Calculating a Community Lien on an Appreciating Asset in an Arizona Divorce

Tue 11th Apr, 2023 Arizona Community Property Laws

If you are going through a divorce and either you or your spouse owns a home as his or her sole and separate property, you will need to know about calculating a community lien on an appreciating asset in an Arizona divorce.

Fortunately, the Arizona Court of Appeals and Arizona Supreme Court in the published decision in Saba vs. Khoury provided the insight into calculating a community lien on an appreciating asset in an Arizona divorce.

Husband and Wife married in 2009. During their marriage Husband and Wife purchased two separate properties, “Leisure Lane” and “30th Way.” The first property the couple purchased was Leisure Lane. Community funds were used to make the down payment on Leisure Lane.

To take advantage of a first-time homeowner tax credit, and because Husband had poor credit, Leisure Lane was deeded in Wife’s name as an unmarried woman. Wife was also the sole borrower on the loan for Leisure Lane.

After about two years Wife wished to obtain refinancing on the Leisure Lane property. However, the title company required Husband to sign a disclaimer deed before it would refinance the property. Husband complied and signed a disclaimer deed on Leisure Lane.

Wife then executed a new warranty deed describing Leisure Lane as her sole and separate property as a married woman.

The second property the couple purchased was 30th Way. Community funds and Wife’s sole and separate funds were used to make the down payment on 30th Way. The 30th Way property was also titled in Wife’s name only, and Husband again signed a disclaimer deed.

Husband and Wife rented out the two properties and all rents from the properties were deposited into Wife’s bank account. Loan payments on the properties were also paid using Wife’s bank account.

In 2017 Husband and Wife divorced. The Superior Court of Arizona divided the couples’ property declaring: (1) Leisure Lane and 30th Way were Wife’s separate property, (2) Wife’s bank account was community property, and (3) the community was entitled to reimbursement for payments it made on Leisure Lane and 30th Way.

Husband appealed to the Arizona court of Appeals arguing that his disclaimer deeds were incorrectly scrutinized and that the community was entitled to the full value of Leisure Lane. Wife cross-appealed arguing that her bank account was not community property.

The Arizona Court of Appeals affirmed that Husband’s disclaimer deeds operated as a forfeiture of his interest in the properties, and that the community was not entitled to the full value of Leisure Lane. The Arizona Court of Appeals also affirmed that Wife’s bank account was community property.

The case was then appealed to the Arizona Supreme Court who took the opportunity to clarify Arizona’s laws on community liens.

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Disclaimer Deeds Forfeit Ownership Interest Unless Fraud or Mistake Exists

In Arizona, property acquired during marriage is presumed to be community property. Under A.R.S. § 25-211(A), it states “all property acquired by either husband or wife during the marriage is the community property of the husband and wife.”

Legal authorities often refer to this as the “community property presumption.” But, the community property presumption is not absolute in its application. For example, there are two exceptions listed in § 25-211(A)(1)-(2) that protect certain types of property from becoming community property. The community property presumption is also rebuttable.

In Arizona, one way to rebut the community property presumption is to evidence that the other spouse has signed a disclaimer deed.

A disclaimer deed is a legal document that forfeits a spouse’s interest in land. In Arizona, a disclaimer deed is a valid rebuttal to the community property presumption unless the disclaiming party proves by clear and convincing evidence that the disclaimer deed was procured by fraud or mistake.

Here, Husband did not argue that his disclaimer deeds were procured by fraud or mistake. Instead Husband argued that disclaimer deeds should be legally examined the same way as postnuptial agreements.

The Arizona Court of Appeals rejected Husband’s argument and declined to scrutinize disclaimer deeds the same way as postnuptial agreements. The Arizona Supreme Court agreed.

The Arizona Court of Appeals and the Arizona Supreme Court acknowledged that Husband intended for Leisure Lane and 30th Place to benefit the community.

However, married couples have freedom to characterize their property however they choose, and Husband freely chose to disclaim his interest in the properties. Absent a finding of fraud or mistake, the properties are deemed Wife’s sole and separate property.

Commingling Community and Separate Funds Can Transmute Separate Property Into Community Property

Community Lien on Real Property in Arizona Divorce

Wife argues the Superior Court incorrectly determined Wife’s bank account was community property. In Arizona, when sole and separate funds are commingled with community funds the entire fund is presumptively community property, unless the separate funds can be explicitly traced. Explicitly tracing funds means Wife must differentiate which funds are separate property and which funds are community property.

