Understanding the distribution of assets and debt during divorce.
When couples decide to divorce, one of the biggest questions is “what money will I get from the divorce and will it be enough?” People often think that they are entitled to half of everything and that it is pretty clear cut. Unfortunately that is almost never the case. Yes, the law dictates what each person is entitled to and what each person owes, but the application of that law to assets and debts is not as straightforward. The first step in the divorce is getting a clear picture of what a couple’s finances look like in the here and now. That being said, the best place to define what are considered assets and debts as they pertain to divorce.
What are considered assets? Assets in a divorce are considered anything that has any real value. Examples of assets include:
- The home
- Rental properties
- Retirement accounts
- Brokerage accounts
- Checking/savings accounts
- Anything with future value acquired during the marriage
While this is not an exhaustive list of assets, these are usually the big ones. Now the question is which of these assets are considered community property? Community property is defined as all marital property acquired during the marriage. To be more specific, anything a couple acquired after the date of marriage until the date of separation is considered community property. That being said, the date of separation becomes a very important date. The date of separation is its own topic in itself and will be covered in a separate article.
Debts follow the same principle that assets do – everything acquired during the marriage is considered a community property debt. For example, home loans, car loans, credit card debt, any future obligations, etc. count as community debt. A couple of things to note about debt – whether you or your spouse incurred the debt or whether you are even aware of the debt, it is still community debt as long as it happened during the marriage. Collectors can still come after both of you if there is an outstanding debt incurred during the marriage.
Once couples understand exactly what counts as an asset and debt, how are these assets and debts divided? Let’s start with the assets. Assets are each assigned a value based on the type of asset as of the day of separation. For example, if there was $30K in a brokerage account that was built with income made during the marriage, then it is safe to say that each person is entitled to half of the value since it is community property. Then the question becomes what is the best way to split the asset so that other financial consequences are not triggered (i.e. taxes). Remember all assets are not equal in value despite what it may look like at first sight. For example, when people say “you take the house and I’ll take the 401K and that should make us even,” is that true? NO. Why? Because a house can be sold for the entire cash amount while a 401K is subject to age restrictions and tax consequences. Cashing out money from the 401K before you are eligible for retirement will mean that you will pay a penalty and taxes. And even if you are of retirement age and you start taking money from the 401K, you are still subject to taxes. This is only one example of how splitting an asset is not as simple as 50/50. The entire picture of all the assets needs to be put together before they can be divided. Then we must consider the marital debt.
As explained earlier, marital debts need to be accounted for, regardless of who acquired them and if both parties knew about them. One of the easiest examples of debt is to look at credit card debt. If a joint credit card has a balance of $10K at the date of separation, then each person owes $5K. Simple. But what if the wife has her own credit card in her name and husband has his own credit card in his name and neither of them use each other’s credit card? As long as the purchases on their separate cards were made during the marriage, they are still considered community debt which means they are BOTH on the hook for all of the debt. There is a misconception that because people keep their finances separate during marriage and certain accounts only have one name on them, that they are considered separate property/debt. Unfortunately, this is not true in California.
The nuances of the division of assets should always be addressed by a certified divorce financial analyst (CDFA). It is their job not only to split your assets and debt, but make their clients aware of possible tax consequences and common mistakes that can be avoided. For example, one of the common issues I see is that when people sell their house, whether they are in the divorce or leading up to the divorce, they split the proceeds and move on. However, when couples assume that the proceeds are no longer part of the analysis since they have already been disbursed. BUT when the overall analysis of the assets and debts are complete, there is oftentimes an equalization payment. An equalization payment is when one spouse owes the other spouse a lump sum to “equalize” how much each spouse is walking away with. There are many different ways to handle that equalization payment, one of which could have included the proceeds of the house. However, once the proceeds have been split and disbursed, it is much harder to use those funds for the equalization payment. Splitting assets and debts is not only a skill, but an art.
There are so many complications that can arise in the splitting of assets and debts. One of the most common issues I’ve seen is when there is a claim that an asset was acquired by both community and separate property. This usually comes up when there is a house in play. Many couples buy a house with separate down payments before they are married, but once they are married, all the funds that go toward paying the mortgage is considered community property. In that case, a calculation must be done to determine how much separate property was contributed, how much community income was contributed, how much of these funds contributed to the appreciation of the house and then how should the house be divided. If the house is sold, what are the capital gains and who is responsible? This is only one example of a complication in the division of property.
Although the asset and debt split may seem simple in the sense that everything is split 50/50, there are many situations and layers that need to be considered in order for the assets and debts to be split properly. A CDFA will understand how these nuances work and will be able to explain to the couple how best to split the assets and debts in the most tax efficient manner. How the assets and debts are distributed have far-reaching consequences once the divorce is over so it is imperative for couples to understand and be comfortable (not necessarily happy) with how everything shakes out.
If you are thinking about divorce, going through a divorce or are post-divorce, schedule a complimentary consultation to understand your current financial picture and financial future.