Three Common Mistakes on Marital Balance Sheets
May 26, 2020 - The marital balance sheet is an important document when considering the division of assets in a divorce. Prepared correctly, it shows all of the parties’ assets and liabilities in one place so well-informed decisions can be made regarding property division. Yet, if prepared superficially or by inexperienced personnel, the document could lead attorneys and their clients to make ill-informed decisions or waste valuable time during settlement negotiations. Aside from inadvertent math errors—usually the result of adding or removing rows while building out a spreadsheet—the following are some other common mistakes that can occur with marital balance sheets.
1) Incorrectly allocating a nonmarital interest in real estate awarded to the other spouse
Attorneys need to be diligent when allocating real estate to one spouse, in which the other has a nonmarital claim. Consider Illustration 1A where husband has a $50,000 nonmarital interest in real estate awarded to his wife with a fair market value of $400,000.
Illustration 1A appears to give credit to the nonmarital interest and each party receives 50% of the marital estate after the equalizer payment of $75,000 from wife to husband.
However, Illustration 1A is inaccurate because the husband never actually receives the $50,000 for his nonmarital interest in the marital residence. As shown, the wife is allocated $350,000 in marital property, but in reality, she receives an asset worth $400,000.
Without including a subsequent adjustment for husband’s $50,000 nonmarital interest in the property, the equalizer payment of $75,000 from wife to husband is too low. As shown in Illustration 1B, the wife actually owes husband an equalizer payment of $125,000: $75,000 for his net marital equity (i.e. 50% times the difference between the $350,000 marital value less the $200,000 mortgage) plus $50,000 for his nonmarital interest.
While the additional adjustment on Line 3 of Illustration 1B appears inconsequential within this simplified balance sheet example—as the adjusted net assets are the same under both examples—it is vital for purposes of properly calculating the equalizing payment.
2) Conflating pre-tax and after-tax retirement accounts
Occasionally, all of the parties’ retirement accounts will be lumped within the same section of the marital balance sheet. However, not all retirement accounts are created equal, and aggregating the accounts could lead attorneys and their clients to conflate pre- and after-tax retirement accounts. Pre-tax retirement assets are worth less than post-tax retirement assets and not separately delineating between these types of accounts may lead to an unequal allocation of retirement assets upon divorce.
With a pre-tax account, an employee or employer will put money into a retirement account before taxes are assessed. Some common types of these pre-tax retirement accounts include 401k and 403b plans, profit-sharing plans, and traditional IRAs. With these types of accounts, there is a tax deduction received when contributions to the retirement plan are made, which lowers taxable income for that year. For that reason, upon withdrawal, the entire amount of the withdrawal—whether stemming from the original pre-tax contributions or subsequent earnings (i.e. dividends, interest, or capital gains)—will be taxed as ordinary income.
With an after-tax retirement account such as a Roth IRA, contributions are made with after-tax dollars and any earnings within the account grow tax-free. Because contributions are made with after-tax dollars, you can withdraw contributions at any time, for any reason, with no tax or penalty. Further, any withdrawals of earnings will also be tax-free and penalty-free, assuming you have had the Roth IRA for at least five years and the withdrawal is taken when you are at least 59½ or for other qualified reasons—such as a first-time home purchase, college expenses, and birth or adoption expenses.
For illustrative purposes, assume the parties have $350,000 in retirement assets consisting of $275,000 in pre-tax and $75,000 in after-tax retirement assets. As shown in Illustration 2A, by not separately delineating between pre-tax and after-tax retirement accounts the proposed division of marital property places both types of accounts on equal footing. The assumption is that the husband’s retirement assets consisting of $100,000 in pre-tax and $75,000 in after-tax accounts are equal to the wife’s $175,000 in after-tax accounts.
Yet, based on the preceding discussion, we know that the wife’s retirement accounts are worth less than the husband’s retirement accounts because, upon withdrawal, all of the wife’s retirement assets will be subject to ordinary income tax, whereas only a portion of the husband’s will be. Considering this distinction, Illustration 2B demonstrates how to properly delineate between these two types of accounts on the marital balance sheet.
As shown in Illustration 2B, after equalizing payments, both parties walk away with equivalent amounts of pre-tax and after-tax retirement assets.
3) Not delineating unrealized gains or losses within a brokerage account
When it comes to brokerage accounts—taxable investment accounts— the marital balance sheet must delineate any built-in unrealized gains and losses because the owner of the relevant assets will be responsible for any capital gains and losses upon sale. Unrealized gains and losses are calculated based on the difference between the asset's current market value and its cost basis. Cost basis is the original value of an asset for tax purposes—usually, the purchase price adjusted for stock splits, dividends, and return of capital distributions.
Consider Illustration 3A in which the parties have two investment accounts, each valued at $250,000.
Without considering built-in unrealized gains and losses, the investment accounts appear to be of equivalent value. However, after reviewing the relevant account statements, the accounts include differing amounts of unrealized gains and losses that should be considered for purposes of property division. As shown in Illustration 3B, if each party would have been solely allocated the investment account titled under their name, the husband would have unknowingly been accepting assets with significantly higher built-in gains—taxes on which would be owed upon sale.
Further, proposed divisions of property will quite often allocate more of a brokerage account to one spouse to eliminate the need for a separate property settlement equalizer payment. However, in general, brokerage accounts should not be allocated for this purpose, but rather should be allocated to the parties equally (unless the brokerage account consists solely of cash balances or your expert calculates and shows the estimated taxes on the balance). This is because most brokerage accounts are made up of many types of assets (e.g. cash, equities, bonds, mutual funds, etc.)—each with its own cost basis—so any unequal allocation of the account may have unintended tax ramifications.
Ensuring Equitable Distribution of Assets
Having a qualified expert or experienced personnel construct the marital balance sheet is critical to helping ensure that assets are equitably distributed between the divorcing parties. By thoroughly identifying and delineating all asset values—whether marital or non-marital—along with current and future tax liabilities, a properly completed marital balance sheet will provide clarity and neutrality to what is often an already emotional divorce process. Better informed decisions can be made by attorneys and their clients, and the parties can move forward in the divorce proceedings knowing that they received their fair share of assets. While the parties involved may not wholeheartedly agree with the ultimate property allocation, they can take solace in the fact that all of the cards were on the table.