By Charles F. Vuotto, Jr., Esq. and Cheryl E. Connors, Esq.*
As matrimonial practitioners we often fall into the trap of concentrating on valuation, tax and other issues only in the context of business valuation and fail to consider that the same issues exist with regard to many other assets that are addressed in divorce including but not limited to real estate. Part I of these materials will address the appropriate standard of value to be utilized when valuing real estate incident to divorce and whether it is consistent with the standard used in valuing a business. Part II of these materials will address whether or not real estate owned by a business should be included in the value (i.e., considered an “operating asset” or a “non-operating asset”). Part III of these materials will address various tax issues incident to real estate including but not limited to the ability to take mortgage interest deductions and capital gains tax exposure depending on various distribution scenarios. Part IV of these materials will address the appropriate transfer documents and procedures to be employed when distributing real estate at the conclusion of a marriage as well as recent changes in the law concerning those documents and real estate transfer fees. Lastly, Part V will address a number of practice pointers that will assist practitioners when dealing with real estate incident to divorce.
PART I
VALUATION OF REAL ESTATE
a. STANDARD OF VALUE
This portion of these materials will address the question of what “standard of value” should be applied when valuing real estate incident to divorce. Perhaps the more interesting question is whether there should be one “standard of value” for all assets being valued in the context of divorce. Unfortunately, no New Jersey matrimonial case specifically discusses the appropriate standard of value to be applied when valuing real estate incident to divorce. Therefore, we must evaluate standards applied to real estate valuation in other contexts.
The “standard of value” is that standard by which a property or asset is measured. Shannon Pratt, discussing standard of value, states the following:
The standard of value usually reflects an assumption as to who will be the buyer and who will be the seller in the hypothetical or actual sales transaction regarding the subject assets, properties or business interests. It defines or specifies the parties to the hypothetical transaction. In other words, the standard of value addresses the questions: “value to whom?” and “under what circumstances?” The standard of value, either directly by statute or (more often) as interpreted in case law, often addresses what valuation methods are appropriate and what factors should or should not be considered.[1]
The standard of value sets the criteria upon which valuation analysts rely.[2] A standard of value is “a definition of the type of value being sought.”[3] “Among many factors, it dictates whether you use a hypothetical buyer and seller, a market-participant buyer and seller, value to a single person, or a willing or unwilling buyer and seller.”[4] Before we explore the standard of value applicable to real estate, we will briefly summarize the definitions of the more widely utilized standards. These are most often, but not always, in the context of business valuation.
The essence of our discussion in this section is an analysis of “value.” Black’s Law Dictionary defines value as “the significance, desirability, or utility of something” or “the monetary worth or price of something; the amount of goods, services, or money that something will command in exchange.”[5] Therefore, notwithstanding the numerous standards of value that exist, the standards are essentially divided into two camps (i.e., “value in use” and “value in exchange”).
There are a number of standards of value. Some, but not all, are defined below:
Value in Exchange: “[T]he value arrived at in a hypothetical sale, with assumptions ranging from the seller departing immediately and competing with his or her former business, to the seller staying on to help transition management.” Underlying value in exchange are two standards: (1) Fair Market Value and (2) Fair Value.[6]
Fair Market Value: “[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Sometimes this standard further assumes that the hypothetical buyer and seller are “able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.”[7]
Fair Value: A context- and geographically-sensitive term, this usually represents a standard of value created by statute and/or precedent for specific circumstances. In New Jersey, fair value is essentially fair market value without discounts for lack of control or lack of marketability/liquidity, barring extraordinary circumstances.[8] However, over-application of this general rule is dangerous. “Extraordinary circumstances” usually relates to the good or bad faith of the shareholders involved in the particular corporate action. While this concept completely contradicts divorce litigation policy, which makes marital fault irrelevant in deciding the distribution of assets, it is the standard to be used when valuing closely held corporations for purposes of equitable distribution.[9]
“In one context, fair value can entail an exchange, but not necessarily from a willing seller. Fair value may also assert that a lack of intention to sell a business prevents its valuation as a value in exchange.”[10] Other fair value cases adhere more to a value to the holder premise.[11] Because fair value of an asset could be its market value, its intrinsic value, or its investment value, this standard is subject to wider interpretation from a judicial perspective than fair market value.[12] In the shareholder context, “‘[f]air value carries with it the statutory purposes that shareholders be fairly compensated, which may or may not equate with the market’s judgment about the stock’s value. This is particularly appropriate in the close corporation setting where there is no ready market for the shares and consequently no Fair Market Value.’”[13] No reported case in the State of New Jersey (before Brown) has expressly utilized “Fair Value” as a standard of value incident to divorce, although one may interpret various cases as having implicitly utilized this or some other value standard. In fact, all cases expressly speaking to the issue have specifically used “Fair Market Value.” The real question is: Can or should this standard be applied to real estate?
