The persistent issues of the Covid-19 pandemic have decimated real estate as vacancies have risen, net operating income has dropped significantly in the past year, and transaction velocity within certain sectors has slowed. This situation poses an interesting and timely question for married individuals with ownership interests in real estate and who are considering divorce, especially in equitable distribution states like New Jersey and Florida: Is now the optimal time to file?
The drop in operating companies’ bottom lines could work in the propertied spouse’s favor, as lower values could mean distributing less to one’s spouse in the divorce settlement.
However, the law is not exact as to how to quantify and distinguish between active and passive appreciation related to real estate assets for purposes of determining the distribution of the marital value. Indeed, courts stress that “[f]lexibility must be the byword in determining which approach is best suited in a particular instance because ‘[t]here is no inflexible test for determining fair value, as valuation is an art rather than a science [that] ... requires consideration of proof of value by any techniques or methods which are generally acceptable in the financial community and otherwise admissible in court.” (Steneken v. Steneken (quoting Lawson Mardon Wheaton Inc. v. Smith)).
When valuing income-producing real estate assets, market participants utilize the capitalization approach which converts income into value. The two key components of value are the net operating income and the capitalization rate. We posit that the net operating income has both an active and passive component while the capitalization rate differential between the two dates of value is best viewed as solely passive appreciation (or depreciation). The classification of active and passive components will have a drastic effect on determining whether the asset has a marital value which would be subject to equitable distribution.
Passive vs. active assets and their appreciation
Before discussing the valuation methodology, it is important to understand the differences between passive and active assets. Passive assets are those for which the appreciated value over time is a result of market forces outside of the owner’s control or unattributable to the owner’s actions; for example, artwork whose value increases due to passage of time or interest in a particular artist. Active assets, however, involve owner contributions and efforts that directly impact the asset’s value.
The first step in analyzing the appropriate valuation methodology is to determine whether the property is an immune asset or a marital asset subject to distribution. Assets acquired prior to the parties’ marriage, or acquired by gift or inheritance during the parties’ marriage, are generally considered to be immune assets and not subject to equitable distribution. New Jersey Statutes Section 2A:3-23 (h). Conversely, assets acquired after the parties’ marriage, whether individually or jointly held, are considered marital assets and are subject to equitable distribution.
The law does not stop there; even immune assets can still have a marital component which may be subject to distribution. (Scavone v. Scavone.) As they concern matrimonial litigation, real estate assets determined to be immune from distribution will have a marital component based on their classification as passive or active assets as follows:
Passive immune assets—such as those that were gifted, inherited or, are pre-marital—in one name, and whose incremental values are viewed as separate property, are not subject to equitable distribution. (Scavone v. Scavone.) When that asset is exclusively passive, meaning any change in value is entirely dependent on external factors and not the result of any efforts by the owning or non-owning spouse, any increase in value is also not subject to equitable distribution. Regarding active immune assets, the courts have held that when the increase in value is solely a result of owner’s efforts, that value is not distributable to the non-owning spouse, and as such, there is no need to establish a valuation date. (Scavone v. Scavone.) Conversely, when such value is derived, in part or in whole, from the efforts of the non-owning spouse, the appreciation is subject to distribution. For example, contributions towards the mortgage paydown contribute to the incremental value of the asset and consequently transform an otherwise immune, pre-acquired asset into one that is to be included in the equitable distribution for limited purposes.
Generally, the burden of establishing that an asset or a portion is immune from distribution rests upon the spouse who asserts it. (Sculler v. Sculler.) Once that burden has been met and the asset is determined to be immune from distribution, the burden is then shifted to the party seeking to overcome the rebuttable presumption that any subsequent increase in value was also immune. The presumption of immunity is rebutted by establishing that the asset is indeed an active asset whose value increased due to the spouse’s active efforts.
However, whether an asset is exempt or jointly held, or whether the owning and/or non-owning spouse performed actions related to the asset’s value, is immaterial to deriving the passive appreciation component of the income producing real estate asset. Let’s take a closer look.
Valuation of income-producing property
It is generally accepted that an income-producing real estate asset such as an office building, retail strip center, or a multifamily property requires hands-on property management and marketing and is therefore, active. However, there are external and passive factors, such as location, market forces, or economic dynamics that also contribute to property values—infrastructure, zoning, opportunity zones, area amenities, environmental detractors or improvements, the economy, consumer spending, interest rates, tax policies, and capital costs.
