The concept of property division, or equitable distribution, is an issue in nearly every divorce. Child support and custody only apply to couples with children, and even alimony isn’t applicable in every divorce. Property division is unique in that almost every marriage will have some marital property to divide, and therefore it is a consideration in most divorces.
We’ll explain the process for how property is divided, but as an initial matter it is worth noting that some marital assets are easy to value and divide, while others prove more challenging. This article will focus on some of these more challenging situations – the tricky cases.
The court will employ a four-step process when determining how property should be divided amongst the parties.
1. Identify Everything
First, all property must be identified; regardless of whether it is considered marital or separate it must be identified. Basically you will need to come up with an itemized list of all assets and debts that belong to either party.
2. Classify Everything
Second, the identified property will be classified. Classification refers to the process by which the court determines whether the property is marital or separate. In North Carolina, there is a presumption that all property acquired by the parties during the marriage will be considered “marital property.” Alternatively, property that is not marital will be considered “separate property.”
The North Carolina statues and various court opinions have carved out certain nuances and exceptions with regard to the concept of marital and separate property. For detailed rules, be sure to reference our article: Equitable Distribution: The Details.
3. Place a Value on Everything
Third, the property will then be valued. Basically, the court will need to attach a fair market value as of the date of separation to all marital property. The total net value will be determined after any encumbrances are taken into consideration.
4. Distribute the Assets
Finally, the court will distribute the property equitably. In North Carolina, there is a presumption that marital property should be divided evenly between the parties, but that presumption can be rebutted if there are factors present that would warrant an unequal distribution.
As you can see, the process is fairly straightforward: identify, classify, value and distribute. Easy enough, right?
Sometimes, yes. For example, if a husband and wife purchased a $300,000 house during the marriage (unencumbered) that would be considered marital property and each party would be entitled to a value of $150,000. This is an easy example; there is no doubt that the house is marital property and it is easy to assign a fair market value to a real estate. If there is any question as to the value of the home, the court can look at the tax value or an appraisal.
Not every piece of property is that easy to classify and value, however. This article is designed to explain how property division works in trickier cases.
Improvements to Separate Property
People often ask us about a situation where marital funds are used to improve separate property. For example, say Tim bought a house in 2008, and subsequently married Lisa in 2009. Between 2009 and 2013 major improvements were made to Tim’s house – they added a bedroom, renovated the kitchen, and installed a swimming pool. The couple used marital funds to pay for these improvements. Now, in 2014 Tim and Lisa are separated. While Tim purchased the house for $200,000 in 2009, thanks to the improvements the house is now worth $300,000. Does the $300,000 that the house is valued at belong to Tim, since the house was originally his separate property?
The answer is no.
Active Increase v. Passive Increase
The law protects the party who helped improve the property. Any active increase in value that takes place during the marriage will be considered marital. In applying this rule to our example, Tim’s original $200,000 would be separate property, but the $100,000 in improvements would be considered marital and subject to distribution.
Note that this applies to any active increase in separate property. For instance, had Tim and Lisa not spent marital funds on the improvements but rather made the improvements through their own blood sweat and tears, the $100,000 increase would still be considered marital. The rationale is that the parties were taking time away from the marriage to improve the property, thus the active increase is marital property.
Contrast this with passive increases. Say Tim’s house that was originally purchased for $200,000 in 2008 is worth $250,000 now, but the increase is simply due to market fluctuation and not any improvements made to the property. In that case the passive increase will be considered separate property, and Tim would be entitled to the $250,000 value of the house.
Mortgage Payments on Separate Property
Our example with Tim and Lisa above assumes that Tim purchased the house with cash, and that it is not encumbered by a mortgage. Now, assume that he paid a reasonable down payment and financed the majority of the purchase price with a mortgage. Once they are married and Lisa moves in with Tim, her income also contributes to the mortgage. Mortgage payments are made with marital funds for four years before Lisa moves out.
In this situation Lisa is entitled to part of the equity in the home because marital funds were used to pay off the mortgage.
The calculation would be more complicated in reality, but to illustrate our point we will use easy numbers. If the four years of mortgage payments resulted in an increase in equity of $50,000, Tim will owe Lisa half of this $50,000 increase in equity.
Post Separation Mortgage Payments
Another tricky situation that we have noticed occurs when one spouse makes the mortgage payments after the date of separation while the other spouse lives in the house. The following example illustrates this concept.
Bob and Deborah separated, Deborah remained in the marital home after the date of separation, but Bob made the mortgage payments even though Deborah was in exclusive possession of the home.