Investment Value/Value to the Holder: This is the specific value of an investment to a particular investor or class of investors based upon individual investment requirements.[14] “Application of this standard contemplates value not to a potential hypothetical buyer but rather to a particular buyer, which in the case of divorce is the current owner, hence, value to the holder.”[15]
Intrinsic or Fundamental Value: The value to an investor of an investment (usually common stock) based upon the perceived characteristics of an asset. This becomes the basis of the “market value” for the asset. The methods of calculating intrinsic value are usually based upon finance theory.[16] This standard of value is based on the assumption that the business or business interest will not be sold.[17]
The standard of value varies from state to state. It is important to note that courts may refer to one standard of value while in reality the court is applying a different standard of value.[18] In other words, a court may declare that it is applying a fair market value standard while attributing elements and theory more closely related to investment value. These “misnomers” are likely a result of the courts’ desires to distribute assets in a fair and equitable manner.[19]
In the context of business valuation incident to divorce, thirty-three states and the District of Columbia fall under a value in exchange premise, including Arkansas, Alaska, Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Louisiana, Maryland, Massachusetts, Minnesota, Mississippi, Missouri, Nebraska, New Hampshire, North Dakota, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Utah, Vermont, Virginia, West Virginia, Wisconsin, and Wyoming.[20] Only two states, Louisiana and Arkansas, have statutes that provide guidance as to the standard of value to be used in divorce, both directing that fair market value be applied.[21] Ten states fall under some version of a value to the holder premise including Arizona, California, Colorado, Kentucky, Michigan, Montana, Nevada, New Mexico, North Carolina and Washington.[22] The remaining seven states do not fall into either category. Breaking down those categories into specific standards of value, eleven states, Arkansas, Connecticut, Florida, Hawaii, Kansas, Louisiana, Missouri, Nebraska, New York,[23] South Carolina, and Wisconsin, specifically direct the use of fair market value by statute or decisional law, and one state, Minnesota, uses the term market value, which could be categorized as fair market value under the circumstances presented in the case law.[24] In addition to the states that expressly identify fair market value as the standard, it is implicit in case law of numerous states that the fair market value standard is being applied. These states include Alaska, Delaware, Idaho, Illinois, Iowa, Maryland, Massachusetts, Mississippi, New Hampshire, North Dakota, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Texas, Utah, Vermont, and West Virginia.[25] In contrast, four states, Indiana, Louisiana,[26] Virginia, and Wyoming apply a fair value standard.[27] Ten states, Arizona, California, Colorado, Kentucky, Michigan, Montana, Nevada, New Mexico, North Carolina, and Washington, apply an investment value.[28] New Jersey, New York and Ohio have been characterized as hybrid states, applying more than one standard of value.[29] States that have not identified a definitive standard of value are Alabama, Georgia, Maine and South Dakota.[30]
The below chart illustrates these statistics:
State
Standard of Value
State
Standard of Value
1. Alabama
None Identified
2. Alaska
Value in Exchange
Fair Market Value
3. Arizona
Value to the Holder
Investment Value
4. Arkansas
Value in Exchange
Fair Market Value
Standard is expressly stated in statute
5. California
Value to the Holder
Investment Value
6. Colorado
Value to the Holder
Investment Value
7. Connecticut
Value in Exchange
Fair Market Value
Standard is expressly stated in case law
8. Delaware
Value in Exchange
Fair Market Value
9. Florida
Value in Exchange
Fair Market Value
Standard is expressly stated in case law
10. Georgia
None Identified
11. Hawaii
Value in Exchange
Fair Market Value
Standard is expressly stated in case law
12. Idaho
Value in Exchange
Fair Market Value
13. Illinois
Value in Exchange
Fair Market Value
14. Indiana