To determine the property’s valuation, appraisers divide the net operating income (NOI) by the capitalization rate (cap rate), which is the expected return on the investment. Since the cap rate fluctuates irrespective of the ownership’s efforts, it is a 100% market-derived and passive factor. By extension, the cap rate differential between time of asset acquisition and disposition also represents passive appreciation or depreciation and is a quantifying appraisal factor.
As shown in the table below, the market values in 2000 and 2020 were $2.5 million and $8.3 million respectively. These values were derived by dividing the net operating income by the capitalization rate of their respective years. This resulted in a $5.8 million value appreciation.
When we fixed the NOI to $1 in 2000 and 2020 and then divided by the respective cap rate, we were able to isolate the cap rate effect on value. This resulted in 33.3% appreciation due to the cap rate differential.
So, when we multiply the $5.8 million appreciation by the 33.3% for cap rate differential, this results in $1.94 million attributed to passive appreciation.
As shown in the table below, 66.67% or $3.88 million of the remaining appreciation is due to the net operating income differential which may have both an active and passive component.
The controlling factor dictating the valuation date is the classification of the active or passive nature of the asset. If the asset increases in value between the time controlling for purposes of inclusion and evaluation—ordinarily the date of filing the complaint—and the time of actual distribution ordered by the court, this accretion in value must be analyzed in terms of whether it was attributable to the personal industry of the party controlling the asset, apart from the non-possessory partner, or simply to fortuitous increase in value “due merely to inflation or other economic factors,” e.g., a rare painting in a rising art market or a sole proprietorship commanding one party’s substantial time and energy. (Mol v. Mol; see also Bednar v. Bednar.)
If the increase in value is simply due to market factors or inflation, each party should share equitably in the increment. However, interim accretions pending actual distribution due to the diligence and industry of a party in possession of an asset, independent of identifiable market forces, should accrue to that party alone. (See Scavone v. Scavone.)
Ambiguity in the courts
The courts have issued ambiguous rulings regarding the equitable distribution of active or passive assets—or portions thereof—based on determinations of value increase resulting from the non-owning spouse’s efforts or joint efforts by the parties. And, while immune assets will generally be the owning spouse’s property, if it is determined that some portion of the increase in value is the result of the non-owning spouse’s efforts or joint efforts by the parties, that portion of the increase will be subject to equitable distribution.
Case example: After determining that the asset was a premarital active asset, the court held that plaintiff’s, or wife’s, actual contribution to the property was “minimal.” (Valentino v. Valentino.) However, the judge also recognized that during the marriage, the defendant, or husband was able to devote his time to the income-producing property, in part because the plaintiff took care of the home, worked part-time, and raised their child. The court ultimately found that "[t]his contribution certainly assisted (the defendant) by allowing him to devote his time to the business.”
- In addition, the date of valuation of joint assets is entirely dependent on the passive or active nature of the asset. Any change in value to a passive asset after the filing of a complaint will be subject to equitable distribution, thereby making the date of valuation the date of distribution or trial.
- However, any increase or decrease in value to an active asset after the filing of a complaint will solely belong to the party responsible for the change and the date of valuation will remain the filing date of the complaint for divorce.
Despite the courts’ flexibility in considering all facts relevant to a case, the grey area around what contributes to a property’s value increase, and what is deemed eligible for equitable distribution remains unclear. Therefore, we opine that the net operating income has both an active and passive component while the capitalization rate differential between the two dates of value, is solely passive appreciation, or depreciation, as it pertains to matters of equitable distribution in divorce.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Mark Dunec is a managing director in the Real Estate Solutions Practice of FTI Consulting, based in its Roseland, NJ, office. With more than 20 years’ experience in the real estate industry, Mr. Dunec specializes in underwriting pro forma cash flow, valuation, acquisition due diligence, financing, recapitalization, asset and entity restructuring, and repositioning. Contact him at firstname.lastname@example.org.
Daniel Serviss is a partner in the Matrimonial Department of Greenbaum, Rowe, Smith & Davis, LLP. He concentrates his litigation practice on matrimonial and family law. He has extensive experience in all aspects of the practice of family law, including divorce, prenuptial agreements, business and other asset valuations, and domestic violence matters. Contact him at email@example.com.
The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
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