Division of Assets and Debts

California is a community property state, and the basic principle that governs the division of assets upon divorce seems simple enough: each spouse is entitled to one-half of the property that was acquired during the course of the marriage. As straightforward as this appears, the financial reality of dividing assets can be complex. Remember, upon divorce, you and your spouse are essentially selling everything you own to (a) each other, or (b) a third party.

Here are some of basic things you should know about asset division in California:

  • Assets in California are classified in one of three categories: (1) community property, (2) quasi-community property, or
    (3) separate property.
  • All property acquired during marriage and before separation, other than by gift or inheritance, is presumptively community property. California law calls for the equal division of community property upon divorce.
  • All property acquired before marriage, after separation, or by gift or inheritance is separate property. Each spouse retains his or her own separate property upon divorce.
  • Any debt incurred during the marriage is considered community property, regardless of who incurred it.
  • If community property funds are used to pay down a separate property debt (i.e., a debt incurred by one spouse before marriage), the community is entitled to a reimbursement for the amount paid.
  • When one spouse uses his or her separate property to acquire community property, he or she has a statutory “tracing right” of reimbursement. Such contributions include payments of principle (i.e., a down payment on a house), payments made to improve community property (i.e., an addition to a home), and payments that reduce the principal of a loan used to purchase or improve community property.  
  • A retirement account or plan is considered community property to the extent the benefit was earned during the course of the marriage.
  • Some retirement plans are creatures of federal law, and as a result, they can only be divided by a special order, called a Qualified Domestic Relations Order (a “QDRO”).

Asset Division, Practically Speaking

The intense stress of divorce often causes couples to ignore the many costs associated with dividing or selling assets. The consequences of doing so, however, can resonate for years to come. As with any other aspect of your divorce, you will benefit greatly if you and your spouse reach a fair settlement outside of court. Keep in mind that courts do not typically account for the many costs associated with maintaining and selling various assets, such as insurance, maintenance fees, commissions, and taxes. Nowhere is the disparity between the legal reality of divorce and the financial reality more glaring than when your assets are divided.

Consider the following simple scenario: John and Sue Smith are in the midst of a divorce. The Smiths have $100,000 in cash and shares of a mutual fund valued at $100,000. Despite the poor state of the economy, the mutual fund has done quite well, returning nearly 8% per year. Clearly the mutual fund has done much better than the tiny return earned by cash in a savings account. Therefore, it might seem that if the cash goes to John and the mutual fund to Sue, Sue is in a good position. After all, why not stick with a winning investment?

In reality, Sue is getting a raw deal. All of the accumulated capital gain will be taxed when the mutual fund is sold, and Sue will be wholly responsible for paying the taxes. If the Smiths held the shares for many years and saw the value rise significantly, the tax bill could be substantial—many thousands of dollars. The net effect is this: John is getting a better deal by walking away with cash.  

 Putting Together the Financial Puzzle

Transparency is the key to a quick and fair settlement. Both spouses must have a complete picture of the family finances before any meaningful discussion about the division of assets can occur. Cooperation will ultimately save both spouses an immense amount of money in legal fees. Discovery, the process used to request and disclose financial information, is exceedingly expensive and time consuming. Couples in high conflict divorces can easily find that discovery alone drastically reduces their net worth.   

In many relationships, one spouse plays the role of financial planner. This spouse has a great advantage when it comes to obtaining a clear picture of the family finances. He or she may be tempted to “spin” the presentation of assets and liabilities to his or her advantage. This is particularly problematic in two situations:  (1) when a privately held business represents a significant source of income, and (2) when one spouse operates a professional practice (medicine, law, accounting, etc.). 

So how do you piece together the financial puzzle if you aren’t the spouse who kept the books? First, try not to let the process overwhelm you. Many people find that getting a handle on the family finances is easier than they suspected it would be, largely because their spouse wrapped everything they did in a shroud of mystique. Some controlling spouses want to maintain the illusion that what they are doing is extremely complex. In most cases, the situation is not so mind-boggling. It may be a relief to know that no advanced math skills are required to piece everything together.

Do not wait until your divorce is well underway before beginning your financial investigation. Start immediately. If you are lucky and the family finances are nicely captured in a tidy set of books and records, the process should be relatively straightforward. If, like many couples, you and your spouse kept several boxes of receipts stashed around the house, getting an overview of your finances may take a bit more work. Here are basic places to start looking:

Tax returns:  Assuming your spouse isn’t a tax fraud (in which case you have bigger problems), your federal tax returns are an excellent starting point. If you don’t have your tax returns for the past five years, you can obtain them from the IRS by filling out Form 4506. It’s simple to download the form directly from the IRS website: www.irs.gov.

A careful analysis of a return can illuminate income that comes from a source other than W-2 wages. During this process, a previously overlooked asset may surface. When examining an income tax return, pay particular attention to the following schedules:

Schedule A – Itemized Deductions:  Examine this schedule for real estate taxes and mortgage interest paid. The existence of such payments indicates the existence of real estate holdings, whether it’s the family residence, a vacation home, or investment properties.

Schedule B – Interest and Ordinary Dividends:  Income reflected on this schedule naturally indicates the existence of an underlying asset, which may be held in a brokerage or savings account. The amount of interest earned should give you some indication of the asset’s value. Keep in mind, however, that many securities do not pay dividends. As a result, the existence of non-dividend-paying stock can’t be ascertained by examining Schedule B.

Schedule C – Profit or Loss From Business:  Be warned, business accounting is a complex discipline and is vulnerable to extensive manipulation. Couples who act like grownups and fully disclose all financial information won’t play any of the income-hiding games that can plague the divorce process. Nevertheless, even well-meaning spouses can have an extremely hard time valuing a business. Analyzing the income from a business reported on Schedule C is a start, but it often only represents the tip of the iceberg. Understanding the accounting method a business uses is critical to understanding how a business reports income. Under the cash basis method, a business only reports cash income actually received, not money that is owed to it by customers. Expenses are deducted only if actually paid. Under the accrual basis method, income is reported when earned, not when it is actually received. Similarly, expenses are deducted when they are incurred, not when they are actually paid.