Value in Exchange
Fair Value
15. Iowa
Value in Exchange
Fair Market Value
16. Kansas
Value in Exchange
Fair Market Value
Standard is expressly stated in case law
17. Kentucky
Value to the Holder
Investment Value
18. Louisiana
Value in Exchange
Fair Market Value
Standard is expressly stated in statute
Fair Value is also suggested by case law
19. Maine
None Identified
20. Maryland
Value in Exchange
Fair Market Value
21. Massachusetts
Value in Exchange
Fair Market Value
22. Michigan
Value to the Holder
Investment Value
23. Minnesota
Value in Exchange
Fair Market Value
Standard is expressly stated in case law as market value
24. Mississippi
Value in Exchange
Fair Market Value
25. Missouri
Value in Exchange
Fair Market Value
Standard is expressly stated in case law
26. Montana
Value to the Holder
Investment Value
27. Nebraska
Value in Exchange
Fair Market Value
Standard is expressly stated in case law
28. Nevada
Value to the Holder
Investment Value
29. New Hampshire
Value in Exchange
Fair Market Value
30. New Jersey
Hybrid
31. New Mexico
Value to the Holder
Investment Value
32. New York
Hybrid
33. North Carolina
Value to the Holder
Investment Value
34. North Dakota
Value in Exchange
Fair Market Value
35. Ohio
Hybrid
36. Oklahoma
Value in Exchange
Fair Market Value
37. Oregon
Value in Exchange
Fair Market Value
38. Pennsylvania
Value in Exchange
Fair Market Value
39. Rhode Island
Value in Exchange
Fair Market Value
40. South Carolina
Value in Exchange
Fair Market Value
Standard is expressly stated in case law
41. South Dakota
None Identified
42. Tennessee
Value in Exchange
Fair Market Value
43. Texas
Value in Exchange
Fair Market Value
44. Utah
Value in Exchange
Fair Market Value
45. Vermont
Value in Exchange
Fair Market Value
46. Virginia
Value in Exchange
Fair Value
47. Washington
Value to the Holder
Investment Value
48. West Virginia
Value in Exchange
Fair Market Value
49. Wisconsin
Value in Exchange
Fair Market Value
Standard is expressly stated in case law
50. Wyoming
Value in Exchange
Fair Value
51. District of
Columbia
Value in Exchange
Fair Market Value
The standards of value referenced above are the most common. However, other standards exist in different areas of the law. For example, in the context of taxes, several standards of value have been applied: full value, full cash value, cash value, fair cash value, full and fair cash value, true value, true and actual valuation, actual value, full and actual cash value, full and true value, true cash value, true value in money, and market value of fair market value.[31] For purposes of federal gift and estate taxes, fair market value is the statutory standard of value.[32] The Estate and Gift Tax Regulations set forth requirements for determining the fair market value as follows: the price at which a property would change hands; a willing buyer; a willing seller; neither being under any compulsion; both having reasonable knowledge of the relevant facts; specific value as of a specific valuation date; and applicability of subsequent events.[33] In contrast, fair value is the mandated standard for financial reporting that is subject to regulation by the Securities and Exchange Commission.[34] Fair value is also used in almost every state as the standard for dissenting and oppressed shareholder action.[35] Although the standard of value may be identified in these contexts, “there is no guarantee that all would agree on the underlying assumptions of that standard.”[36] These examples illustrate the vast array of standards that can be applied, but the question here is: what standard of value is appropriate in valuing real estate?
New Jersey Constitution
To determine the appropriate standard of value for real estate in New Jersey in the context of a divorce, we first turn to the New Jersey Constitution. The Constitution states:
All real property assessed and taxed locally or by the State for allotment and payment to taxing districts shall be assessed according to the same standard of value, except as otherwise permitted herein, and such real property shall be taxed at the general tax rate of the taxing district in which the property is situated, for the use of such taxing district.[37]
The concept of standard of value for real property is not only addressed in our State Constitution but also in numerous provisions throughout our statutory scheme.
