Is Income Earned by a Spouse During the Marriage Always Marital Property?

Over many years of practice, the matrimonial attorney has come to trust that the law provides for certain dispositions in a divorce when it comes to a party’s separate property claims (i.e., property to which the other spouse has no claim). For example, and as a general matter, an asset acquired by a party prior to the marriage maintains its separate property nature throughout the marriage so long as the titled party can show a clear tracing to the separate property source and the asset has not been adulterated or diluted in any way by a comingling with marital assets. By the same token, we may sometimes assume that income received and reported by a party on joint income tax returns during the course of the marriage is marital. Section 236B(1)(c) of New York State’s Domestic Relations Law defines marital property as “all property acquired by either or both spouses during the marriage and before the execution of a separation agreement or the commencement of a matrimonial action, regardless of the form in which title is held . . .” Attorneys and litigants can be further lulled into the mistaken assumption that all income earned during the marriage is “marital property,” given that the application of the child support formula on the Child Support Standards Act does not differentiate between income from separate property sources versus marital sources.

So, when the time comes to identify the marital assets that should be divided as part of Equitable Distribution, a knee-jerk assumption may be that the rental income received during the marriage from separate property real estate and deposited into a bank account must be “marital” property and, therefore, divided between the parties. After all, the income was earned during the marriage and reported on the parties’ joint income tax returns. It should not matter where the monies were deposited or whose name is on the account. Generally, title to an asset does not automatically control or dictate how the asset will be divided. Income earned during the marriage should be marital property, right? The simple answer is, yes, but not always! As with many issues encountered in a divorce, there are many grey areas that create confusion and misconception, and the courts in New York have provided some guidance on this issue.

As a starting point, courts have held that income earned during the marriage may be presumed to be marital property.[1] The burden then rests with the party asserting the separate property claim to rebut this presumption.[2] In this regard, sometimes the manner in which the funds are received, though technical in nature, will determine whether a titled spouse gets to keep the income as their separate property. For example, in Mahoney-Buntzman, the Husband sold a separate property business interest during the marriage. Because the sale proceeds were then reported on the parties’ joint income tax returns as self-employment business “income,” the Court of Appeals ultimately determined that the sale proceeds ($1.8 million) were marital property and, therefore, subject to being divided with the non-titled spouse. Had the sales proceeds been reported as capital gains realized upon the sale of an asset (as opposed to “income”), the implication is that there would have been a different result, and the Huband’s separate property funds from the sale of his separate property asset may have been preserved.[3]

One of the most often cited holdings from Mahoney-Buntzman is that a party to a litigation is precluded from taking a position contrary to the representations made on an income tax return that are material to the characterization or taxation of any income derived from the separate property.[4] In line with this holding, the court in Winship v. Winship[5]rejected the argument that a farm inherited during the marriage was a party’s separate property because the parties had depreciated property and equipment used to operate the farm on their joint tax returns for nine years before the inheritance. The court reasoned that a party cannot depreciate property that he or she does not own.

On the surface, this would appear to put the issue to rest; simply examine how the parties treated the transaction on their joint tax returns to determine if the separate property has been preserved or if it has been converted to marital property or marital property income.

However, and notwithstanding the foregoing, courts have also held that the mere reporting of income earned from the separate assets of one spouse on a joint return does not necessarily transmute the separate property to marital property because both spouses are required to report all of their income, whatever the source, on a joint income tax return. For example, in Giannuzzi v. Kearney, [6] the Husband contended that the Wife’s IBM stock was marital property. Even though the stock remained in accounts maintained exclusively by the Wife throughout the marriage, the parties had filed joint income tax returns reporting the income from the stock, the parties utilized the dividends to maintain the marital standard of living, and the stock was pledged as collateral on loans used by the parties to finance the purchase of real properties. The court found these arguments to be unavailing favoring the rationale that the separate assets cannot be transmuted to marital property upon the mere reporting on joint income tax returns of income earned from separate property because both spouses are required. The court’s rationale was that a contrary rule would force married persons to file separate income tax returns and to pay higher income taxes, simply to protect the non-marital status of their separate property.[7]

Returning to our example from above, it has been held that reporting rental income and expenses relating to separate property real estate on a joint income tax return does not automatically “transmute the separate property to marital property.”[8] More importantly, courts have further held that where the rental income from separate property is deposited into a segregated account that is not commingled with marital monies or converted to a marital asset through some other action, the account (i.e., the rental income earned during the marriage) may remain the titled spouse’s separate property.[9]

It is notable that in the drafting of prenuptial agreements, attorneys often employ boilerplate language to make it clear that “the income from or increase in value of separate property shall remain a party’s separate property, regardless of whether such income or increase is due in whole or in part to the direct or indirect contributions of either party and whether such income or increase is passive or active.” Terms like this eliminate the guesswork in scenarios such as the ones above which would otherwise require costly litigation to determine competing claims to the asset at stake.

The foregoing demonstrates that there can often be a fine line between designating income as marital property and preserving its separate property character. For a titled spouse it is important, amongst other things, to keep all transactions involving the separate property source as clean as possible, which can include using a segregated account for all income received from the separate property, never depositing (comingling) marital funds with that account, and keeping clear and complete records of all transactions. For the non-titled spouse who is up against a meticulous recordkeeper who may have employed a little divorce planning during the marriage, the focus will be on determining the nature of the separate property source. For example, if it is a rental property, did the titled spouse actively manage the property during the marriage? Did the non-titled spouse make any financial or non-financial contributions towards the asset? Were marital monies utilized to maintain the asset? These facts could then support a claim to at least a portion of the appreciation of the asset (e.g., that bank account housing the rental monies) that occurred during the marriage.