Schedule D – Capital Gains and Losses:  This schedule reflects the sale or exchange of a capital asset. Virtually everything you own is a capital asset. When you sell the asset, any gain is taxed at capital gains rates.

Schedule E – Real Estate, Royalties, Partnerships, Trusts:  This schedule will provide further evidence of rent-producing real estate. In addition, K-1 income from partnerships, S corporations, and limited liability companies will show up on Schedule E. If you become aware of the existence of any such entity, be sure to request a copy of the tax return for that organization. With regard to real estate, in particular, holding assets in a limited liability company is increasingly common. A limited liability company offers its members protection from liability while allowing so-called “flow through” taxation.

Bank and brokerage account statements:  This may seem obvious, but obtaining these valuable statements can provide you with a wealth of financial information. A credit report (see below) should divulge the existence of most accounts. 

Credit reports:  Obtaining a credit report is easy. The Fair and Accurate Credit Transactions Act (FACTA) provides that the three major credit-reporting bureaus (Equifax, Experian, and TransUnion) must provide a free copy of your credit report every 12-month period. Simply call 1-877-322-8228, or visit www.annualcreditreport.com.

Title reports:  Paying a visit to the county recorder’s office and conducting a title search is a good way to determine if any liens have been placed on your real property (e.g., your home). If you would prefer not to manage this process yourself, the web is crowded with service providers who will happily conduct a title search for you.

Retirement plans:  Be sure to keep tabs on any work-related pensions or savings accounts. Like everything else wholly or partly earned during the marriage, some or all of the value of these plans is community property.

Insurance policies:  If you maintain a whole life policy, know the cash value of the policy. Regardless of whether the policy is whole life or term, be sure you keep track of who is listed as a beneficiary.

Credit and loan applications:  These applications can be a good source of financial information.

Some assets are hard to miss. Your house, car, stocks and bonds, and retirement plans are relatively easy to track—and tough to forget. However, don’t let other less significant assets slip away. Taken separately, they may not represent a large sum of money, but added together, they can make a difference. Such assets can include the following:

Vacation pay:  Accumulated days of vacation should be valued based on the pay rate of the spouse who accrued the time off. In addition, some employers will compensate employees for unused sick days at the end of the year. This benefit can also be calculated and split.

Tickets to sporting or cultural events:  For some couples, deciding what to do with a pair of highly-sought-after season tickets becomes quite contentious. Though the psychological value of the seats may be sky-high, valuing the tickets for divorce purposes isn’t difficult. Many online resources exist that will give you a sense of what a third party might pay for the tickets.

Tax refunds:  If you expect a tax refund, determining how it will be split is an important issue that should be addressed in your marital separation agreement.

Frequent flyer points:  Valuing frequent flier points can be quite difficult. Some divorce professionals simply assign a monetary value to each point accumulated—two cents, for instance. Others recommend that the miles themselves be divided, or that one spouse issue a free ticket in the name of the other spouse. This is complicated by the fact that some airlines don’t allow miles to be divided. A good starting point is simply reading the fine print on your frequent flier miles statement.

Club memberships:  Country club or social club memberships are often quite valuable. In some cases, a club will require a significant up-front cash payment before granting membership. This sunk cost is something that should be accounted for in a divorce. In some instances, a couple is able to sell their membership interest and split the proceeds. In other cases, one spouse cashes out the other spouse by compensating him or her for half of the value of the membership.

Timeshares:  Often a poor investment, a timeshare is sometimes worth less than the amount owed on it. If you and your spouse get along well, you may continue to own it jointly. If it’s worth something, you may be able to sell it. If it’s worth less than you owe, you may simply let it go into foreclosure.   

A note about gifts:  As a general rule, gifts received during marriage are the separate property of the spouse who obtained the gift. Sadly, gifts can create quite a bit of conflict in a divorce. If you are a husband who made a habit of giving your wife expensive jewelry, it’s time to swallow hard and move on. The jewelry belongs to your wife and won’t be split upon divorce. Likewise, if you are a generous wife who gave your husband an expensive piece of artwork for each birthday, you will likewise have to say goodbye to these valuable gifts.

Tracing gifts by family members is much more challenging. For instance, consider the following scenario: John Smith’s father gave him $50,000 to buy a used sailboat. At that time, John was married to Sue. John took title to the property to the sailboat in his own name as his sole and separate property. John subsequently used community property funds to maintain the boat. Because the boat was bought with funds given to John by his father as a gift, it will be classified as John’s separate property. However, Sue may be eligible for partial reimbursement for the maintenance done on the boat.

Hiding Assets

As always, spouses who freely share information reap incredible benefits in the long run—both financially and emotionally. Unfortunately, occasionally one spouse tries to hide assets from the other in contentious divorces. The logic is simple: if the other spouse is unaware of the existence of the asset, it won’t be included in the pool of community property that must be divided. Aside from being highly unethical, this strategy can backfire horribly.

A favorite example that illustrates the foolishness of hiding assets is a well-known California case involving a woman who won a lottery jackpot of $1.3 million. Eleven days after winning the jackpot she decided she wanted to leave her husband of 25 years and filed for divorce. Of course, she never told her husband about the winnings, and she worked hard to keep the funds secret during the divorce proceedings. She was successful at first, but two years later the husband learned of her winnings when he received a misdirected piece of mail. A Superior Court judge was not amused by the wife’s deception and, in accordance with the applicable law, ordered that the entire jackpot be given to the husband. The wife subsequently filed for bankruptcy.