New Jersey Statutes
For instance, in the context of taxation, the Legislature has declared that “Article VIII, Section I, paragraph 1 of the Constitution of the State of New Jersey requires that all real property in this State be assessed for taxation under the same standard of value, which the Legislature has defined as “true” or “market” value.”[38] The meaning of “true value” in the Constitution and the statutory scheme has been defined by case law as “fair market value” as of the date of tax assessment and as the price in money at a fair sale between a willing seller and willing buyer.[39]
Numerous statutes address the concept of standard of value or specify the standard of value to be applied to real estate or other property rights in a particular context.[40] Some employ the fair market value standard (e.g., abandoned tenant property, value of computer systems, multifamily housing, library materials, bonds, notes, mortgages, residential mortgages, theft offenses, estates and trusts, agricultural preserves, farmland preservation, tidelands management, garden state preservation trust, pinelands protection, mortgage guarantee insurance, education, eminent domain, sale of state highways, New Home Warranty and Builders’ Registration Act, state property, and tax assessment of personal property);[41] others refer to fair value (e.g., state farmland assessment, conveyance of outstanding interest against certain residential realty, farmland preservation, inland waterways, liabilities of shareholders in corporations, mergers and acquisitions of corporations, rights of dissenting shareholders, and sale of personal property in the education context);[42] several use intrinsic value (e.g., oath of appraisers, time for owner of distrained property to take action, and appointment of appraisers);[43] and finally one refers to value to the holder (e.g., sale of health insurance).[44]
It must be noted that our legislature had the opportunity to expressly mandate a specific standard of value when N.J.S.A. 2A:34-23.1 was added to the statutory framework of divorce law in 1988 (and amended in 1997). It did not do so. This must imply that the legislature has accepted the standard adopted by case law at least to that point in time.
New Jersey Cases
Notwithstanding the foregoing, no case in New Jersey directly addresses the appropriate standard of value to be applied to real estate in the context of matrimonial litigation. However, multiple cases discuss or apply a fair market value standard in assessing the marital home.[45] For example, in several cases the Appellate Division affirmed the trial court’s findings as to the fair market value of the marital home for purposes of equitable distribution.[46] Other Appellate Division cases simply refer to fair market value as the standard applicable in valuing the marital home.[47] One Appellate Division case awarded the husband the difference between the fair market value of the marital home and the sale price in light of the fact that the wife sold the home for less than fair market value.[48] In one trial court decision, the court rejected the husband’s contention that his house was sold below fair market value.[49] Even in the case of Brown v. Brown, in which the court set the standard of value for business valuation as fair value, the Appellate Division declined to interfere with the trial court’s equitable distribution of the marital home, which was valued using the fair market value standard by stipulation of the parties.[50] Moreover, in that case the court distinguished between fair value and fair market value, stating:
“Fair value” carries with it the statutory purpose that shareholders be fairly compensated, which may or may not equate with the market’s judgment about the stock’s value. This is particularly appropriate in the close corporation setting where there is no ready market for the shares and consequently no fair market value.[51]
As an aside, does the emphasized language regarding a “ready market” suggest that a different standard of value (fair market value) should be utilized if there is a ready market for the subject business? Putting that question aside, the Brown court further reasoned that “[c]lose corporations by their nature have less value to outsiders, but at the same time their value may be even greater to other shareholders who want to keep the business in the form of a close corporation.”[52]
In the context of real estate, those same concerns may not apply. Generally, there is a market to sell real estate, or at the very least, market comparisons are readily available to value real estate (even if they require adjustments as discussed in Part V below). Thus, the court’s reasons for applying a fair value standard in business valuation may not have any relevance in assessing the value of real estate. However, is it possible to argue that the value of a custodial parent retaining the former marital home for continuity in the children’s lives and other related issues is greater than the value that would result from a sale on the open market? If so, shouldn’t that value be used in order to be consistent with the precepts of Brown?
