By Kristi Anderson Wells, Esq.
Unique issues arise in divorce when income-producing real estate constitutes a portion of the marital estate. We often see cases where the value in the marital estate is held in companies that own real estate, sometimes in a single real estate holding company, sometimes held in a series of entities with different investors in each entity. Sometimes the entities contain development projects that are in progress, sometimes they own existing office buildings, residential long or short-term rentals, retail strip malls or warehouses, and in some cases apartment buildings. In one divorce during the last downturn, the marital estate was made up almost entirely of hundreds of millions of dollars of “broken” condominium projects which the real estate investor had acquired when the initial developer went bankrupt and was in the process of redeveloping and refinancing. In all of these cases similar issues arise. Here are some things to be aware of if you are thinking about getting divorced and the marital estate contains a real estate portfolio.
- Unless real property was purchased recently, the underlying real property will have to be appraised to establish the value of the ownership interest in any entity. Commercial real property appraisals cost significantly more than residential real property appraisals and often take ninety days or more to complete. As a result, the first thing we do in any real estate divorce is document all of the entities, and all of the properties owned by each of the entities, determine if any recent appraisals or refinances have taken place that could be used to establish value. If not, we get appraisers lined up to value the real estate as soon as possible.
- The marital estate in a real estate divorce often lacks liquidity because real estate investors have a tendency to reinvest in new deals. Where the marital estate lacks sufficient liquidity to ensure that each spouse gets a fair share of the total value up front, sometimes the equalizing payment must be paid in installments over a period of years. In such cases, a promissory note setting forth the terms of the loan from one spouse to the other should be executed, stating the amount of each installment payment, the interest rate, and what happens in the event of default.
- If support is at issue, the amount of each installment payment allocable to income on the note should be included in the recipient spouse’s income when calculating spousal or child support.
- One way to avoid the need for a promissory note may be to transfer the ownership interest in a real estate entity from one spouse to another, especially if the recipient spouse has experience in real estate investing or can be given support through a property management company to manage the interest. Prior to agreeing to such a transfer, it is important to review the operating agreement or other governing documents to determine if the ownership interest can be transferred without the permission of the other owners. If there are multiple investors in a real estate entity, there may be prohibitions on transfer of the ownership interest as many real estate investors don’t want to become business partners with someone new without having a say in it. There may also be provisions requiring the other owners be provided with a right of first refusal to purchase the ownership interest upon transfer.
- Similarly, many operating agreements or governing documents will prohibit using the ownership interest to secure a promissory note. Again, the reasoning is that real estate investors don’t want to end up being business partners with a bank or a stranger if one of the owners defaults on a loan.
- It is also important to review the terms of any mortgage or financing agreements to ensure that a transfer or pledge of stock will not trigger acceleration or default on the mortgage.
- Given the potential limitations imposed under the terms of the operating or financing agreements, it may be difficult to provide security for a promissory note equalizing the value of the marital estate. Most lenders prefer to have a security interest in real property and that is likely to be the case in a divorce as well. However, where one spouse owes the other spouse an equalizing payment in divorce, and all of the real property interests are held in entities with multiple owners, the underlying real estate cannot be encumbered without permission of the other owners. In addition, if the governing documents or operating agreement prohibit owners from pledging or encumbering their ownership interest in the real estate entity, the stock in the entity cannot be used as security either. The other big asset that many people may have in their marital estate, qualified retirement plan accounts like a 401(k), cannot be pledged as security. In those cases, there may be residential real estate such as a marital residence or vacation home that can be used as security, provided such arrangement does not violate the terms of any existing mortgage.
- Income producing real property, or the entity owning income producing real property, should be valued taking into account depreciation recapture. Depreciation recapture is the portion of the gain attributable to the depreciation taken on the property during prior years of ownership, also known as accumulated depreciation. Depreciation recapture is currently taxed at 25%. Depreciation recapture follows the property until it is sold but can be kicked down the road if investors use a Code Section 1031 exchange. Whether capital gain should be included in the determination of value is a matter in the court’s discretion in Colorado. As a result, it is a good idea to have your valuation expert calculate the amount of gain and the amount of the depreciation recapture so that the issue can be discussed in mediation or put before the court at a permanent orders hearing.
To schedule a consultation or for more information you can call (303) 309-1077. Our office is located at 1660 Lincoln St., Suite 1525, Denver, CO 80264.