There is wide acceptance from the courts that both spouses associated to a marital estate should benefit from the wealth accumulated from either party during the marriage. Yet, the same perspective is not upheld when there is property that was accumulated before the marriage and always held in a separate name. This type of property is called separate property. Only marital property is subject to division, not separate property, This assumes you can substantiate your position. Also, the appreciation of separate property may or may not be subject to division depending on your situation and how you handled the property in question.
Questions to think about
If you have separate property in your divorce, some questions you will want to address are:
- Is your property deemed marital property or separate property?
- If there is separate property, how much should your spouse receive from your divorce?
- What happens if the lines got blurred and funds were merged? How do you determine who gets what?
The technical phrase of converting separate property into marital property is called transmutation. It is the process of mutating (changing or transferring) property from one state (separate property) into a different state (marital property). This is an important concept to understand as it speaks volumes to the questions around:
- Was there anything that was actually transferred between the parties?
- If so, what was the legal vehicle (if any) that created the transfer and related terms and conditions of the transfer? Note: verbal agreements (intent) to transfer property may be upheld in court.
- If separate property exists, who holds the burden of proof and who should communicate when?
If you cannot prove the assets are separate property, many courts may then default to the position that the property is marital property and subject to division with your spouse. If you are the holder of the separate property it is your responsibility to prove your case using clear evidence as your backbone for your communications. You not only have to prove it, you also have to demonstrate in a comprehensive yet simple manner why your rationale for the property should be deemed separate property. This all comes down to the details of the analysis and the supporting evidence.
Separate property can be very valuable to your future wealth position (versus transferring it to your spouse). The time, effort and money you invest towards this process can be well worth its weight in gold. Yet, you have to make the decision whether it makes sense to invest time and money towards this initiative. It all depends on:
- how valuable the property is to you
- the future return you may receive from it
- how much you want your spouse to own (or not) in the property
- among other factors
If separate property exists and you choose to not to go down this path, you can expect the court to share the value of the property with your spouse.
Definition of separate property
Separate property is defined as all property acquired by a spouse:
- before the marriage
- via a gift from another party
- via a bequest from a decedent
This assumes the property was not commingled with other property in the marital estate. In other words, the property is not used to pay for funds on behalf of the marital estate (expenses or obligations) and you didn’t include your spouse’s name on an account. Once the property is commingled, people may deem the property as fungible (i.e. cannot be easily separated). Yet, do not stop there. If you can separate the property from the marital estate then the effort will likely be worth it. The separate property will come off the top before any allocation of jointly held property. This could help you preserve your accumulated wealth.
It is worthy to note, if you exchanged separate property during your marriage for other separate property it is still deemed to be separate property. For example you may have executed a 1031 exchange — swapping one piece of property for another “like kind” property — where you transferred one piece of property for another and never included your spouse’s name on the property.
If you have any income from the separate property, the income is also deemed separate in nature. In other words, any income (taxable or not) would be associated to the spouse who is claiming the separate property. Any taxes associated to the separate property would be the obligation of that person, not a joint obligation. Also, any deferred costs (e.g. deferred maintenance on real estate) would be deemed separate and not jointly obligated.
How income is classified is a very important issue that needs to be addressed in context to a divorce and can be a mixed question of both the facts of the situation and the law. In other words, your facts and circumstances may guide a Judge how to rule in context to the law which may or may not be completely defined for your specific situation. It is important for you to have mental clarity about your issues and the related arguments you need to convey to a court of law. Examples include, yet are not limited to:
- What was the reason for entering into the transaction in the first place?
- When was the property acquired?
- What funds were used to acquire the property (non-marital or marital)?
- Were the funds ever commingled? If so, for how long?
- Who is on the title of the property?
- Was the title ever changed from its then-current state to its present day state? If so, when?
- Did the property only passively appreciate or was there some active appreciation too? (more on this below)
These issues, among others, will need to be incorporated into your positioning to enable the court to assign the proper classification to the property, either separate property or marital property. Throughout this process, it is critical to be able to convey the information in a clear manner to get your points across. In other words you may be able to figure out the analysis, but you may need help with the communications aspect of your situation to make your argument hold water.
Allocation of the separate property
Each person’s financial estate may be entitled to an interest in the property, depending on which funds were used to contribute or maintain the property and the related contribution ratios. This type of thinking leverages the concept of “the sources of funds” (i.e. where did the funds come from) and “basis of investment” (i.e. how much is the basis of the investment for each spouse). These issues can be tricky to tease out during a divorce as the person working through the calculation can identify opportunities where money will silently swing one way or the other depending on how the issues are handled.
When assigning contribution ratios it is important to look at active appreciation versus passive appreciation. To provide context, let’s talk about this in terms of a piece of real estate. During the marriage the active appreciation would occur where one or both spouses contributed monies towards the improvements of the home. Depending on where the source of funds came from (non-marital resources or marital resources) would define how the contribution ratio is defined for defining the portion of active appreciation. This can become a complex issue where one person is retired and the other is not. Improvements made from marital resources which required the retired person to consume non-marital resources (i.e. separate property) to invest in the improvements may be deemed separate property during the marriage (beyond the scope of this article). It is worthy to note active appreciation may not only be reflected as direct financial contributions. They may also be in the form of managerial contributions made to the property (real estate, business interests, etc.) which may have to be imputed to assign a value to those contributions.