Deceitful spouses have cooked up any number of schemes intended to hide assets from their spouse and save them money in a divorce. There is no end to the creativity attributable to these misguided spouses. If you suspect your spouse is performing financial gymnastics in an attempt to hide assets from you, you may need to hire a forensic accountant. It will cost you quite a bit of money, but a good forensic accountant can uncover any number of tricks. Here are a few examples of how a spouse might try to hide assets:

Paying money from a business to a close friend or family member, ostensibly for “services provided.” In many cases, no work was ever done. The maneuver is simply a way to hide funds during the divorce process. As soon as the divorce is final, the friend or family member will invariably give the money back to the spouse.

Colluding with an employer to delay payment until after a divorce is final. This delayed payment might consist of a cash bonus, stock options, or simply deferred compensation. Uncovering this type of collusion is tricky, and often requires the use of a forensic accountant.

A few other common methods of hiding assets or income:

  • Transferring money to a custodial account set up in the name of a child.
  • Repaying a false debt to a friend.
  • Attributing the purchase of luxurious goods (paintings, antique furniture, etc.) to business expenses.
  • Delaying the consummation of an important business deal until after the divorce is final. This is considered hiding assets if it is done solely to lower the value of a business.
  • Keeping cash in the form of traveler’s checks or money orders.         

Dividing the Investment Portfolio

If you have a financial advisor, consulting with him or her will be an important part of the divorce process. Some assets are subject to a number of complications such as confusing taxation or illiquidity. That said, if your financial situation isn’t particularly complex, you should be able to split your investment portfolio without enlisting an army of advisors.

Determining which investment best serves your needs requires careful analysis. Just because owning a specific asset made perfect sense during the marriage doesn’t mean that it makes any sense upon divorce. Remember that running two households is significantly more expensive than one. A high-risk, high-reward investment may no longer suit your needs.

When deciding how to apportion your portfolio, keep in mind your own appetite for managing various types of investments. Some investments, like rental properties and high-risk stocks, require a certain degree of vigilance to manage properly. Others, such as mutual funds and government bonds, require virtually no work at all. Consider both your appetite for risk and your ability to devote time to managing investments when divvying up your assets.

One simple maxim can help guide you through the mess of a divorce: “Sell it now.” While selling an asset isn’t the best course of action in every instance, in the vast majority of cases, disposing of assets before a divorce greatly simplifies the process. Selling the asset before the divorce allows you to share the selling costs and potential tax burden with your spouse.

Getting into the mindset of selling assets before the divorce will help you consider all the tax and other costs associated with the sale. This prevents confusion regarding the true net value of an asset. To make wise decisions during the asset division process, it is essential that you understand the concept of tax basis. For a purchased investment, the tax basis is the amount paid. If inherited, the tax basis is the value of the asset on the date of the original owner’s death. If received as a gift, the tax basis is the amount that was originally paid for the investment, unless the market value of the investment on the date the gift was given was lower.

Capital gain is determined by subtracting the tax basis of the asset from the sale price. No one likes to take a loss, but remember that selling an asset and taking a loss is the ideal way to offset a gain. Consider the following example:

Sue and John buy shares of Company X stock for a total of $4,000 and shares of Company Z stock for a total of $4,000. Two years later, they sell the Company X stock for $2,000, taking a $2,000 loss. Two weeks later, they sell the Company Z stock for $6,500, taking a $2,500 gain. If they didn’t sell the Company X stock, their capital gains tax would be $375. However, due to the loss offset resulting from the sale of the Company X stock, their capital gains tax is only $75 ($2,500 gain minus $2,000 loss multiplied by 15%).

This simply goes to show that thinking strategically when liquidating assets during the divorce process can save you money. The stress of divorce can cause spouses to shut down a part of the mind that is more critical than ever—the ability to think strategically when it comes to their finances.

Valuing Assets

For those divorcing couples who are committed to doing things the grownup way—coming to a fair agreement outside of court—determining the value of each asset ranges from incredibly simple to fairly complex. The following information should help you get started:

Cash and receivables:  Simply perusing your bank account statements should give you an accurate picture of the amount of cash you hold. Don’t forget to search your files for copies of any receivables (i.e., money due to you under a personal loan). Sometimes families lend money to other relatives on an informal basis. While formalizing such loans is essential and avoids the inference that such a loan was actually a gift, many individuals skip this important step. As a result, you should try to locate evidence of all loans (informal and formal) you or your spouse have made to other individuals. 

Stocks and bonds:  If you use a brokerage firm or an online service to purchase your stocks, you can either (i) call the firm’s trading department and ask them to give you the current price of a stock or fund, (ii) simply check the business section of the paper, or (iii) locate the price on any one of the numerous financial websites that crowd the Internet. Your brokerage firm should be able to help you with the value of your bonds.

Insurance:  Assuming you are listed as the owner of the policy, the insurance company or broker who obtained the policy for you should be able to give you the policy’s current value and surrender value. If you don’t own the policy and you have a cooperative spouse, ask your spouse to provide you with the required information. If you are embroiled in litigation, this information may simply come out during the discovery process.

Collectibles and other personal property:  A highly-regarded estate planning attorney once remarked, “The second you walk out the shop door with a piece of jewelry or a collectible, you’ve taken a 50% loss.” There is a great deal of truth to his off-the-cuff comment. Collectibles are rarely worth as much as their owners like to believe. The key here is to get an appraisal. When valuing an item, make sure you use its resale value, not its retail price. Unfortunately, you may hear a host of different values according to who is performing the appraisal. The trick is to find a valuation that both you and your spouse find acceptable.

The closely-held business:  Because they aren’t listed on the various exchanges and therefore aren’t readily liquid, partnership interests, stock in privately held corporations, and membership interests in a limited liability company can be quite difficult to value.

