Transmuting Separate Property Into Community Property by Commingling in Arizona

Mon 19th Dec, 2016 Arizona Community Property Laws

Turning Separate Property in Community Property in Arizona

Arizona law recognizes that a spouse may cause a transmuting separate property into community property in Arizona by commingling that sole and separate property with community property.

Generally, property a spouse acquired before marriage remains the separate property of that spouse. In some cases, however, it transmutes into community property. This can happen when the spouse that owns the separate property comingles it with community property.

In Potthoff v. Potthoff, 627 P.2d 708 (1981), the Arizona Court of Appeals addressed transmutation of separate property into community property in an Arizona divorce.

Impact on Transmutation of Using Community Funds for Sole and Separate Property in Arizona

Mr. Potthoff and Mrs. Potthoff married in 1962 and lived in Arizona. Mr. Potthoff was a physician in Phoenix. He had been married before to Mrs. N. He paid Ms. N $7,700 in spousal support during the marriage to Mrs. Potthoff.

In 1978, Mrs. Potthoff filed for dissolution. The trial court held a trial, then entered a minute entry dissolving the marriage.

The order also divided Mr. Potthoff and Mrs. Potthoff’s interests in various properties owned by them. It ruled that the real property identified as the Palm Grove property and the Hyder property were both community property. Therefore, it divided the equity between the spouses in the dissolution proceedings. In November 1978, the court issued its judgment which ordered the two parcels to be sold.

A month later Mr. Potthoff and Mrs. Potthoff reached a settlement agreement. The agreement settled all issues between them except those concerning the Palm Grove and the Hyder properties.

Mr. Potthoff appealed from the court’s finding that the Hyde and Palm Grove properties were community property.

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Property Acquired Before Marriage Versus Property Acquired After Marriage in Arizona

The Court of Appeals considered each of the properties separately. First, it discussed Arizona legal principals applicable to both. It noted that community property law in Arizona provides that property acquired during the marriage is community property and property acquired prior to marriage is sole and separate property.

Arizona courts determine whether the property is community or separate by reviewing the owner’s marital status when he or she acquired it. A property purchased before marriage remains separate even if community funds are used to pay for it. A property retains its status until changed by agreement of the parties or by operation of law.

Here, Mr. Potthoff acquired the right to both properties before his marriage to Mrs. Potthoff. At the time of their marriage, these properties were Mr. Potthoff’s separate properties. The Court reviewed the facts of each property to determine whether the status changed to community property.

Husband’s Sole and Separate Properties Are Not Transmuted into Community Property Because the Acquisition or Right of Acquisition Occurred Prior to Marriage

Separate Property Transmuting to Community Property Post-Marriage in Arizona.

Before his marriage to Mrs. Potthoff, Mr. Potthoff bought a one-half interest in a section of land near Hyder, Arizona. Two months prior to his marriage to Mrs. Potthoff, he bought the other one-half interest in this land. He paid for the latter purchase after marriage. The deeds gave him the title as “his sole and separate property.” This property, at time of trial, was unimproved, raw desert land.

Mr. Potthoff also bought a one-half interest in land termed the Palm Grove property before the marriage. In 1960, he bought the other one-half interest from his partner, Daniel Roe. He intended to develop this into a shopping center.

Transmuting Separate Money Into Community Money May Occur When Spouses Mix Separate Money with Community Money in a Bank Account

During the marriage, Mrs. Potthoff and Mr. Potthoff had a bank account under the name of “M.D.” account. Mr. Potthoff was the only signatory on that account. He put all income of both spouses into that “MD” account.

That included income from his medical practice, loan proceeds, property sale proceeds, and proceeds of the sale of Mrs. Potthoff’s separate property.

Impact on Transmuting By Using Community Funds to Pay for Sole and Separate Assets in Arizona

From the “M.D.” account, Mr. Potthoff paid all expenses of his practice, living expenses, investments and expenditures related to the two properties he claimed were his sole and separate properties.

The trial court found that the community funds and sole and separate funds in the “M.D.” account were so commingled that the identity of separate funds was lost. It, therefore, considered the entire account to be community property.

Mr. Potthoff obtained interim financing for the construction of the shopping center on the Palm Grove property. Both his name and Mrs. Potthoff’s was on the note. However, when he got permanent financing, Mr. Potthoff signed the note and mortgage himself.

