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Author's Note

The issue of erosion of the owner spouse's equity in refinances during marriage has been a topic of much debate. After wrestling with this problem for over a year, I believe I have found a solution. As a service to the family law bar, and the forensic community, I have chosen to make the following article available at no charge.

SOLVING THE SEPARATE PROPERTY EROSION PROBLEM

IN REFINANCES DURING MARRIAGE

©2004 by T. Wilson - Posted December 2, 2004

INTRODUCTION

This article presumes that you have a thorough understanding of the "Moore/Marsden" rule and the basic calculations performed under that rule.

The article addresses the troublesome problem of how to handle erosion of the separate property owner's equity that can occur when refinance loan proceeds are characterized as community property. When such erosion occurs, the forensic practitioner is confronted with two choices: (1) Treat the erosion as a gift to the community by the owner spouse, or (2) modify the basic Moore/Marsden calculations in a manner that will maintain the owner spouse's equity if possible.

This article adopts the second choice and offers a solution that I believe is sensible and legally sound. Because I am assuming you have a full grasp of the subject, I will simply set forth my "assumption set," and then take you through a step-by-step explanation of a sample spreadsheet that chronicles three post-marital refinances, one in which the separate property equity is not eroded, and two in which the separate property equity is eroded. Accordingly, before you begin to read the article, you must download and print out the sample spreadsheets so that you can follow along: Download in Excel format or download in PDF format .

I have decided to self-publish this article on my Web Site so that it can be disseminated quickly. Accordingly, I would be deeply grateful if you would pass along the following link to your colleagues so that we can spark discussion and constructive criticism.

http://www.yourmanfriday.com/art_erosion.html

While I do not claim that my approach is the "final answer," I have yet to find anything better. I welcome your comments and thoughts at twilson@yourmanfriday.com

THE ASSUMPTIONS/METHODOLOGY

The following assumptions and methodology apply to the calculations in the sample spreadsheets:

1. The loan proceeds received during marriage are presumed to be community property.
2. At the first refinance, the owner spouse could sell his or her property instead and realize the net proceeds of sale, less the community's accrued Moore/Marsden interest. At the time of any subsequent refinance, the owner spouse could sell the property and realize his or her separate equity accrued at the time of the refinance.
3. Separate equity will be maintained if possible. Separate equity should not be charged with the community's "cash out."
4. After the first refinance, the strict Moore/Marsden formula cannot be used because the loans are no longer "loans by which the property was purchased." However, the spirit and intent of the formula is maintained by allocating appreciation based upon equity percentages of total value at each refinance. Total value equates to "purchase price" in the original Moore/Marsden formula.
5. Accrued community and/or separate equity may be eroded by the "cash out." If so, debit against the community equity first, and only if the community equity is exhausted will separate equity be eroded.
6. If separate equity is eroded, allocate that amount from the community loan proceeds to the owner spouse for the purpose of calculating the percentage of total value, which will be used to allocate appreciation.
7. As to pay-downs of principal, credit to eroded separate equity first, and if the pay-down is greater than the eroded separate equity, then credit to the community. If the pay-down is less than the eroded separate equity, separate equity permanently loses the difference. This approach is equitable because:
• All separate equity is included in the calculation to determine the percentage of total value, which in turn gives a greater percentage of the appreciation;
• The separate equity is partially restored by the principal reductions, which have been paid by the community;
• As a member of the community, the owner spouse has presumably benefited from the "cash out," including the amount attributable to any separate equity that may be permanently lost.

THE CALCULATIONS:

EXHIBIT "A" - THE BASIC CALCULATION AT THE FIRST REFINANCE

We begin with Exhibit "A," which is the Moore/Marsden calculation that takes place at the first refinance. I use a separate spreadsheet for this calculation because it is always a simple, straightforward Moore/Marsden calculation. This spreadsheet is linked to the main calculations, which employ a much more complicated template.

The calculations should be very familiar to you. The important concept to grasp is that if the owner spouse had sold the property instead of refinancing it, he or she would have received $140,000. [Item 25] The total sale proceeds would be $250,000 [Item 29]. The outstanding loan of $30,000 would be paid out of escrow [Item 30] leaving total net sale proceeds of $220,000 [Item 31], from which the community would be paid its pro tanto share [Item 25] leaving the separate owner with the remaining $140,000. (Note: I realize there would be closing costs and realtor's fees, but I ignore them in these calculations because the sale is hypothetical).