Appraising a private business is part art, part science. In a contested divorce, valuing a small business can turn into a battle of the appraisers. Thankfully, though, valuing a company is less of a guessing game than it used to be, partially due to a constantly growing database of information on comparable sales, which can be accessed through entities such as BizComps and the Institute of Business Appraisers.

While a public company can fetch upward of thirty times its earnings on the market, a private company may be lucky to sell for five times its annual earnings. Buyers place a premium on one simple factor: predictable and growing cash flow. Of course, if you’re dealing with promising intellectual property in its infancy, the cash flow analysis is less important. A company with attractive intellectual property may sell for many times its annual earnings. Indeed, a company with no earnings may still be quite valuable if it holds a patent that is well positioned to influence a particular marketplace in the future.      

Certain intangibles also affect the value of a business. Location can be very important. A technology company in San Jose might garner a higher bid than a rival in Stockton simply because of the quality of the workforce and its proximity to the industry’s nexus. Likewise, a company that manufactures a car part with ten customers will fetch a lower price than a competitor of similar size that boasts fifty reliable customers because it doesn’t enjoy a revenue source that is quite as diversified.

A private company that is on the cusp of going public will undoubtedly fetch a much higher price than one that is less growth-oriented. And a company that is likely to be sold to a “strategic buyer” (one that will use the company to expand its product line or territory) will garner a generous price.

Sound complicated? It certainly can be. If you own a “mom and pop” store that has maintained fairly consistent revenue over the course of two decades, valuation should be relatively simple. If you own a company that is growing quickly, or that has developed some particularly valuable intellectual property, you will need a great deal of help. Professional assistance can come at quite a cost, but it is the only way to get a reasonable ballpark figure.

Selecting the right professional to appraise your business can be equally daunting. A CPA with no specialized training in business valuation is probably a poor choice, while one who is a certified valuation analyst is a better bet. A mergers and acquisitions specialist may also be able to provide you with a reasonable appraisal.    

Keep in mind that appraising your business can involve quite a bit of work on your part. Already emotionally exhausted from your divorce, the last thing you’ll want to do is gear up for a tedious valuation. You can expect to produce several years of financial statements and explain them in excruciating detail.

How much does a business appraisal cost? It varies according to the size of your company, but to give you a general sense of the fees involved: a business with less than $1 million in annual sales and good record keeping might incur a fee of $5,000. A company with $15 million in sales could pay many times that amount simply due to the complexity of its accounts.

Stock options:  An increasingly important part of many employees’ compensation packages, stock options require careful consideration during the divorce process. Stock options are deceivingly simple compensation contracts. When an option is exercised, its payoff rises by one dollar for each dollar the stock price is above the exercise price (also called the “strike price”). If the stock price is below the exercise price when the option matures, the option is not exercised and it has zero payoff. Despite the basic nature of this concept, few employees truly grasp all of the implications of option ownership. Indeed, surveys have shown that employees tend to place unrealistic expectations on their options and hold them in higher esteem than their value merits.

The complexity of dividing options upon divorce depends on whether the options have vested or not. If a spouse’s stock options have vested during the course of the marriage, the options are clearly community property and are therefore subject to equal division. However, the situation gets more complicated when some or all of the options haven’t yet vested.

California courts acknowledge that unvested options, though they have no present value, are subject to division. The manner in which a court determines what portion of the unvested options belongs to each spouse varies from case to case, and a judge has wide discretion in deciding which formula or approach to use in allocating options. In general, the longer the interval between separation and the date the options vest, the smaller the portion allocated to the non-employee spouse will be. For example, if a significant number of options vest only a few months after separation, a large portion of those shares will be considered community property. However, if a significant number of options vest three years after the date of separation, a much smaller portion will be considered community property.

In most cases, a court will use one of two formulas when determining how many options should be considered community property. Before applying one of the formulas, though, a court often determines whether the options were granted to the employee as a reward for past services, to attract the employee to the job in the first place, or as an incentive to stay with the company in anticipation of future job performance.

If the court determines that the options were granted to the employee spouse (1) as a reward for past service, or (2) as an up-front incentive to attract the employee to the job, the following formula may apply:

Community Property Shares =
[(DOH—DOS) / (DOH –DOE)] x [Shares Exercisable]
where “DOH” = Date of Hire
and “DOS” = Date of Separation
and “DOE” = Date of Options May be Exercised


To illustrate how this might work, let’s use the example of John and Sue Smith. John and Sue live in Silicon Valley. John started working at a start-up company, TechComp, on January 1, 2010. After three years at TechComp, the CEO expressed his delight at John’s performance by offering him 1,000 options, exercisable on a four-year vesting schedule. In other words, 250 of John’s options were scheduled to vest each year. For three years John exercised his options in accordance with his option agreement. Because 750 shares of TechComp vested during his marriage to Sue, all 750 shares are clearly considered community property. However, on August 2, 2016, 152 days before John earned the ability to exercise the last 250 options, he and Sue separated.

Applying the formula set forth above to the last 250 options, then, we have:

Community Property Shares =
[(DOH—DOS) / (DOH –DOE)] x Shares Exercisable

Community Property Shares =
[(2405 days) / (2557 days)] x 250 Shares

Community Property Shares = 235 Shares

Note that the vast majority of the shares that vest on January 1, 2017 are considered community property. This makes sense, as the reason behind granting the options (rewarding John for past performance) hinged upon his performance during the marriage.

Contrast the above formula with the approach that is used when options are granted as an incentive to keep an employee with a company:

Community Property Shares =
[(DOG—DOS) / (DOG –DOE)] x [shares exercisable]
where “DOG” = Date of Grant
and “DOS” = Date of Separation
and “DOE” = Date of Options May be Exercised


To illustrate how this formula works, and how it generates a different result, let’s alter the facts in the example set forth above. This time, on January 1, 2013, after John has worked for three years with TechComp, the CEO becomes worried that John may leave, and as an incentive to keep him around, he offers John 1,000 options, vesting on the same four-year schedule.

