mom and Dad add the children’s names to the title as joint tenants and ask the children to contribute financially to maintain the cottage.
Transfers Between Common Entities- The Business Activity Trap: The last trap for a Trustee does not arise so much from statutory definitions, but from a literal interpretation of the real property tax statute and a surprising spin on the statute provided by the Michigan Court of Appeals. The facts were straight-forward. There were two irrevocable Trusts in the family. The Trustees of the two Trusts were identical. One Trust owned residential real estate. The real estate was transferred from one Trust to the second Trust. Generally a transfer of title between two commonly owned entities will be exempt from an uncapping. One would think that a transfer between two Trusts with the same beneficiaries and the same Trustees would satisfy the commonly owned entity exception. Surprise! Because the two Trusts (your typical estate planning Trusts designed to hold assets for the benefit of family member beneficiaries) were not considered by the Court to be engaged in a business activity, an uncapping occurred on the deed from one Trust to the other Trust. All this is counter-intuitive. If residential real estate is held in trust, then we can find an exception to an uncapping as described earlier. But when a Trust that holds residential real estate transfers that residential real estate to a second Trust, with the same Trustees and the same beneficiaries, it causes an uncapping because the Trusts are not engaged in a business activity- passively holding title is not a business activity. In sum, a business activity is as essential to transfers between entities as residential property is essential to family transfers. Sebastian/Mancuso Family Trust v City of Charlevoix, 300 Mich App 1 (2013). Surprises like those in the Mancuso decision make it extremely difficult to understand Michigan’s uncapping statute and its exemptions making most advisors reluctant to make predictions if a transfer will survive an uncapping assertion by the assessor.

Concluding thoughts: If you have read this far (poor you!) you will readily concede that following Michigan’s uncapping property tax rules and the multiple exceptions to those rules is not for the faint-of-heart. By breaking down proposed transfers into multiple small steps it may be possible to fit the proposed transfer into one of the several statutory exemptions. Similarly, if title is to pass from a probate estate or a Trust, it may be possible to obtain a court order which can be used to shield the court-ordered transfer of the real estate from an uncapping if a nonqualifying family member is the intended transferee. The final piece of advice is to make no assumptions as to who fits nicely into the statutory definition of qualified family member. Sons-in-law and daughters-in-law don’t count. Neither do nephews or nieces. Nor, apparently, do adopted grandchildren or aunts or uncles. (God only knows why the Legislature decided that adopted grandchildren are not to be treated as a family member.) In sum, go very slow before deeds are signed keeping an ever-present eye on the uncapping rules and the definitions used in the statute.