In this case, Wife was unable to satisfactorily trace her separate funds because Wife was unable to show which funds in the account should be her separate property.

Wife stated there was no commingling in the account. However, Wife’s financial experts testified there was occasional commingling of community funds in Wife’s account.

Funds from another account, which had been characterized as community property, had been deposited into Wife’s account multiple times.

Wife’s expert stated “most” but not all these transfers were from tenants. There was also another deposit of a few hundred dollars into Wife’s bank account which was completely unaccounted for.

The Arizona Court of Appeals determined Wife could not adequately distinguish which funds were separate property and which funds were community property.

The Arizona Court of Appeals had no choice other than to credit the community with payments made from Wife’s account toward the principal owed on the two properties. The Arizona Supreme Court agreed.

Valuing a Community Lien in Arizona

Valuing a Community Lien in an Arizona Divorce

In Arizona, when community funds or labor are used to benefit the separate property of another spouse the community is entitled to a share of the “enhanced value” of that property. In such case a community lien (also known as an equitable lien) can be placed on separate property to secure the community’s fair share.

Arizona courts have long recognized that community contributions that increase the value of a spouse’s separate property are entitled to reimbursement.

In assessing the value of a community lien under such circumstances Arizona takes a “value-at-dissolution” approach.

To determine the value of a lien under the value-at-dissolution approach courts measure “the separate property’s total increase in value resulting from the community’s contributions.”

In doing so, Arizona courts assumed increases in value of separate property during marriage were the result of community contributions. Increases in value were therefore either classified as entirely community or entirely separate.

However, Arizona courts began to recognize that “seldom will the increase in value of separate property during marriage be exclusively the product of the community’s effort or exclusively the product of the inherent nature of the separate property.”

Arizona courts then abandoned what was essentially an “all or nothing” approach. Now, increases in the value of separate property resulting from a combination of separate property and community funds or labor must be proportioned accordingly.

The Arizona Supreme Court acknowledged “various methods of apportionment may be suitable depending on the circumstances of each case”, but courts should select “whichever method will achieve substantial justice between the parties.”

As time went on new questions about the use of community liens began to emerge. For example, can community liens be used to reimburse the community when community funds are used to make mortgage payments on separate property?

Put another way, can a community lien be used to reimburse the community when the community funds used did not increase the value of the separate property but rather increased the separately owned equity in separate property?

Arizona courts were faced with this question in the case of Drahos v. Rens, 149 Ariz. 248 (App. 1985). In that case the community sought reimbursement for mortgage payments and repairs made on a spouse’s separate property.

The Drahos court determined the community was entitled to share in the equity of the separate property “simply due to the expenditure of funds.” The formula used in Drahos “divides the property’s appreciation in value in proportion to the contribution to principal.”

However, when the Drahos formula was first introduced it became clear it was not a one size fits all solution. The Drahos formula in its original form overcompensated the community because it calculated appreciation from the date of purchase rather than the date of marriage.

That is where the case of Barnett v. Jedynak, 219 Ariz. 550 (App. 2009) comes into play. The court in Barnett refined the formula used in Drahos to prevent overcompensating the community.

Under Barnett, when community funds are used to make mortgage payments on separate property, and that separate property appreciates in value, a modified version of the Drahos formula must be used to adequately compensate the community for the increased value of the separate property. Today Arizona courts refer to this as the Drahos/Barnett formula.

The Arizona Supreme Court stated, in their view, “a fair return on the amount paid to reduce the principal balance of the mortgage would be the rate of return that money would have otherwise earned for the community and may be reimbursed by a share of the increase in the home’s value proportionate to the amount paid to reduce the principal balance of the mortgage.” The Arizona Supreme Court declared the Drahos/Barnett formula adequately accounts for this.

The Arizona Supreme Court again emphasized that Arizona courts are not bound by a single method of valuing a community lien but may choose whichever valuation method will achieve “substantial justice.”

Arizona courts must consider the unique individual factors of each case when choosing a method of valuation.

But, the Arizona Supreme Court indicated the value of a community lien must, at a minimum, reflect “the amount of the community contribution and a division of equity reflecting the increase in value due to the community contribution consistent with a market rate of return on that contribution.”