Applying the formula set forth above, we have:

Community Property Shares =
[(DOG—DOS) / (DOG –DOE)] x Shares Exercisable

Community Property Shares =
[(1309 days) / (1461 days)] x 250 Shares

Community Property Shares = 223 Shares

Clearly the two methods offer different results when it comes to calculating the number of options that should be considered community property. In the end, if you decide to litigate your divorce, the judge will decide which method he or she prefers (or indeed, use another method entirely). If you and your spouse mediate your divorce, the two formulas can provide a reasonable backdrop for your discussions.

Of course, the analysis set forth above is only the tip of the iceberg when it comes to stock options. Stock options and other equity incentive devices come in many formats. Two commonly seen iterations include incentive stock options (ISOs) and nonqualified stock options (NQSOs).

ISOs can only be granted to employees of the underlying company and benefit from favorable tax treatment. Upon exercise of ISOs, the employee does not have to pay ordinary income tax on the difference between the exercise price and the fair market value of the shares issued. Rather, if the shares are held long enough (one year from the date of exercise and two years from the date of the option grant), the profit from the sale of the shares is taxed at the long-term capital gains rate.

NQSOs don’t qualify for the special treatment granted to incentive stock options. Instead of being taxed at the long-term capital gain rate, NQSOs are taxed as income to the recipient at the time of exercise. As you might expect, this less favorable tax treatment comes with far fewer restrictions with regard to the timing of exercise.

Regardless of the nature of the equity incentives you or your spouse have earned, you should consider enlisting the help of an accountant or other executive compensation specialist in determining how the taxation of your incentives will affect their value. The IRS rules regarding the taxation of stock options transferred between spouses upon divorce are complex, and you will most certainly appreciate the help.

Spouses frequently “trade” options for other property when negotiating a divorce settlement. A spouse who has labored away at a start-up company may feel strongly about retaining all of his or her options, though this insistence on retaining all the options is typically misguided. To many employees, stock options represent a chance, however miniscule, at striking it rich—a dream that doesn’t typically accompany a “boring” standard salary. Before trading the right to options for other property, it is important to get a firm grasp on the value of the options. Various models of valuing options exist, and when dealing with early-stage startup companies, the process is more art than science. As with deciphering the tax implications of transferring options upon divorce, enlisting expert help when valuing options will greatly ease the strain of the divorce process.

Retirement Benefits

For many couples, a pension or retirement account is not only a sizeable asset, but it also an asset that may carry significant personal value to one spouse. Like virtually everything else, a retirement account is considered community property to the extent the benefit was earned during the course of the marriage. Dividing a retirement plan is no small task, and the vehicle used to effectively split a plan varies according to the type of plan.

First, understand that most retirement plans broadly fall into two categories: (1) defined benefit plans, and (2) defined contribution plans. Defined benefit plans are often called pension plans, and in such a plan, an employer often pays the employee a monthly sum until the employee dies. Defined contribution plans, on the other hand, usually constitute a mixture of contributions by both the employee and the employer. A 401(k) plan is an easy example of a defined contribution plan. An Individual Retirement Account (IRA), while a close cousin of the defined contribution plan, stands on its own.   

Valuing a defined benefit plan can be difficult simply because doing so involves actuarial calculations. In other words, the value of the plan depends on several variables, including the rate of inflation and the life expectancy of the beneficiaries. Dividing such a plan is therefore correspondingly complex. A defined contribution plan or an IRA is much simpler to value, simply because the plan administrator will report the current value of the account to the holder in regular statements.

What portion of a plan is community property? A simple calculation is typically used to determine how much of a retirement plan will be considered community property (this is often referred to as the “California Time Rule”:

  1. First, determine the total number of months of plan participation.
  2. Next, determine the number of months of plan participation between the date of marriage and the date of separation.
  3. Finally, divide the first number by the second to obtain the percentage ownership interest.

Consider this example:

John Smith works for a manufacturing company that offers a generous defined benefit plan (a pension). He has been accruing retirement under the plan for 23 years (276 months), and has been married to Sue for 19.5 of those years (234 months). The percentage of the pension that is community property is therefore 85% (234 divided by 276). Sue is therefore entitled to ½ of the community property share (or 42.5%), while John is entitled to both ½ of the community share and his separate property share (a total of 57.5%).

The valuation method has a drawback, of course, and that is the simple fact that the contributions to the plan early in employment (typically when an employee’s salary is lower) are less valuable than the contributions made later in employment (when an employee’s salary is higher). A precise calculation may require the help of an actuary, pension administrator, or financial planner.

Sometimes spouses are shocked when presented with the actual present value of a seemingly sizeable plan. We all know that a dollar today is worth far more than a dollar ten years from now. Nevertheless, the degree to which the “present value factor” can diminish the current value of the plan is often startling. Here’s an example using simplified data:

Tim Larsen is 42 years old. Upon retirement at age 65, his plan will pay him $20,000 annually for the rest of his life. Let’s assume actuarial tables state that Tim should live until age 75. Theoretically, then, he should receive a total of $200,000 ($20,000 per year multiplied by 10 years). Remember, of course, that Tim won’t retire for another 23 years. Assuming a 4% inflation rate, the present value of Tim’s right to receive $20,000 for 10 years starting at age 65 is roughly $50,000. His wife, Tina Larsen, is therefore surprised to learn that her 42.5% share in the plan is only worth approximately $21,000. If she waits until Tim retires, she will be eligible to receive a much larger sum. Such is the nature of present value calculations.