In light of the case law using fair market value when valuing real estate, the most logical conclusion is that fair market value is the appropriate standard for valuing real estate. In fact, “[o]ne of the most common applications of fair market value is in the valuation of real property.”[53] In the context of valuing real property, it can be referred to as market value rather than fair market value. Market value is defined as:
A type of value, stated as an opinion, that presumes the transfer of a property (i.e., a right of ownership or a bundle of such rights), as of a certain date, under specific conditions as set forth in the definition of the term identified by the appraiser as applicable in an appraisal.[54]
In assessing the fair market value of real estate, experts generally employ a concept of “highest and best use for the property.”[55] The phrase “highest and best use” is the “reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, and financially feasible and that results in the highest value.”[56] In addition to the requirement that the highest and best use of a property be reasonably probable, it must also meet four implicit criteria: (1) physical possibility; (2) legal permissibility; (3) financial feasibility; and (4) maximal productivity.[57] These four implicit criteria can be examined through the interaction of four forces, which include social trends, economic circumstances, governmental controls and regulations, and environmental conditions.[58]
One caveat is that the highest or maximally productive use of the property may not always be the highest and best use of the property particularly in the context of valuing a residential home. In other words, the valuation expert must distinguish between the “highest and best use of the land as though vacant and highest and best use of the property as improved.” For example, if a single family home used as a residential property is located in a commercial zone, it could potentially be used as a commercial property, which would likely yield the maximum productivity for the property. However, if the market value for residential use is greater than the market value for the commercial use less demolition and improvement costs, then the highest and best use of the property is continued residential use.[59]
While not often given much consideration in the matrimonial setting, market value may not always be the most appropriate standard to value real estate. Assume that the wife owns a minority interest in a real estate holding company; the real estate owned by the company is leased by an international bank for use as a retail branch. The international bank has a thirty-year lease. The base rent in the lease was set during a downturn in the local real estate market five years prior to the matrimonial proceeding and rents are only set to escalate with inflation. As such, the rents are significantly below market rates. The husband obtains a “market value” appraisal of the real estate, which he uses to calculate equitable distribution. Upon your review of the appraisal, you find that the husband’s appraiser used current market rents based on comparable properties, as opposed to the actual rents paid that are significantly below market. From an economic perspective, the market value appraisal significantly overestimated the wife’s interest in the real estate holding company because it was based on future income that the company would not receive under the terms of the lease. There is a separate standard of value “leased fee value” which more appropriately values the property as encumbered by the lease, which would also provide a better basis to determine the value of the wife’s interest in the real estate holding company. Given this particular fact pattern, the leased fee standard of value is more consistent with the “fair value” standard than “market value.”
In one Appellate Division case, although the court specified the use of “Fair Market Value,” as applied to the value of the marital home, its approach and discussion suggests that some other standard was used.[60] In that case, the marital home was a two-family house and the parties rented out one unit in the house to the wife’s mother.[61] The Appellate Division determined that the income production aspect of the home must be considered in the asset’s valuation.[62] To determine the value, the court capitalized the income production factor, based on the improbable assumption of a constant monthly rent at the current amount for the next eleven years and a 3.5% rate of interest of an annuity.[63] Such calculations suggest that the court employed an investment value rather than a fair market value standard when valuing a home with an income producing aspect.[64]
Conclusion as to Standard of Value
There are certain conclusions we can reach from the foregoing analysis: (1) the Legislature has declared that “Article VIII, Section I, paragraph 1 of the Constitution of the State of New Jersey requires that all real property in this State be assessed for taxation under the same standard of value, which the Legislature has defined as “true” or “market” value.” The meaning of “true value” in the Constitution and the statutory scheme has been defined by case law as “Fair Market Value”; (2) “Fair Market Value” appears to be the most common “standard of value” referenced in reported matrimonial cases, which address the valuation of real estate including but not limited to Brown v. Brown; (3) “Fair Market Value” may not have any functional difference with “Fair Value” since there is a “ready market” for most real estate addressed in a divorce context and there are usually no minority owners – therefore there should be no need for a Marketability Discount or Minority Interest Discount; and (4) at least one court (i.e., Gemignani) used a different approach when dealing with income producing property that more accurately reflected the benefit to the holder when the facts required such an application and under certain circumstances leased fee value may the appropriate standard of value.
