Differentiating active vs. passive appreciation in divorce

From the January/February 2019 issue of BCC Advisers Litigation & Valuation Report

he laws in most states make a distinction between marital and separate property for purposes of marital dissolution. Marital property is subject to division, while separate property — such as property a spouse owned prior to marriage or received by gift or inheritance — isn’t divisible. But what happens if separate property appreciates significantly in value during the marriage? Should that increase in value be considered marital property? In many jurisdictions, the answer is yes.

Not all appreciation in the value of separate property is treated as marital property, however. Typically, the courts make a distinction between “active” and “passive” appreciation, particularly when the property is a business or business interest. When this distinction is made, the courts classify only active appreciation directly attributable to a spouse as marital property.

What’s the difference?

Active appreciation is an increase in value that’s attributable to the efforts of one spouse (or both spouses) during the marriage. For example, a spouse might invest capital, management expertise or labor hours to help the investment grow.

Passive appreciation generally results from external factors, such as market forces, inflation, legal or regulatory changes, and the efforts of others. The last factor, the efforts of others, isn’t technically passive, but it’s included in this category to distinguish it from the active efforts of the spouses.

How to divvy up appreciated value

For certain types of property, distinguishing between active and passive appreciation is relatively straightforward. Suppose that a spouse owned undeveloped real estate on the wedding date, and then built a rental office building on the property during the term of the marriage. The active portion of the property’s appreciation in value typically equals the property’s overall appreciation in value at the time of divorce minus the amount of appreciation a comparable undeveloped property would have experienced over the same period.

Dividing up active vs. passive appreciation for a business interest is more complicated and often calls for the use of a valuation expert. The first step is to determine the value of the business on the wedding date (or when it was acquired by inheritance or gift). This can be challenging, particularly if the business is closely held and wasn’t valued regularly in the past.

Next, the business valuation professional determines the value on the date of divorce. Assuming the business has appreciated in value, the valuator must then identify passive factors that influenced the business’s value and quantify the impact of the factors, often by applying econometric analysis or other statistical methods.

Once passive appreciation has been quantified, any remaining appreciation is considered active. But other owners and key employees might be responsible for a portion of the active appreciation, too, unless one or both spouses were the dominant force behind the operation of the business. The business valuation expert may exclude from the marital estate any portion of active appreciation that’s attributable to third parties.

It’s important to note that distinguishing between active and passive appreciation for a business requires a holistic view. That is, a valuator can’t cherry-pick business assets to include or exclude from the marital estate based on whether changes in their standalone values result from active or passive forces. (See “Bair v. Bair: Court rejects active-passive appreciation analysis” below.)

Appreciating the difference

The classification of appreciation as active or passive can significantly affect the division of property in marital dissolution cases in states that recognize this distinction. Divvying up value can be especially challenging when one or both spouses are private business owners. A business or business interest is often a spouse’s most valuable asset; so, it’s critical to determine whether that asset is marital property. Sophisticated valuation analyses may be needed, depending on the facts and circumstances of the case.