Present value calculations can be done using present value tables or, even better, an online calculator. Many reputable websites offer free present value calculators that are quite simple to use (www.investopedia.com is one example).

The mechanics of retirement plan division:  Dividing different types of plans requires different types of orders. Retirement plans that are controlled by federal law (which preempts state law) must be divided by an order known as a Qualified Domestic Relations Order (a” QDRO”—pronounced “quadro”). Other plans can be divided by a state court order alone. A QDRO is an extremely important document, and it must be perfectly accurate, simply because anything omitted from the order can’t be reinstated later. Virtually all mediators, and most family lawyers, rely on specialists to draft QDROs. 

The following table sets forth a few of the common types of plans and the type of order required.

Plan TypeType of Order Required to Divide Plan
401(K)QDRO
Thrift Savings PlanQDRO
Employee Stock Ownership Plan (ESOP)QDRO
Tax Sheltered Annuities (TSAs)QDRO
Traditional IRAOrdinary court order
Roth IRAOrdinary court order
Deferred AnnuityOrdinary court order
Corporate or Business PensionQDRO
Military PensionSubject to very specific government regulations regarding division upon divorce


Income tax considerations associated with retirement accounts:  The IRS always gets its share. True, some retirement plans have very real tax advantages, but the IRS always takes a bite of the money you accrue for retirement at some point.

A common trade-off used by divorcing couples allows one spouse to take the retirement plan while the other retains the equity in the family home. If you are the spouse taking the retirement plan, you need to understand how withdrawals from the plan will be taxed to determine if it is a fair trade. Ideally, the retirement plan was funded with after-tax dollars, which means that you will be able to withdraw part of the proceeds at retirement without being taxed.

By either contacting the retirement plan administrator or checking your annual benefits statement, you should be able to determine the ratio of pre-tax to after-tax contributions. As a general rule, if your employer partly funded a retirement plan (i.e., with matching contributions in a 401(k), for instance) the portion that the employer contributed will be taxed when withdrawn at retirement.

Keep in mind that you do not pay taxes on money that you contribute to a traditional IRA. However, a Roth IRA works very differently. You are taxed on the money you contribute to a Roth IRA at the time of contribution, but you receive the benefits tax-free upon retirement. This clearly makes receiving a Roth IRA a more attractive proposition upon divorce.

The true value of an account:  The date of separation is critically important when valuing a retirement plan. As is the case with the income of either spouse, any increase in the value of the plan after the date of separation is the separate property of the beneficiary spouse. Contrast this with the way in which assets are valued—at the date of trial. This may lead to confusion, even among financial professionals. Consider the following example:

John and Sue Smith decide to divorce in 2008. John moves out of the house and rents an apartment. Neither John nor Sue hopes for reconciliation. However, John and Sue aren’t in any great hurry to get divorced, and they don’t complete the process until 2012. All of the appreciation in John’s retirement plan between 2008 and 2012 is considered his separate property. Sue is therefore only entitled to half of the value of his retirement plan as valued from the date of their marriage to the date of separation.

Calculating the true value of a retirement plan is an important part of the asset division process. It can seem daunting at first, and some people choose to have a third party (such as an accountant) value a retirement plan.

Division of Debt

For many married couples, dividing debt is just as important as dividing assets. Again, remember that any debt incurred during marriage and prior to separation is community property, regardless of who incurred it. This means that if your spouse secretly racked up massive credit card debt while you were married, you are out of luck. However, this is a glimmer of hope, and that involves the nature of the debt. If the debt was incurred to benefit the “community,” i.e., the two of you, it is considered community property. However, if the debt was incurred solely for the benefit of one spouse, relief may be available. Consider the following example:

Anthony and Maria Andretti live modestly. They make timely payments on their mortgage, take a single inexpensive family vacation per year, and rarely eat at nice restaurants. Anthony completely manages the family finances, from balancing the checkbook to paying credit card bills. Unbeknownst to Maria, while they were living in the same house (and separation wasn’t yet being discussed), Anthony was incurring huge credit card bills on hotel rooms and lavish meals in an attempt to impress his young lover. Maria is greatly relieved to learn that the debt associated with Anthony’s seduction of his lover is his separate property.

Note, however, that Maria’s relief may be short lived. While a court can certainly divide debt and order that one spouse is solely responsible for a particular debt, credit card companies are not hindered by these orders if the credit card was a joint card. Creditors may still collect from either spouse. The only remedy for the aggrieved spouse is to go after the spouse who incurred the debt for reimbursement.

Use of community property to pay pre-marital debt:  Sometimes one spouse enters a marriage with debt. If community property funds are used to pay down that separate property debt, the community is entitled to a reimbursement for the amount it paid. Consider the following example:

Sue Smith had large credit card debts incurred prior to marrying John. To improve their credit rating so they could buy a house, Sue and John worked hard to pay off the debt using community property funds. Now that they are debt free, Sue files for divorce. Because Sue and John used community property earnings to pay off Sue’s separate property debt, the community is entitled to reimbursement for the amount paid. In other words, John should ultimately recover half of the amount used to pay off Sue’s debt, as half of all community property is his.     

Use of separate property to pay community property debt:  In California, if one spouse’s separate property is used to pay off a community property debt, a court will presume that a gift was made to the community. However, there is an important exception to this rule. When one spouse uses his or her separate property to acquire community property, he or she has a statutory “tracing right” of reimbursement. Such contributions include payments of principal (i.e., a down payment on a house), payments made to improve community property (i.e., an addition to a home), and payments that reduce the principal of a loan used to purchase or improve community property. Note that this does not include payments for maintenance of the property, interest on the underlying loan, or taxation. Consider the following examples:

Example 1:  Carrie and Marcus Olefsky decide to send their child, Bobby, to private school. Marcus uses funds from his separate property brokerage account to pay the tuition. He is not entitled to reimbursement from the community for this payment. It is considered a gift to the community.