However, if the general conclusion is that “Fair Market Value” or “Market Value” is the “standard of value” to be applied when valuing real estate incident to divorce, the question is how does this jive with Brown’s mandate for “Fair Value” in valuing a business? This writer respectfully submits that it does not. Assuming Brown is correct, then shouldn’t all assets in a divorce be valued by the same “standard of value”? I respectfully answer this question in the affirmative. It is clear that the “standard of value” follows the area of the law: (e.g., (1) estate and gift tax is “Fair Market Value”; (2) real estate valuations for taxation is “Fair Market Value”; (3) shareholder disputes is “Fair Value”, etc.) Our research has not disclosed varying standards of value within an area of law. This is logical since the “standard of value” is linked to the policy underlying the particular area of law. Remember the definition of “standard of value”: the standard of value addresses the questions: “value to whom?” and “under what circumstances?” The answers in the context of divorce are: husband and wives going through a divorce. The question does not ask, “what kind of property?” If the policy in divorce is to treat divorcing parties fairly and compensate them for the present value of the lost future benefit of the asset they will not retain (as Brown suggests), then this salutary policy should apply to all assets, not just businesses. If the value of a closely-held business interest may have more value in the hands of the owner than to a third party purchaser, the same may apply to the value to a custodial parent’s retention of the marital home versus selling it on the market. How such value may be quantified is problematic. Perhaps one calculates the present value of the future rental value of the home for the retaining party’s lifetime or fixed period before a contemplated sale. This writer understands that there are many potential problems with such an approach. However, that does not mean that one “standard of value” should not be used for all assets, but highlights why the use of “Fair Value” for a business interest is incorrect. As this writer has stated elsewhere, the correct “standard of value” is “Fair Market Value” and should be applied to all assets in a divorce.
PART II
“OPERATING ASSET” VERSUS “NON-OPERATING ASSET” IN THE CONTEXT OF VALUING A BUSINESS THAT OWNS REAL ESTATE
In the context of matrimonial litigation, we have all encountered business valuations where the business owns the real estate upon which it is located. The issue to be addressed within this section is when and to what extent the underlying real estate should be subsumed in the value attributed to the value of the business or treated as a separate and distinct asset. The issue comes down to whether the real estate is an “operating” or “non-operating” asset of the business.
An “operating asset” is an asset that contributes to the income from a company’s operations[65] or is otherwise necessary to the continuing operations of the business enterprise. In contrast, a “non-operating asset” is not necessary to ongoing operations of the business enterprise.[66] These two simple definitions have led to great debate in matrimonial proceedings due to disagreement between what business assets are “necessary” and what assets are “unnecessary.” In the case of real estate, the determination of whether real property is non-operating is based on the judgment that:
(1) The business operations are inextricably connected to the real estate; or
(2) If relocation is possible, whether it will have a significant impact on the future earnings of the business.
The following examples illustrate each of these points.
Golf Course Valuation: The proper valuation of a golf course involves the valuation of the real estate underlying the golf course, as well as a valuation of the business enterprise. The real estate valuation will consider the value of the land and improvements – the tangible assets of the golf course, while the business valuation will consider the value of the real estate in addition to goodwill, membership lists and any other intangible assets that the golf course has developed through its business operations. Back to the question at hand, is the real estate an operating or non-operating asset? In consideration of item (1) above, the real estate and intangible assets of the golf course, such as goodwill, are inextricably connected. Stated another way, if the business operations were to relocate to another vacant golf course (if one could be found), the intangible assets (e.g., goodwill) would have to be recreated. Furthermore, if relocation were an option, the business enterprise would again have to invest in local advertising and marketing to build a membership base – and perhaps have significant capital investments in the course itself to differentiate it from other courses in the area. Thus, the relocation issues have a significant impact on the future earnings of the business.
Golf courses are just one example of businesses in which the real estate is typically considered an operating asset. Other examples include quarries, power plants, amusement parks, airports, and highly specialized manufacturing facilities.
Professional Practice Valuation: On the other end of the extreme, we see several professional practices that own real estate. A professional practice is not typically considered inextricably connected to real estate. For example, an accounting firm does not necessarily need to own a specific office condo to continue its business operations. Other office space is typically available, and the impact on future earnings is usually limited to moving related expenses. Other examples of businesses that own non-operating real estate include retail stores, professional service firms (lawyers, accountants, and physicians), restaurants, general manufacturing facilities, and most other personal service businesses.