Passive appreciation is exactly what it sounds like. It is when the property appreciates over time merely as a result of the performance of the market. Each spouse would benefit from the passive appreciation based on the “basis” or contribution ratio made towards the investment over time. If a gift was executed then the basis may change over time.
Who owns the burden of proof?
The burden of proof to prove that an asset is truly separate property is on the person who is claiming that separate property exists. Once there is sufficient evidence to prove that separate property exists then the other party has the burden of proof to prove some or all of the separate property is marital property. In other words, the burden of proof shifts from one spouse to the other spouse.
Let’s clarify this with an example. If Mark and Jessica are married and Jessica had a rental property in her name only before the marriage (never commingled) Jessica may be able to prove (along with other evidence) the property is separate property. In other words, the initial burden of proof to demonstrate separate property exists in the marital estate would initially be borne by Jessica. If Jessica does not prove it then the property may be deemed marital property. A Judge would have no other information to reference otherwise and may not be able to rule differently.
Yet, if substantial proof was presented and agreed upon by the parties or a Judge, and Mark claims a portion of the separate property should be marital property, then Mark would bear the burden of proof to demonstrate with evidence that marital funds were used to improve or maintain the “separate property” or a gift occurred. Marital funds used may be classified as “active appreciation” where the contributions to the separate property strengthened the value of the property and therefore a portion is deemed marital. Active appreciation takes on various definitions depending on the context of the situation. So, you have to be careful how you define active appreciation in context to your situation.
What is Transmutation?
Transmutation is the concept of converting separate property into marital property. This concept is grounded in the theory the owner of the separate property has gifted the property to the other spouse. A gift can be an outright gift through a deliberate act (e.g. placing your spouse on the title of the property, Quitclaim Deed, etc.). The gift would have to be voluntary in nature without any compensation for the transfer and not be based on any duress. Through this process, the provider of the gift gives up what is referred to as “dominion and control” (i.e. ownership and rights to transfer that portion of the property in the future). Spouses can debate whether a true gift was made or not by showing:
- a lack of intent to make the gift
- no agreement (written or verbal)
- a fraudulent transfer
- coercion or duress was applied to execute a transfer
If the court finds these issues factual, then the court may classify the property as separate property.
Common arguments to support or refute asset classifications
There are a number of arguments that support or can refute how an asset is classified in a divorce. They are as follows:
- The funds were commingled
This argument is based on the fact that it is difficult to figure out who contributed what, and when. If you have no evidence and do not know how to convey your position then this argument can hold weight. Yet, many times there is some sort of evidence (or evidence can be captured in a different manner) to substantiate your position. If you can get that box checked then all you have to do next is figure out how to convey your position in a comprehensive and socratic manner for a third party decision maker to understand where all of the questions of uncertainty are resolved in the conveyance process. Overall the commingling of funds argument is truly a weaker argument as something usually, yet not always, can be done to substantiate the position.Questions to think about in this context
- Were the funds used for marital purposes?
- How long were the funds commingled? Were they used temporarily or for a longer period of time?
- What were the funds used for during the holding period?
- Did the account balance (e.g. joint checking account) ever go below the previous balance it has always maintained? If not, was there a true commingling of funds where the funds were not used for marital purposes?
- Title was assigned to the other spouse
This is a good argument assuming a title was actually transferred to the other spouse and not under duress as noted above. The titling process would indicate a “gift” was provided from one spouse to another. To put this in context a good example is when one spouse refinances a piece of real estate and places the other spouse on the title at that moment in time. If you can prove it was under duress (although possibly difficult to demonstrate) you may have an argument the property should remain separate and not marital.A key issue to look at in this situation is whether titled changed during the marriage from before the marriage. Let’s put this in context. If Jessica (noted above) transferred the title to Mark during the marriage, even through a refinancing, then at that point in time Jessica may have executed a gifting transaction to Mark. Therefore, the separate property became marital property at that point in time, albeit not sufficiently clear without the real facts behind the situation.
Let’s take another situation. Let’s assume Jessica and Mark were co-owners of the property before they got married. Under this situation, they were both on the deed of the real estate for their respective contributions to the property prior to the date of the marriage. In other words, they were both investors in the property. As a result, they had to determine the basis of each of their investments in the property. Any other investor would do the same thing (i.e track their basis in a property to determine contribution ratios and resulting value).
Questions to think about in this context
- Now, since they got married does the act of their marriage translate into a gifting of property from one spouse to the other? The answer is not necessarily as they were each owners of the property beforehand and the spouse who owned fewer equity interests in the property did not add to her or his basis over time. If she or he made more contributions prior to the marriage then there may be an argument to support the issue.