Example 2:  Luis and Rosa Lopez want to purchase a home. Luis has significant savings that he accumulated prior to marriage. He uses these savings to make the down payment on their new home. Luis is entitled to “trace” this contribution back to his separate property, meaning he has a right of reimbursement from the community for the amount of the down payment.

Example 3:  Seo and Mingi Tran decide their home is too small, and Seo uses savings that he accumulated prior to marriage to “improve” the property by adding an extra room. Seo is entitled to trace this contribution back to his separate property, and he is therefore entitled to reimbursement from the community.

Example 4:  Jake and Elizabeth Williams are struggling to pay all of the expenses associated with living in their home. As a result, Jake agrees to pay for the maintenance of the home and all associated property taxes using his separate property savings. Unfortunately for Jake, he is not entitled to reimbursement from the community for any of this amount. Had Jake used his separate property to make principal payments on the mortgage, he could trace his contribution and qualify for reimbursement. However, because Jake used his funds to pay taxes and maintenance costs associated with the home, he is out of luck.    

Use of separate property to pay community property debt after separation:  Once a couple has separated, a spouse who uses separate property to pay pre-existing community debt is entitled to reimbursement from the community. This reverses the presumption of a gift that exists when separate property is used to pay a community debt before separation. Note, however, that there are a few exceptions to this rule. The first is that the paying spouse is entitled to reimbursement only when the amount paid is substantially in excess of the value of the use. This may sound like a mouthful, but all it means is that a spouse who enjoys the use of the property should not be reimbursed for paying down debt associated with that property, so long as the value of the use is roughly equal to the amount paid. Consider the following example:

John and Sue Smith separate, and John continues to make loan payments on his pickup truck. The loan is community property, but Sue never drives the truck—John is the only one who enjoys the benefit of the truck. As a result, the payments John makes on his pickup truck can be correlated to his use of the truck. He is therefore not entitled to reimbursement from the community for the loan payments, even if the truck is held jointly.

There are two additional exceptions to the rule that a spouse is entitled to reimbursement for amounts contributed to pay off a community debt after separation: (1) where the parties have agreed that the payments will not be reimbursed, and (2) where the payments were intended as a gift or as child support or spousal support.

Use of community property funds to pay separate living expenses after separation:  The community is only entitled to reimbursement when one spouse uses community property funds to pay his or her separate living expenses to the extent that those expenses exceed a reasonable amount of child support and spousal support. Of course, as is the case in so many areas of the law, understanding the meaning of the term “reasonable” is important. While the term will vary from case to case, a reasonable amount would probably be the amount of guideline support that a court would order in an application for temporary child and spousal support. Consider the following example:

After separating from John Smith, Sue remains in the family home and continues to care for their son, Bobby. Sue’s part-time work brings home only $1,500 a month, and as a result, let’s assume a court would likely order that John pay her $3,000 per month in temporary child support and spousal support. However, Sue is waist-deep in a midlife crisis, and she soon finds herself spending $7,000 a month to support her new lifestyle. She sells $5,500 worth of stock from the Smith’s community property stock portfolio each month for five months to make ends meet. A judge might order that Sue reimburse the community to the tune of $12,500 ($2,500 per month for five months). Remember, the community would likely be entitled to reimbursement only for the amount spent that exceeds guideline support. Here, Sue spent $5,500 in community property funds for five months, when guideline support would have totaled $3,000 per month.    

One spouse remains in primary residence while other spouse makes mortgage payments:  Quite often one spouse moves out of the family home during separation while the other spouse remains in the home. The spouse who leaves may offer to keep paying the mortgage and property taxes. Unless these payments are made in accordance with an agreement to waive reimbursement or the payments are a form of child or spousal support, the paying spouse may be entitled to reimbursement because he or she is paying a community debt with separate property funds.

Lastly, the spouse who stays in the home could be in trouble in a contested divorce if the fair market rental value of the home exceeds the mortgage payments. If a home was recently purchased, the mortgage payments will almost always exceed the fair market rental value of a home. However, this is often not the case with older properties. A home bought twenty years ago may be encumbered by a fairly modest mortgage. However, in the intervening twenty years, the fair market rental value of the home may have increased dramatically. The spouse remaining in the home after separation may therefore be required to reimburse the community for the difference between the mortgage payments and the fair market rental value of the home between the date of separation and the date of trial. Consider the following example:

John and Sue Smith decide to separate, and they both agree that Sue should stay in the home with their son, Bobby. John continues to pay the mortgage using the income from his job. The Smith’s bought their home 20 years ago, and as a result, their mortgage payments are a modest $1,500 per month. However, the fair market rental value of their home is $2,500. The Smiths separated ten months before their divorce becomes final. As a result, Sue may owe the community $10,000 ($2,500 – $1,500 multiplied by 10). And it doesn’t stop there. The community may also be entitled to reimbursement for the mortgage payments themselves (another $15,000). In the end, Sue will be dismayed to know that she owes a total of $25,000 to the community simply because she was allowed to remain in the home during the period of separation. The net cost to Sue is $12,500 (because half of the community is hers, after all), and the net benefit to John is $12,500 (because half of the community is his).     

The lesson here? If you are the spouse remaining in the home during separation, make absolutely sure that you document in writing that the privilege of remaining in the house should be considered an element of spousal support (or child support, if applicable) and that the paying spouse should not receive any reimbursement as a result.

