How Rental Property is Divided in California Divorce

California law considers any property acquired during the marriage while residing in California as community property.  According to the Family Code, all community property is divided in half in divorce cases. 

The defining condition as to whether a property is community or separate property is based on when the asset was acquired not who owns the property or whose name is on the title (except in cases of transmutation or commingling).  Commingling an asset may involve adding the other spouse’s name on the property title or mortgage lender agreement.  Another exception allowing the exclusion of the property purchased during the marriage from being characterized as community is if the property is excluded from joint ownership in a prenuptial agreement. 

In this case, if one party plans to purchase rental properties during the marriage, yet wants to retain full ownership, a prenuptial agreement can provide for that if the agreement is upheld by the court.  Lastly, if a property is inherited by one spouse during the marriage that property is also separate property with exceptions noted above regarding commingling or transmutation, or if tracing deems that the property did not lose its separate property characteristic.

The key considerations are the value of the property, how much income the rental property produces, the percentage of ownership the parties have if owned by other third party investors, how taxes will be managed, and what tasks and expenses are involved in managing the rental property. An immediate consideration is whether the current tenant has an existing lease and the length and terms of the lease agreement.

During the pendency of divorce, the parties need to reach agreement regarding management of the property and how the income will be divided while the divorce is pending.

There are several options, each with pros and cons that the attorneys and financial professionals will discuss, regarding the division of real estate rental community property. 

1.    Continue to Co-own the Property Post-divorce

Both parties continue to jointly own the rental property, share in the proceeds and share in the costs. While this avoids selling the property, allows for cash flow to be derived and has tax advantages for both parties, the parties will be entangled for years after divorce. Of course, this option works for parties who remain able to communicate peacefully during and after divorce. Most spouses find it very difficult to work with a spouse after a divorce is finalized.

Since there are numerous legal and practical factors that determine how to manage the jointly co-owned properties post-divorce, careful consideration must be given to the operating agreement.  Regardless of the entity owning the property, many “what ifs” need to to be thought through to prevent future disagreements and issues. 

The legal entity of the property is important—will it be placed in an LLC with the two parties as members?  Also, what happens when one of the parties passes and it is left to a new spouse who now jointly co-owns the property with the ex-spouse? How will disagreements about tenant selection, improvements, timing of a future sale, be managed? The operating agreement should be carefully crafted to consider many different contingencies, exit plans, terms of a future sale, and a bevy of other considerations.

2.     Offset the Property’s Value with an Equivalent Asset

In this case, one party has sole ownership and offsets the other party’s interest in the property with other assets such as investments in a brokerage account.  The value of the rental property is determined by the value of the land and buildings on the land and the income generated by the property.  Oftentimes, a ten-year window is considered for the income generation.  The rental fee is grossed up for inflation, expenses are grossed up for inflation, and appreciation of the property is estimated.  Vacancy rates should also be taken into account.  A buyout of ownership often requires refinancing into that owner’s name either immediately post-divorce or within a few years of the finalizing of the divorce.  

If the property is a good source of income and there is a support obligation, the property’s income may be considered as income available for support in lieu of a buyout of the spouse’s interest in the property.  It would be important to avoid double counting by buying out the non-owning spouse and then considering the income as income available for child support or spousal support. 

In the case of the marital estate having multiple rental properties, the parties can divide the properties to ensure equal value for each of the spouses. One spouse may take two lesser-valued properties in exchange for one of high value.  This option is often fraught with negotiations

3.    Sell the Rental Property and Divide the Net Proceeds Equally

Often the option to simply list the property for sale with a commercial real estate broker is an easier and less complicated option.  This provides immediate cash once the sale is completed.

Also, selling avoids identifying an equivalent asset to offset one spouse retaining the property and the calculations and assumptions that go into that negotiation.  The current market value would be established by the market itself, eliminating the need for multiple appraisals to determine an agreeable value of the property. 

In each of these options, the best resolution depends on factors unique to the parties’ case.  Is there a need for additional income for one or both spouses? Is there a need for greater liquidity? Do both spouses have the time and skills to manage the rental property? Is a property manager expense agreeable to both parties? And what are the future goals and priorities of each party post-divorce? 

Rental properties are one of the more complex concerns in the division of assets in a divorce. The decision regarding the disposition and ownership of such property is multi-faceted and should be mindfully considered in the context of the parties’ unique situation. 

Note:  This article is for informational purposes only and is not intended to provide either tax or legal advice.  Please contact your attorney or accountant and rely on their independent research and advice for these matters.