- Does each spouse have to gift their share of the property to the other spouse to be deemed a conversion from separate property to marital property? The answer to this question is Yes. Yet, a refinancing where both spouses are already on the deed or have always been on the deed would not necessarily translate into a gifting process. It again, all depends on the facts of the situation.
- Active contributions (active appreciation)
As noted earlier, this refers to contributions (financial or managerial) where the marital funds were used to contribute to the property or said differently only one spouse makes the contributions. A common question that arises is sweat equity. If you invested the time to build different portions of your home can you claim that as an active contribution? The answer is, unfortunately, it depends. It may be possible but it depends on the facts and evidence that can be gathered around your situation.Common issues around managerial contributions are when someone owns a business. The spouse who actively contributes to the value of the business may receive a value that is deemed active contributions and in essence obtain “credit” for the active contribution. These issues are not easy to define especially when the business has appreciated over time. In these situations, the active appreciation has to be segregated from the rest of the value of the business. Where there are active contributions in the form of a business or another asset the key is to define the value pre-marriage and as of the date of separation (or date of filing for divorce or final date of settlement).
- Enjoyed by the family throughout the marriage
This sounds good, but more credence may have to be put forth to truly substantiate this type of position. Arguments put forth by the opposing party are often about statements made by the owner of the asset, maintenance and management of the property, investments made by the non-owner spouse or a verbal or written agreement between the spouses to transfer the property from one spouse to the other
Should separate property be assigned a rate of return?
If the person who was deemed the rightful owner of the separate property before the date of marriage did not gift any of the shares to the other spouse during the marriage, then the separate property should be assigned a reasonable rate of return.
Let’s take this issue one step further. What happens if Jessica placed Mark on the title during the marriage. What happens then? Up to the point in time Jessica owned the property as separate property she would be eligible to receive a reasonable rate of return on the separate property. After she gifted the property then she would share the rate of return based on their respective ownership interests at that point in time.
The key to the argument of separate vs. marital property is intent. Was the intent to gift the property from one party to another? If there was intent then the issue may be sufficiently clear, yet still requires substantive evidence to demonstrate intent. A far majority of the states recognize equitable distribution (vs. community property distribution) as the appropriate way to distribute property. Equitable distribution does not mean the other spouse automatically enjoys 50% of the marital property once the party becomes married. If it can be reasonably proven, depending on where the burden of proof lies in the process, that the separate property is truly separate then equitable distribution can be based on the basis of investment each individual has into the property. The facts and circumstances of each case is usually sensitive where the details matter.
If you have a situation where you need help teasing out the facts, organizing them and presenting them in a cogent way please contact us. We can help.
About the Author
Larry Smith is a Founding Partner of Divorce Outcomes, a specialized professional services firm that manages all of the financial aspects in a divorce process. Since 2003 he has worked as a trusted financial advisor, financial advocate, divorce architect and technical financial expert; he is not an attorney. He is an alumni of KPMG and Andersen with expertise in technical accounting, forensics, sophisticated taxation, management consulting, risk management, advanced process engineering, business combinations, divorce management, multi-party negotiations, advanced quality analytics and cognitive performance technologies. Since 1986 Larry has been advising individuals and organizations about innovative financial solutions to resolve complex financial challenges that arise in life and in business.
For both personal and business divorces, Larry is considered an expert in divorce strategies, divorce process management, financial divorce architecture, financial risk management, taxation for divorces, financial divorce forensics, advanced divorce analytics, financial divorce negotiations and mediation, business valuations and sophisticated equity structures. He helps clients shape complex financial decisions, manage communication risks and ever-changing negotiating positions to strategically preserve or grow wealth from these types of transactions.
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About Divorce Outcomes
Divorce Outcomes is a specialty services firm that helps people both domestically and internationally manage all of the financial decisions that arise in their divorce process. We are not attorneys. We are financial experts who partner with our clients as their personal financial advocates. We help our clients manage their divorce process, uncover hidden financial risks, architect divorce solutions, manage ever-changing negotiating positions, communicate complex financial matters and close the divorce process as soon as possible with a goal to arrive at the best outcomes possible. Throughout the process we evaluate the current state of our clients’ financial lives with an objective to best reposition their future. We do not sell any products. We simply raise issues that are in our clients best interest. Our clients share with us we:
- unfold, analyze and repackage their financial life so they are well positioned after their divorce
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As we reach an agreed upon settlement structure, we help our clients identify a fitting attorney who can leverage the financial solution to draft and record the requisite legal documents. Where outcomes are at risk from a traditional process, we function as expert financial negotiators or financial mediators to turn around the situation and achieve our client’s desired outcomes.
Learn more about us at divorceoutcomes.com or review our blogs to gain a clearer understanding about our approach and how we maximize the financial outcomes for our clients.
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute formal advice or a recommended course of action as every person’s situation is unique and different. The information here is not intended to be, and should not be, relied upon by the recipient to make a decision without professional guidance.