Separate Property Transmuting to Community Property Post-Marriage
Generally, property a spouse acquired before marriage remains the separate property of that spouse. In some cases, however, it transmutes to community property. This can happen when the spouse that owns the property comingles it with community property.
In Potthoff v. Potthoff, 627 P.2d 708 (1981), the Arizona Court of Appeals addressed transmutation issues.
Facts and Procedure
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.
Principals of Property Status
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 acquired prior to marriage is separate property.
Arizona courts determine whether property is community or separate by reviewing the owner’s marital status when he 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 GMrs. 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.
Acquisition of the Hyder and Palm Grove Properties
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 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.
After the marriage, Mr. Potthoff sold a corner of the Palm Grove property to Humble Oil Company. Daniel Roe got $34,840 of the sale proceeds to pay for the Palm Grove property.
During the marriage, Mrs. Potthoff and Mr. Potthoff had a bank account termed the “M.D.” account. Mr. Potthoff was the only signatory. He put all income of both spouses into this account. That included income from his medical practice, loan proceeds, property sale proceeds, and proceeds of the sale of Mrs. Potthoff’s separate property. From this account, Mr. Potthoff paid all expenses of his practice, living expenses, investments and expenditures related to these properties.
The trial court found that the funds in the M.D. account were so commingled that the identity of separate funds was lost. It 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.
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 comingling.
Therefore, transmutation only can happen to 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.
Palm Grove Property
The lower 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 to community property.
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 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.
The Court also disagreed that building a shopping center completely changed the character of the land and transformed it to community property. If community funds were used to improve 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.
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 the Mr. Potthoff’s community efforts were community property.
The Court of Appeals held that the trial court erred in finding the Palm Grove property to be community property.
The Court of Appeals reversed and remanded. It ordered the trial court is 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 that is attributable to community efforts. That is also an equitable lien in favor or the community.