Pre-Owned and Inherited Assets

The issue of pre-owned assets frequently arises in divorces involving persons who were married later in life or second marriages.  If one or both of the parties have accumulated assets prior to their marriage, very difficult issues often arise as to how those assets should be treated in the event of a divorce.
Although this article will not specifically discuss Prenuptial Agreements, the best advice to be given to any person who own significant assets at the time of their marriage, is to negotiate and properly execute a Prenuptial Agreement.
The Prenuptial Agreement should specifically itemize the pre-owned assets by description, estimated value, account number or other clear and unequivocal identification.  The Agreement should then define not only the intended distribution of such assets in the event of a divorce, but the distribution of any increase in value and whether or not either or both of the parties should receive credit for maintaining or paying the carrying costs such as mortgage payments or taxes for a pre-owned asset.
However, in those cases in which the parties do not negotiate and enter into a Prenuptial Agreement, the distribution of pre-owned assets can become a complex issue in the event of a divorce.
The general rule is that only assets which are “acquired” during the marriage are subject to distribution at the time of the divorce.  By definition, assets which were owned prior to the marriage are not “acquired” during the marriage and are, therefore, not subject to marital distribution.
The starting point for any analysis of pre-owned assets is to develop a balance sheet of the assets which either or both parties owned at the time of the divorce and, to the extent possible, from account statements, IRA or 401(k) account statements, pension statement or real estate tax records establish a value of the asset as of the date of the marriage.
Unfortunately, however, as with any general rule, there are often more exceptions to the rule than there are consistencies in its application.
One of the most frequently encountered exceptions is when one or both of the parties transfer pre-owned assets from their individual names subsequent to the marriage.  Many people make such transfers for tax claiming purposes, estate planning purposes or sometimes simply in order to have control over the asset in the event of the other party’s disability.
While the transfer of a pre-owned asset from individual to joint names may be appropriate for any of these purposes, it may also have very significant consequences in the event of a divorce.  In most instances, the law will find that there was a “transmutation” of the asset from an individual pre-owned asset which would be exempt from marital distribution into a marital asset.  It is presumed that the person making the transfer intended the other person to have a joint interest in the asset and it is further presumed that the person making the transfer understood that by doing so, the asset would become subject to marital distribution in the event of a divorce.  Although rebuttable, these presumptions are very difficult to overcome at the time of a subsequent divorce and any time a pre-owned, individually titled or owned asset is to be transferred into joint names, serious consideration must be given to the impact which such transfer would have upon that asset in the event of a divorce.
Further problems arise when the pre-owned asset increases in value during the marriage.  For example, a home which is owned by one of the parties at the time of the marriage may significantly increase in value over the several years of the marriage.  Similarly, a business owned by one of the parties at the time of the marriage may increase in value during the marriage.  Or, something as simple as an IRA account, a brokerage account or a bank deposit may increase in value over the course of the marriage.
Any time there is an increase in the value of the asset, the increase in value must be analyzed from several perspectives.
First, was the increase as a result of additional contributions to the account or, in the case of real estate, improvements to the property.  If so, such added contributions or improvements would be “acquired” during the marriage and would be subject to marital distribution in the event of a divorce.
On the other hand, if the asset has increased in value without added investment, contributions or improvements, the increase must be analyzed as to whether it is “active” or “passive.”  “Active,” generally speaking, means that the increase was as a result of work effort or management by one or the other of the parties.  “Passive” means that the increase in value has been simply as a result of market forces or inflation.
For example, a simple brokerage account which was not traded, but yet increased dramatically due to market force would probably be a “passive” increase.  On the other hand, if the account was actively managed, traded and controlled by one or the other of parties, and the increase in value could be traced to that party’s trading or management decision, the increase would likely be “active.”
In the case of most small businesses or professional practices, the increase in value is almost always attributed to work efforts of one of the parties.  In the case of real estate, an increase in value may be a combination of inflation and market factors or as a result of the party’s maintenance, improvement or upgrades to the property.
Obviously, it is very difficult to accurately and precisely separate the amount of increase which is “active” versus that portion of the increase which is “passive.”