Bankruptcy and Divorce

It’s a sad truth—for some couples, bankruptcy is simply a part of the divorce process. Indeed, financial woes are often the cause of the divorce itself. When debts become so overwhelming that a couple sees no way out, filing for bankruptcy may be the best option. Before coming to the decision to file bankruptcy, though, you should exhaust all other options. A bankruptcy will destroy your credit for many years to come and may affect your ability to rent an apartment, get a job, or qualify for a loan of any amount. Furthermore, declaring bankruptcy is much harder than it used to be, thanks in large part to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

First, it is important to understand the difference between the two most common types of bankruptcy: Chapter 7 and Chapter 13. Chapter 7 allows you to discharge all of your debts forever. Chapter 13, on the other hand, is a “reorganization” and requires that you pay some of your debt. The 2005 Act has made it much harder to qualify for the more forgiving Chapter 7 bankruptcy. For instance, if your income is above your state’s median income, you have to file for Chapter 13 in all but the most extraordinary of circumstances. Even if your income is below the state median, you have to file for Chapter 13 if you can pay more than $100 per month on your unsecured debt over the following five years.

Various types of debt can’t be discharged by bankruptcy, including student loans, judgments involving restitution for a crime, and debts obtained by fraud. In addition, the 2005 Act made the rules regarding the discharge of support-related debts even more stringent—it is now difficult, if not impossible, to get out of such payments through bankruptcy.     

Pay close attention to your settlement agreement to make sure it doesn’t leave you unprotected in the event that your former spouse declares bankruptcy. In some cases, one spouse has no assets to give to the other spouse in exchange for receiving the bulk of the community property (i.e., the family home). As a result, the spouse receiving the larger share of community property may give the other spouse a promissory note. First of all, consider securing the promissory note with a lien on the primary residence. Second, your promissory note receivable is much more likely to survive bankruptcy if you specify in the settlement agreement that the note is made in lieu of alimony.

Keep in mind that bankruptcy is a creature of federal, not state, law. As a result, filing for bankruptcy in the midst of a divorce can create a true mess. The family court is allowed to continue to decide issues regarding the establishment of spousal and child support, but it may not apportion investments, divide the family home, or distribute any other property until federal bankruptcy court grants its permission.

Most importantly, if you are considering filing for bankruptcy, seek the counsel of an experienced bankruptcy attorney. While a family law attorney is likely familiar with the basics of bankruptcy, you should consult with someone who substantially limits his or her practice to bankruptcy.

The Legal Framework for Asset Division

The legal framework surrounding asset division is set forth in California Family Code Sections 2550 through 2660 (Exhibit E of the Appendix).

Classification of Property

Before property can be divided and distributed, it must be characterized as “community property,” “separate property,” or “quasi-community property” as defined in the California Family Code.

Separate property:  Any property acquired before marriage or after separation is considered the acquiring spouse’s separate property. The time of acquisition is therefore important, and is typically set at the time when the original property right arose. For example, with regard to an automobile, the time of acquisition would be the date the purchase contract was signed, not the date the DMV confirmed title.

Property acquired by “gift, bequest, devise, or descent” is also characterized as separate property. For example, if your father leaves you $100,000 in his will, that money is your separate property. Likewise, if your spouse gives you a diamond necklace, the gift is your separate property.

In addition, any assets acquired after the date of separation (but before divorce) are considered the separate property of the acquiring spouse. For example, if your date of separation is June 15 and you buy a new automobile on September 15 using payments you received in the interim as temporary support, that automobile is your separate property.

Community property:  All property acquired during the marriage and before separation, other than by gift or inheritance, is presumptively community property. This includes all compensation, regardless of the form it takes, a concept that will become more important when determining how much (if any) child support or spousal support is appropriate.

The following are examples of compensation:

  • Stock in lieu of salary
  • Employer contributions to an employee profit-sharing plan
  • Incentive stock options
  • A “gift” from an employer (of real estate, for instance), which is in reality deferred compensation in lieu of a pension
  • Vacation pay, or the right to receive certain other financial benefits as deferred compensation upon termination of employment

All earnings from a privately held business are considered community property to the extent they reflect either spouse’s participation in the business. On the other hand, earnings that don’t reflect the labor or skill of either spouse are considered a return on a capital investment and are characterized as separate or community property based on the date of the original investment. This may sound confusing at first blush, but the concept is sensible. Consider the following example:

Before marrying Sue, John Smith invested in a fast food franchise along with two of his close friends. The franchise did fairly well, but by the time John and Sue were married, he was a completely silent partner. He did nothing more than collect his share of the profits generated by the franchise. The income generated by the franchise that is payable to John is his separate property. He performed no work to generate those profits during the course of his marriage to Sue. The “seed was sown” before they were married. Therefore the earnings from the franchise are not community property.

Contrast the previous example with the following: Before marrying Sue, John opened an accounting practice. Getting started took quite a bit of time, and the practice wasn’t even profitable by the time he married Sue. In this case, valuing the business will be quite difficult. Some portion of goodwill is attributable to the work John did before marriage, but the income derived from the practice after marriage clearly reflects John’s labor and skill, and is therefore community property. In a case like this, and outside expert may be required to properly value the business.

As a general rule, simply remember that any asset obtained or income earned during the marriage is community property. This includes the right to receive income in the future—for instance, through a grant of stock options, or perhaps through deferred compensation.

California Family Code Section 910 states that any debt incurred during the marriage and prior to separation is community property. It also doesn’t matter whose name appears on a bill or a credit card statement. If it was incurred during the marriage and prior to separation, it’s a community property debt and both spouses are equally liable. However, potential relief may be offered by Family Code Section 2625, which gives the court the power to assign a debt incurred during the marriage to one spouse if it was not “incurred for the benefit of the community.” 

Quasi-community property:  California Family Code sections 125(a) and 125(b) define “Quasi-community property.” In short, quasi-community property is real estate and personal property acquired by a spouse while living out of state that would have been community property if the spouse had been domiciled in California. The definition of quasi-community property also includes any property that is acquired in exchange for such property. Quasi-community property is a means for California courts to obtain the authority to dispose of non-California assets in a divorce.