Manufacturing Businesses: While the first two examples are relatively clear, there are certain types of businesses in which the determination of the operating/non-operating nature of real estate is not so clear. Manufacturing businesses are one such example. Several large scale manufacturers build highly specialized facilities to meet their needs. Oftentimes, one-of-a-kind machinery is built in place and fixed to the real estate. As such, the business operations are significantly connected to the real estate, and moving would have a significant impact on the future earnings of the business due to an extended interruption of the business operations and the cost of moving and recalibrating the specialized machinery. This is a case that would involve significant professional judgment by an appraiser.
One factor that can significantly complicate this issue is if real estate is used in operations but used far below its highest and best use. Consider a manufacturer with a highly specialized facility, which is necessary for business operations. However, the land is in a prime location that could be used more productively as a retail store. The real estate is inextricably connected to the business, yet the highest and best use of the real estate may exceed the business value (including the real estate). This becomes a matter of the analyst’s judgment. Certainly, the imminence, or lack of imminence, of prospective development or sale of the real estate will play a role in that judgment.[67]
In sum, the determination of whether real estate in a business is an “operating” or “non-operating” asset of the business is fact specific. It is also crucial to the determination of whether the value of the real estate should be subsumed in the value attributed to the business or be treated as a separate and distinct asset. Examples of this distinction occur in the context of a golf course, in which the real estate is typically considered an operating asset, as compared to a professional practice, in which the real estate is typically a non-operating asset to be valued separate and apart from the value of the business. This is one more layer in the context of real estate valuation that the practitioner needs to consider in the context of a divorce litigation.
PART III
TAX ISSUES RELATED TO REAL ESTATE
For many of the topics in this section, we will assume a typical fact pattern that many of us see every day. In our fact pattern, the wife/dependent spouse shall remain in the former marital home, which shall continue to be jointly held, until the youngest child reaches the age of 18. The wife and children shall have sole occupancy of the home. The husband/obligor spouse shall pay the mortgage and taxes (in addition to his alimony and child support obligations). Upon the youngest child reaching the age of 18, the former marital home shall be sold and the parties shall equally divide the net proceeds of sale. Where appropriate, we may alter this fact pattern to highlight variations in the result depending on different facts.
Numerous tax issues related to real estate will arise in the context of a divorce. These issues range from consideration of suspended losses to the deductibility of mortgage interest to the consequence of capital gains. This section is not intended to provide a comprehensive analysis of tax consequences related to real estate but merely to discuss the more common issues that should be considered by the practitioner and to which the client should be alerted so that the client can obtain an appropriate financial advisor (i.e., tax accountant or tax attorney) to consult.
As a preliminary matter, Section 1041 of the Internal Revenue Code provides that no gain or loss shall be recognized on a transfer of property to a spouse or former spouse, if the transfer is incident to the divorce.[68] Thus, for any transfer of real property between spouses or former spouses, provided that the transfer occurs within one year after the termination of the marriage or is related to the cessation of the marriage, no loss or gained will be recognized.
Furthermore, New Jersey courts have held that hypothetical tax consequences resulting from the future sale of marital assets should not be subtracted from present value for equitable distribution purposes.[69] “Although hypothetical tax consequences should not reduce the present value of marital assets, such a consideration . . . has an important place in the equitable distribution process.”[70] Stated differently, the hypothetical tax consequence is a factor to be considered with all other factors in determining an equitable distribution of property.[71] In contrast, any tax consequences resulting from a court-ordered sale or contemporaneous sale of assets necessary to meet an equitable distribution is not speculative and should be deducted from present value.[72] For example, if the spouse retaining an asset has indicated that he or she must liquidate it to meet his or equitable distribution obligations, the resulting tax liability should be deducted from the value charged to that party in the overall scheme of distribution assuming the promised sale occurs.
A. DEDUCTIBILITY OF MORTGAGE INTEREST
Interest paid on a mortgage up to $1,000,000 on a qualified residence is deductible. Similarly, interested paid on a home equity loan up to $100,000 on a qualified residence is deductible. “A ‘qualified residence’ is the principal residence, often the marital residence, and one other residence selected by the taxpayer and which is used as a residence ‘for personal purposes.’”[73] If one spouse leaves the principal residence without an agreement or court order, that spouse will no longer be able to deduct the interest on the mortgage despite continued payments of the mortgage u