Issues arise such as How much did the home increase in value because the parties remodeled the bathroom versus how much the increase is simply attributed to an increase in the value of real estate in general.
Unfortunately, the difficulty in analyzing and distributing pre-owned assets and/or their increase in value does not end simply with this complicated scenario.
Once it is determined that some portion of the increase was “active,” you must then determine which of the parties actively contributed to the increase in value.  If it was the spouse who owned the assets efforts which contributed to increase in value, the increased value is going to be distributed much differently than if it were the active efforts of the non-owning spouse.
Very often, even determining the amount of the increase is simply a matter of expert opinion as opposed to hard and fast figures.  If, for example, a property or a business has been owned for several years, in order to determine the amount of increase in value, someone has to appraise that property as it existed several years earlier.  It is, at best, a difficult proposition to go back in time, analyze comparable sales or comparable businesses as they may have existed several years earlier and then to extrapolate that data into a valid value which can be used for the purposes of determining the amount of increase in value.
All of this simply brings us a full circle to the subject of Prenuptial Agreements.  All of this difficulty, the sometimes subjective determination as to whether the increase in value is “active” or “passive” and the difficulty of conducting appraisals several years in the past can be avoided by the arms-length negotiation and execution of Prenuptial Agreement prior to the marriage.
In addition to prior owned assets, the subject of inherited assets often comes into play at the time of a divorce.
One or both of the parties may have inherited assets during the marriage.  If so, by New Jersey Statute, inherited assets are exempt from marital distribution and remain the property of the person who inherited them.
However, as with pre-owned assets and their increase in value, there are a number of exceptions and complications in the practical application of that seemingly simple rule.  Suppose, for example, a party inherits money which they, in turn, invest in improvements to jointly owned real estate.  Or, suppose that one of the parties inherits money which the couple uses to pay down debt during the marriage thereby allowing their income to be used more fully for investment into a small business or improvements to their real estate.
Again, as a general rule, the principals of “transmutation” apply to inherited assets.  If a person inherits money or assets which they then title in joint names or invest into a jointly owned asset, it would usually be assumed that they intended those funds to become marital property and that the exempt nature of the inherited asset has been “transmuted” into jointly owned marital assets which will be distributed between the parties at the time of a divorce.  Therefore, whenever any married person inherits money or assets, it is important for that person to make their own individual decision as to whether they intend for those funds or assets to become marital property or whether they intend that they should continue to be individually owned, exempt from distribution in the event of a divorce and remain their sole property in the event of a divorce.  Whichever alternative a person chooses, care must be taken in defining the form and nature of the ownership of the assets after the inheritance.
A final and often overlooked consideration regarding pre-owned or inherited assets is a provision in the general equitable distribution statute which provides that the “source” of the funds or assets is a relevant factor in the determination as to the distribution of that asset in the event of a divorce.  Therefore, even though an asset may be “transmuted” from an individual prior owned or inherited asset into a marital asset, the fact that the “source” of the asset as it existed at the time of the divorce was initially a pre-owned or inherited asset may significantly impact the percentage of distribution which each party receives at the time of the divorce.  There is a reported case in New Jersey where a person’s pre-owned small business significantly appreciated during the marriage and, admittedly, appreciated as a result of “active” (i.e., the work efforts) of both parties during the marriage, therefore, the “active” increase in value of the asset was a marital asset and was subject to equitable distribution at the time of their divorce.  The Trial Court, however, awarded the non-owner spouse only 10% of the increased value of the asset.
In summary, pre-owned assets, inherited assets and/or their increase in value during the marriage are complicated and difficult issues.  The best advice to any person owning significant premarital assets is to enter into a Prenuptial Agreement.  In addition, whenever married parties are given tax, estate planning or other advice concerning the form of ownership, the unpleasant subject of what may occur in the event of a divorce must be considered.
Finally, in the event of an inheritance during the marriage, the parties must be aware of and consider the impact and various alternatives concerning the form of ownership, maintenance or control of that asset during the marriage and the impact which those various forms of ownership or control may have at the time of a divorce.