The Effect of Deflation on Marital Property

The determination of appreciation in an asset is usually supported by appraisals that establish the value of the asset as of the date of marriage, and as of the date of commencement of the divorce (or the date of trial or the date of distribution of the asset). Typically, appreciation is determined by subtracting the value of the asset at the date of marriage from the value as of the date of commencement of the divorce proceeding. While this approach is appealing in its simplicity, it deprives the separate property holder of the true economic value of the asset brought into the marriage. An understanding of the role of money in the economy is necessary to understand how this occurs.

A Brief Look At Economics

The currency of the United States, the U.S. dollar, is a flat currency, as it has had no intrinsic value since the abandonment of the gold standard in 1933. The government ceased to exchange U.S. currency for silver in 1968. As a result, the dollar has worth or usefulness only to the extent that it serves as a medium of exchange for goods and services. The rate at which a dollar can be exchanged for goods and services is subject to the laws of supply and demand. If the supply of dollars grows faster than the supply of goods and services, the value of the dollar will decline. Stated alternatively, if the supply of dollars grows more rapidly than the supply of goods and services, it will cost more dollars to purchase the same goods and services. This phenomenon of rising prices is commonly known as inflation, which is often measured by the change in the Consumer Price Index, which in turn tracks the prices of goods and services typically purchased by consumers.

Changes in the value of a dollar, as measured by the amount of goods and services that it could purchase, can be relatively small. For example, the value of a dollar fell by 11% between 1997 and 2002. However, over certain extended periods, the decline can be much greater. Between 1970 and 2002, the dollar lost nearly 80% of its value. Typically, the value of a dollar falls from year to year. Over the past 90 years, its value has fallen in all but 12 of those years.

Appreciation

The consequence of these movements in the value of a dollar is that the appreciation of separate property cannot be measured by subtracting the appraised value of an asset as of the date of marriage from the appraised value of the date of commencement of the divorce, because the two valuation results are typically stated in terms of dollars from different time periods. Because the value of a dollar generally declines over time, separate property credits based upon dollar values from historical periods understate the present value of the separate property.

To illustrate this point, consider the following example. John Weber is the owner/operator of a business worth $100,000 at the date of his marriage, January 1, 1970. The business is a real estate holding company that rents out four residential properties, each appraised at $25,000. At the end of 2002, when Weber gets divorced, the business owns six residential properties, the four existing properties and two acquired during the marriage. These properties are valued at $400,000 at the time of the divorce. The new value reflects the increased value of the four homes owned at the date of marriage, $100,000 each, as well as the two homes acquired during the marriage, which are also worth $100,000 each. What is the appropriate separate property credit for Weber's business? Because the value of his business in 1970 is stated in terms of 1970 dollars, a separate property credit of $100,000 (four homes valued at $25,000 each) in 2002 dollars would entitle him to only one of the homes owned by the business at the time of the divorce. Yet, he owned four of the residential properties at the time he married.

The American Heritage Dictionary defines value as “an amount, as of goods, services, or money, considered to be a fair and suitable equivalent for something else.” Clearly, if Weber's business had a worth based upon four homes in 1970, a separate property credit of one home in 2002 would not be a fair and suitable equivalent. The same analysis can be performed for nearly every asset that Mr. Weber could have owned in 1970 and 2002, from automobiles to whiskey. The quantity of any asset that could be purchased with $100,000 in 1970 will almost always exceed the quantity that could be purchased in 2002 with the same $100,000.

Valuation of an Asset

While the practice of recognizing the changes in the value of a dollar over time when awarding separate property credits may be absent, the basis for pursuing this position exists in nearly every valuation presented in a legal proceeding. To the extent that the valuation of an asset is based upon the present value of future income it will generate, which is the case for many types of assets, such as income-producing properties, closely held businesses and professional goodwill, the court will already have received testimony acknowledging that the value of a dollar changes over time. This testimony will exist in the valuation testimony provided by the appraiser.

Nearly every asset appraisal will consider what is known as an income approach. This approach projects the future income to be generated by an asset and then discounts that future income to determine its present value and the value of the asset. The discount rate used in the income approach will nearly always be expressed as a nominal rate, which means it adjusts not only for the real cost of borrowing, but also for the changes in the value of a dollar due to inflation. In effect, the appraiser has already acknowledged that the value of dollars from future years cannot be directly added to the value of current dollars without making an adjustment to reflect those changes in value. It is a relatively straightforward process to have the same appraiser who prepared the valuation acknowledge that the values of a dollar from different time periods are not directly comparable. This principle need only be extended to provide a convincing argument that a separate property credit should also be adjusted if it is to be paid in current dollars.

Conclusion

As indicated above, the significance of inflation in eroding a separate property credit may be insignificant if a marriage was for a short duration or if it spanned a period marked by low inflation. However, if the marriage is long-term or spanned the inflationary era of the 1970s and early 1980's, then the benefits of pursuing this argument may be substantial.

With the specter of deflation (falling prices) haunting the U.S. economy, the consequences and problems of the inflationary eras of the 1970s and 1980s may be as far from the minds of matrimonial practitioners as it is from the thoughts of central bankers. Nevertheless, if you have matrimonial clients from long-term marriages, an awareness and understanding of the meaning of inflation may help you obtain a more equitable distribution of marital property for those who brought separate property into the marriage.