In any event, the Arizona Supreme Court informs us that the Drahos/Barnett formula is a consistent starting point from which all courts can begin in cases where community funds are used to make mortgage payments on separate property.

The Drahos/Barnett formula is expressed as C + (C/B x A). The letter “C” represents the total of any community contributions towards the principal. The letter “B” represents the appraised value of the property as of the date of marriage. The letter “A” represents the amount the property appreciated during the marriage.

In the case of Leisure Lane it was determined the community contributed $39,741.29 and the purchase price was $199,900. Leisure Lane had an appreciation of $145,100. Therefore, the community lien on Leisure lane was correctly calculated to be $68,588.02.

The 30th Way property had community contributions of $25,176.70. The 30th Way property was purchased for $170,001 and had an appreciation of $150,999. Therefore, the community lien on the 30th Way property was correctly calculated at $47,539.25.

Community Payments Made Before Signing a Disclaimer Deed Are Reimbursable

Wife argued the Superior Court incorrectly credited the community with payments made on the Leisure Lane loan before Husband signed the disclaimer deed. Wife is incorrect.

In Arizona, the community is reimbursed for contributions made toward separate property. Since Husband signed a disclaimer deed, Husband relinquished any past or present ownership in Leisure Lane.

The timing of Husband’s execution of the disclaimer deed does not affect the application of the Drahos/Barnett formula. In other words, because Leisure Lane’s loan was paid using community funds, and because Leisure Lane has been determined to be Wife’s sole and separate property, the community is entitled to reimbursement for all payments the community made on Leisure Lane.

The fact that Leisure Lane was community property up until Husband signed the disclaimer deed does not entitle Wife to a windfall of cash.

Property Funded Solely By Community Funds Does Not Entitle Disclaiming Party to the Property’s Full Value

Reimbursing Community Property Funds Used on Separate Property

Husband argues the community should be credited with the full value of Leisure Lane’s appreciation since the down payment and all principal loan payments on Leisure Lane were made entirely with community funds. Husband cited the case of Femiano in support of his argument.

In Femiano the wife had poor credit, so the couple’s home was titled in husband’s name only; the wife also signed a disclaimer deed.

The couple in Femiano made loan payments using community funds just as Husband and Wife had done in the current case.

The Femiano court, refusing to apply the Drahos/Barnett formula, awarded the community a lien equal to the community’s contributions and the full appreciation of the home.

The Arizona Supreme Court acknowledged Husband had made a legitimate argument by pointing out the inconsistencies between Femiano and the application of Drahos/Barnett formula to his current case. However, the Arizona Supreme Court took the opportunity to clarify Arizona law going forward.

The Arizona Supreme Court stated Femiano is inconsistent and inequitable. Femiano ignores the reality of the situation. The fact of the matter is that Husband freely and voluntarily signed a disclaimer deed. Wife is the one who was and still remains solely responsible for the loans associated with Leisure Lane.

If the community were awarded the full value of Leisure Lane’s appreciation, then Husband would be awarded with 50% of the upside without taking any of the risk associated with the downside.

The Arizona Court of Appeals stated such a result is “inequitable and unreasonable” and that “increases in property value resulting from a combination of separate property and community contributions must be apportioned accordingly.”

The Arizona Supreme Court agreed stating Femiano will not be the law in Arizona. The Arizona Supreme Court stated under Femiano, separate property would essentially be treated as community property.

The object of a community lien is “fair reimbursement of community funds, not an equitable division of property.”

The holding in Femiano assumes the community’s contributions are the sole cause of the property’s increase in value and fails to credit the separate property owner with any increase in value due to simple market appreciation.”

The Arizona Supreme Court directed Arizona courts to part ways with Femiano, and opined that the Drahos/Barnett formula is an appropriate starting point for such cases in Arizona.

Conclusion

The Arizona community property presumption states property acquired during marriage is presumed to be community property unless an exception or rebuttal exists.

In Arizona, a disclaimer deed rebuts the community property presumption. A spouse who signs a disclaimer deed on property that would otherwise be community property, forfeits their interest in that property in an Arizona divorce.

When contributions of community funds or labor are used to benefit a spouse’s sole and separate property the community is entitled to a community lien “reflecting its contribution to the increase in the property’s value.”

When community funds are used to make mortgage payments on separate property the Drahos/Barnett formula can be used to reimburse the community accordingly.

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