MAIN CALCULATIONS - THE FIRST REFINANCE - NO EROSION

The first refinance takes place October 1990 when the property is valued at $250,000. The community borrows $100,000. [Item 7] After the old loan is retired [Item 3] there is $70,000 of "cash out." [Item 9] It is critical here to note that the community has $80,000 of equity [Item 5], which is enough to cover the cash out and still have $10,000 left over. [Item 11] After the transaction is complete the post-loan equity is $150,000, $10,000 of which is community and $140,000 of which is separate. [Item 11] Therefore, in this refinance there was no erosion of the separate equity. Equally important is the fact that because there is no erosion, the community gets credit for the full $100,000 of loan proceeds [Item 12], which, when combined with its remaining $10,000 of hard equity [Item 11] gives it a 44% share of future appreciation. [Item 14]

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MAIN CALCULATIONS - THE SECOND REFINANCE - EROSION

The second refinance takes place in March 1996. From this point on I posit a hypothetical sale to provide an "equity snapshot" for use in maintaining the separate equity if possible. Here, the property has appreciated to $450,000 [Item 18] with the balance of the $100,000 loan now reduced to $50,000 [Item 19], which would result in $400,000 of net proceeds if the property were sold instead of refinanced.

The following "Knowns" section accounts for and allocates this equity. The loan pay-down was $50,000 and was made by the community, for which it is credited. [Item 23]. The "hard equity" extant at the last refinance is carried forward. [Item 24]. Then, the $200,000 of appreciation is allocated based upon the previous percentage of value. [Item 25] What this means is that if the property were sold at that point instead of being refinanced, the community would receive $148,000, and the owner spouse would receive $252,000, which accounts for the $400,000 of total equity. [Item 26]

The new loan is $360,000. [Item 28] After the $50,000 balance on the old loan is paid from escrow there is "cash out" amounting to $310,000. [Item 30]

Now for the most critical part of this entire article: Note that once the cash is taken out, there is only $90,000 worth of equity left! [Item 32]. The separate equity is eroded, even after debiting all of the community equity of $148,000. [Item 26] If we don't do something to correct this, the owner spouse is twice-penalized, once in the loss of equity, and again in the reduction of the percentage of equity used to calculate future appreciation. Bear in mind that it is a combination of community credit and separate property equity that makes it possible for the loan to be consummated in this amount. In my opinion, the only sensible way to surmount this problem is to allocate a portion the community loan proceeds to the owner spouse. This is accomplished in Item 33. After crediting the owner spouse with the remaining $90,000 of equity [Item 32] that amount is subtracted from the owner spouse's pre-refinance equity [Item 26] to determine the amount of the erosion, which is then allocated to the owner spouse in the proceeds of the new $360,000 loan [Item 33].

Note that this methodology does not restore true "hard equity" to the separate owner, but it does provide a proper share of the appreciation based upon the owner spouse's previous equity. And, as the next calculation will show, he or she is likely to recover the lost "hard equity," which is appropriate because the owner spouse could have sold the property instead of refinancing it and received $252,000. Why should the separate owner be penalized for aiding the community by offering security for a community loan?

MAIN CALCULATIONS - THE THIRD REFINANCE - EROSION

The third refinance takes place in June 2000. The same methodology is applied as in the second refinance and need not be repeated in full. Again, we know that if the property were sold instead of refinanced the net sales proceeds would be $300,000 [Item 41], and the "Knowns" section allocates this equity. The new post-loan equity is $120,000 [Item 53], all of which is allocated to the owner spouse. Nevertheless, the separate equity is eroded by $114,000, which is credited to the separate owner in the allocation of the $480,000 new loan. [Item 54]

MAIN CALCULATIONS - DATE OF TRIAL

The final calculation is necessary to determine the respective equity values at the date of settlement or trial. It is essentially the same as the other calculations, but there is no need to allocate a new loan or determine percentages for future appreciation. Certainly there will be cases in which there are even more than the three refinances here. If that is the case, just keep looping in the manner of the second and third refinances here until you reach the end, at which point you finish off with the "Date of Trial" section. The bottom line in this case is that the community has a pro tanto interest of $91,500 in the owner spouse's property.

CONCLUSION

The foregoing theory and methodology is based upon the unassailable fact that an owner spouse could sell his or her property at any time and be subject only to the community's pro tanto interest. Therefore, all reasonable attempts should be made to maintain the owner spouse's equity unless a gift of eroded equity is to be assumed. The solution here is the allocation of a portion of the community loan proceeds to the owner spouse, recognizing that it is a combination of community credit and the owner spouse's separate property that makes it possible for the loan to be consummated.

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