The issue in this scenario is that Bob has continued to contribute to the equity of the home, while not receiving use and possession of the home. By increasing the equity in the home, it would seem unfair for the value of the property to be split evenly simply because it was classified as marital property.
Sometimes this is really a non-issue; if Bob only made a handful of mortgage payments before the parties reached an agreement with regard to equitable distribution, then it is doubtful that the payments made a substantial increase in equity. However, in a situation where Bob paid the mortgage for several years while Deborah had sole possession of the house, Bob’s payments could have significantly increased the equity in the home.
So what is the answer?
Distributional Factors and Judicial Discretion
When one spouse makes post-separation mortgage payments, while the non-paying spouse resides in the home, the court can consider these mortgage payments as a distributional factor. This does not necessarily mean that Bob will receive the exact dollar amount in equity increase that his mortgage payments resulted in, but it means that the court can consider these payments when deciding how to settle the estate.
While the law allows for the judge to consider post-separation mortgage payments to be a distributional factor, the judge retains much discretion when making these decisions. If she thinks that these mortgage payments should be disregarded, it is within her discretion to do so. On the other hand, if the judge believes that the non-paying party should reimburse the paying party by means of an inequitable distribution of assets, the judge may order so.
The takeaway is that how to treat these mortgage payments is within the judge’s discretion. If you are in a situation where you have paid the mortgage on a home that your spouse has resided in for a significant period of time, it could impact your property settlement.
Valuing a Business Interest
The previous cases we have discussed dealt with issues in regard to classification of property as marital or separate. Another issue that can be tricky in equitable distribution cases deals with placing a value on an asset.
Some items are easy to value. Real property can be valued by looking at the tax value or ordering an appraisal. While parties may argue over the true value of a piece of real property, the reality is that conflicting appraisals will generally be in the same ballpark.
With vehicles, you can easily input the information about a vehicle into Kelley Blue Book to determine the fair market value of that vehicle.
Bank accounts, retirement accounts, and similar accounts are also easy to value. You can simply look up the value of any given account on the date of separation to determine the value of the asset.
Some assets are slightly harder to value; it can be difficult to place a monetary value on furniture, jewelry, electronics, keepsakes and other personal property.
And other assets, for example a party’s interest in a business, are extremely difficult to value. To illustrate how difficult this can be, and how costly a mistake in valuation can be, consider the following case that took place in Connecticut.
Undervaluing a Business Asset Can Be Costly
A couple, of seemingly modest means, separated and began divorce proceedings. The wife was a stay-at-home mom, while the husband earned a salary of $48,000 annually at a tech company that he had an ownership interest in. The couple had a modest home, modest vehicles, and lived off of the salary earned by the husband. When they decided to go their separate ways, things were fairly amicable. The husband claimed on his financial affidavit that his ownership interest in the software company equated to $40,000. In the property division suit, relying on the affidavit, the judge ordered that the husband pay the wife $100,000.
Flash forward a few months – the software company that the husband had ownership stake in was sold for millions of dollars; his payout was handsome.
The truth was that the husband knew his interest in the company was worth a lot – there were other comparable offers that came in before the divorce had been finalized. Despite this knowledge he casually reflected on his financial affidavit that his ownership interest was only valued at $40,000. The wife had no reason to believe that this figure was only 3% of what his actual ownership interest was worth.
When the truth came out, the wife sued the husband claiming fraud. She engaged in a ten-year legal battle before the parties were able to reach a settlement. After paying her extraordinary legal fees as well as fees for expert witnesses, the wife only realized $200,000.
How To Avoid This Mistake
As you can see, undervaluing a business asset can be incredibly costly. So how do you make sure that your spouse’s business asset is valued correctly?
Hire an expert. Don’t simply rely on your spouse’s contention that his or her interest in a business is worth a certain amount of money. Don’t assume you can look at the company’s financial information provided by your spouse and figure out what value to place on the business interest.
An expert, such as a CPA can dig into the financial records and make an assessment as to the value of the business interest. Your spouse will likely hire his or her own expert to combat your expert’s opinion. If you end up litigating the value of the business, both experts will testify as to the value of the business and how they reached that number and a judge will make a determination.
Valuing a business interest can be very tricky. This isn’t something you can simply order an appraisal for or look up a tax value for. You have to consider how much ownership interest your spouse has, what the profitability of the business is, what the future profitability is projected to be, and what the business assets are worth to name a few factors. Because of the complexity of valuing a business interest, and the gravity of undervaluing a business interest, it is in your best interest to have an expert determine the value of the business.
While the process for equitable distribution and property division seems straightforward, there are situations that arise that can make it more complicated. These tricky cases come up frequently in our practice and we hope this article opens your eyes to how some of the more complicated cases should be handled.