After the shopping center was finished, Mr. Potthoff opened another account called “Palm Grove-Potthoff Properties Account.” He put rental income into it and paid business expenses from it.

Mrs. Potthoff claims that he also deposited community funds into that account. She also claimed that Mr. Potthoff devoted considerable time and effort in managing, leasing and supervising the shopping center.

In tax years 1967-68, Mrs. Potthoff and Mr. Potthoff filed separate income tax returns. Both listed the Palm Grove property as community property.

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Impact of Spending Community Funds on a Spouse’s Sole and Separate Property

The superior court found that the Hyder Property changed its status to community property because of commingled funds. The Court of Appeals, however, disagreed.

The Court found that the commingling theory did not apply. The law is that separate property does not lose its character as separate even if community funds are used to pay for it. A transmutation only occurs when the identity of separate property is lost by commingling.

Therefore, transmutation only can happen to the property of identical character, such as money. Only this type of property can get blended in a way that transmutes its status. The Court said that the concept does not apply to real property because of its unique nature. Therefore, the trial court erred in applying the “commingling” theory to the Hyder property.

If Mr. Potthoff used community funds to pay for the Hyder property, the community acquired a claim for reimbursement. This is in the nature of an equitable lien on the property. However, the right of the community to reimbursement does not change the property from separate to community.

Turning Separate Property Into Community Property in Arizona.

The trial court found that the Palm Grove property was also community property. It found that the shopping center was built during the marriage using community funds and community loans. It found that the change of the asset caused it to transform into community property. The Arizona Court of Appeals, however, did not agree with the trial court’s approach.

Using Community Funds for Sole and Separate Property Does Not Transmute Separate Property Into Community Property in an Arizona Divorce

The Court of Appeals agreed with the trial court that the funds in the M.D. account were transmuted into community funds. However, the use of community funds to pay for the separate property did not transform that property into community property. It created a lien for reimbursement of the amount of community funds so expended.

The Court found no evidence that community funds were expended to acquire the property. It was acquired by Mr. Potthoff prior to his marriage and was separate property. An encumbrance was satisfied during the marriage. But this was paid for by the sale of a portion of this separate property to Humble Oil Company.

Using Community Money to Improve Real Property Does not Transmute Separate Property into Community Property in Arizona

The Court also disagreed that building a shopping center completely changed the character of the land and transformed it into community property. If community funds were used to improve the separate property, this supports a community lien on the property.

However, the Court found no evidence that community funds were used. Mrs. Potthoff had to sign the promissory note for interim financing. But Mr. Potthoff alone signed the mortgage on his “sole and separate property” to secure that note.

That note was subsequently paid by the proceeds of a loan from American National. That was evidenced by a promissory note and mortgage signed solely by Mr. Potthoff. Any lien for reimbursement was extinguished when the community debt was extinguished by a separate obligation. The Court did find that certain funds from the M.D. account were used in connection with the shopping center. As to these amounts, the community had a lien on the Palm Grove property for reimbursement.

A Spouse Expending Considerable Time and Effort Into Maintaining or Improving Community Property Does Not Transmute A Spouse’s Separate Property into Community Property in Arizona

Mrs. Potthoff also argued that Mr. Potthoff spent considerable time and effort in making the shopping center a paying operation. This did not change the underlying character of the real property from separate to community. Only the profits are classified as community if derived from Mr. Potthoff’s efforts during the marriage. Any increase in the values of the underlying real property attributable to Mr. Potthoff’s community efforts was community property.

The Court of Appeals held that the trial court erred in finding the Palm Grove property to be community property.

Creation of Community Liens When Community Property Funds Are Applied to a Spouse’s Sole and Separate Property in an Arizona Divorce

Changing Separate Property Into Community Property in Arizona.

The Court of Appeals reversed and remanded. It ordered the trial court to determine the amount of community funds expended upon the Hyder and Palm Grove properties and impose an equitable lien in that amount. It also ordered the trial court to establish the amount of increase in value of the property that is attributable to Husband’s community efforts. That is also an equitable lien in favor or the community.

If you have questions about separate property transmuting to community property post-marriage in an Arizona divorce case, you should seriously consider contacting the attorneys at Hildebrand Law, PC. Our Arizona community property and family law attorneys have decades of combined experience successfully representing clients in community property disputes and family law cases.

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Call us today at (480)305-8300 or reach out to us through our appointment scheduling form to schedule your personalized consultation and turn your Arizona community property or family law case around today.

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