Separate Property and Appreciation

The laws for distribution of marital property in most states recognize a classification for certain assets known as separate property. This is, generally, an asset owned solely by either spouse before the marriage, acquired by gift or inheritance after the marriage, or purchased with separate funds after the marriage. The appreciation of separate property will remain separate property, provided that the appreciation is not derived from the efforts of either spouse. However, if the appreciation of the property is attributable to the efforts of either spouse, then the appreciation of the separate property will be considered marital property. This is often the case with closely held businesses.

The determination of appreciation in an asset is usually supported by appraisals that establish the value of the asset as of the date of marriage, and as of the date of commencement of the divorce (or the date of trial or the date of distribution of the asset). Typically, appreciation is determined by subtracting the value of the asset at the date of marriage from the value as of the date of commencement of the divorce proceeding. While this approach is appealing in its simplicity, it deprives the separate property holder of the true economic value of the asset brought into the marriage. An understanding of the role of money in the economy is necessary to understand how this occurs.

A Brief Look At Economics

The currency of the United States, the U.S. dollar, is a flat currency, as it has had no intrinsic value since the abandonment of the gold standard in 1933. The government ceased to exchange U.S. currency for silver in 1968. As a result, the dollar has worth or usefulness only to the extent that it serves as a medium of exchange for goods and services. The rate at which a dollar can be exchanged for goods and services is subject to the laws of supply and demand. If the supply of dollars grows faster than the supply of goods and services, the value of the dollar will decline. Stated alternatively, if the supply of dollars grows more rapidly than the supply of goods and services, it will cost more dollars to purchase the same goods and services. This phenomenon of rising prices is commonly known as inflation, which is often measured by the change in the Consumer Price Index, which in turn tracks the prices of goods and services typically purchased by consumers.

Changes in the value of a dollar, as measured by the amount of goods and services that it could purchase, can be relatively small. For example, the value of a dollar fell by 11% between 1997 and 2002. However, over certain extended periods, the decline can be much greater. Between 1970 and 2002, the dollar lost nearly 80% of its value. Typically, the value of a dollar falls from year to year. Over the past 90 years, its value has fallen in all but 12 of those years.

Appreciation

The consequence of these movements in the value of a dollar is that the appreciation of separate property cannot be measured by subtracting the appraised value of an asset as of the date of marriage from the appraised value of the date of commencement of the divorce, because the two valuation results are typically stated in terms of dollars from different time periods. Because the value of a dollar generally declines over time, separate property credits based upon dollar values from historical periods understate the present value of the separate property.

To illustrate this point, consider the following example. John Weber is the owner/operator of a business worth $100,000 at the date of his marriage, January 1, 1970. The business is a real estate holding company that rents out four residential properties, each appraised at $25,000. At the end of 2002, when Weber gets divorced, the business owns six residential properties, the four existing properties and two acquired during the marriage. These properties are valued at $400,000 at the time of the divorce. The new value reflects the increased value of the four homes owned at the date of marriage, $100,000 each, as well as the two homes acquired during the marriage, which are also worth $100,000 each. What is the appropriate separate property credit for Weber's business? Because the value of his business in 1970 is stated in terms of 1970 dollars, a separate property credit of $100,000 (four homes valued at $25,000 each) in 2002 dollars would entitle him to only one of the homes owned by the business at the time of the divorce. Yet, he owned four of the residential properties at the time he married.

The American Heritage Dictionary defines value as “an amount, as of goods, services, or money, considered to be a fair and suitable equivalent for something else.” Clearly, if Weber's business had a worth based upon four homes in 1970, a separate property credit of one home in 2002 would not be a fair and suitable equivalent. The same analysis can be performed for nearly every asset that Mr. Weber could have owned in 1970 and 2002, from automobiles to whiskey. The quantity of any asset that could be purchased with $100,000 in 1970 will almost always exceed the quantity that could be purchased in 2002 with the same $100,000.

Valuation of an Asset

While the practice of recognizing the changes in the value of a dollar over time when awarding separate property credits may be absent, the basis for pursuing this position exists in nearly every valuation presented in a legal proceeding. To the extent that the valuation of an asset is based upon the present value of future income it will generate, which is the case for many types of assets, such as income-producing properties, closely held businesses and professional goodwill, the court will already have received testimony acknowledging that the value of a dollar changes over time. This testimony will exist in the valuation testimony provided by the appraiser.

Nearly every asset appraisal will consider what is known as an income approach. This approach projects the future income to be generated by an asset and then discounts that future income to determine its present value and the value of the asset. The discount rate used in the income approach will nearly always be expressed as a nominal rate, which means it adjusts not only for the real cost of borrowing, but also for the changes in the value of a dollar due to inflation. In effect, the appraiser has already acknowledged that the value of dollars from future years cannot be directly added to the value of current dollars without making an adjustment to reflect those changes in value. It is a relatively straightforward process to have the same appraiser who prepared the valuation acknowledge that the values of a dollar from different time periods are not directly comparable. This principle need only be extended to provide a convincing argument that a separate property credit should also be adjusted if it is to be paid in current dollars.

Conclusion

As indicated above, the significance of inflation in eroding a separate property credit may be insignificant if a marriage was for a short duration or if it spanned a period marked by low inflation. However, if the marriage is long-term or spanned the inflationary era of the 1970s and early 1980's, then the benefits of pursuing this argument may be substantial.