Diversification is the investment strategy whereby holding a variety of assets creates a greater long-term return because the variety reduces risk. In addition to thousands of tradable stocks and bonds, the average investor may also own real estate.
The advantage of owning real estate as an investment is that you can borrow to buy the real estate (creating a higher return), the interest on that loan is tax-deductible, the calculated depreciation is also tax-deductible and, if the property is rented, there is rental income.
The downsides to owning property are that the property must be physically maintained, the property tax must be paid and the property can only be sold all at once (unlike stocks or bonds which can be purchased in shares or certificates).
One of the biggest downsides to owning a rental property is what to do with the rental property in the case of a divorce. A rental property has value that must be distributed, income that must be accounted for and liabilities that someone needs to be held responsible for.
So, how is a second home or rental property handled in an Illinois divorce?
Is The Rental Property Marital Or Non-Marital?
In Illinois, the first step in determining what happens with any property in a divorce is determining whether that property is marital or non-marital.
“The court shall make specific factual findings as to its classification of assets as marital or non-marital property, values, and other factual findings supporting its property award.” 750 ILCS 5/503
Non-marital property is not divisible in a divorce. If a piece of real estate is held in one person’s name and determined to be marital property, that person will leave the divorce as the sole owner of that property.
“[T]he court shall assign each spouse’s non-marital property to that spouse.” 750 ILCS 5/503(d)
In the case of rental property that is deemed non-marital, the income from that property shall also be deemed non-marital.
“[I]ncome from property acquired by a [non-marital] method” 750 ILCS 5/503 shall remain non-marital.
Marital property, however shall be divisible in a divorce. Illinois divorce courts “shall divide the marital property” 750 ILCS 5/503(d)
Marital property is any property that was acquired during the marriage (with lots of exceptions)
“‘[M]arital property’ means all property, including debts and other obligations, acquired by either spouse subsequent to the marriage” 750 ILCS 5/503(a)
If the property was acquired via an inheritance or a gift, even during the marriage, then the property will be considered the non-marital property of the receiver.
In Illinois, non-marital property is “(1) property acquired by gift, legacy or descent or property acquired in exchange for such property;
(2) property acquired in exchange for property acquired before the marriage;” 750 ILCS 5/503
Real estate that is rented out generates income. If the real estate is non-marital, the assets generated from that rental income will also be non-marital. While income acquired during a marriage is usually marital, there is an exception for “income from [property acquired before the marriage] if the income is not attributable to the personal effort of a spouse.” 750 ILCS 5/503(a)(8)
So long as the rental properties are consistently kept separate from the marital estate, the marital properties and their proceeds will remain non-marital.
A “rental business [will] not become marital property simply because new properties were added and older ones were maintained when all of the funds came from [one spouse’s] separate accounts. Mere marital use of the rental income certainly did not transmute the properties themselves into marital assets.” In re Marriage of Siddens, 225 Ill. App. 3d 496, 499 (Ill. App. Ct. 1992)
Sweat equity from the spouse who doesn’t own the property will have to be disproved.
“Section 503(a)(8) of the Act provides that income from nonmarital property of a spouse becomes marital income unless the spouse claiming that it is nonmarital proves by clear and convincing evidence that the income is ‘not attributable to the personal efforts of [the] spouse.’ ” In re Marriage of Schmitt, 391 Ill. App. 3d 1010, 1018, 909 N.E.2d 221, 229 (2009)
It’s very common for real estate to be an inheritance from one party’s side of the family to that particular party. But, if the inheritance or gift was put into both of the married couple’s names…it becomes marital property.
Even non-marital property that gets put in both parties’ names later becomes marital property via commingling. “[T]he placing of title to nonmarital property in joint tenancy with the spouse raised a presumption that a gift was made to the marital estate and the property thus became marital property.” In re Marriage of Olson, 451 NE 2d 825 – Ill: Supreme Court 1983
Marital property gets divided in a divorce. Illinois divorce courts “shall divide the marital property without regard to marital misconduct in just proportions considering all relevant factors, including:
(1) each party’s contribution to the acquisition, preservation, or increase or decrease in value of the marital or non-marital property” 750 ILCS 5/503(d)
So, if one party to a divorce was exclusively responsible for maintaining the rental property or second home, collecting rents, paying taxes, etc. That party will probably be awarded the property.
The other party will get something for their marital share, however…but it may not be exactly 50%. The Illinois statute only requires the court to award marital property in “just proportions.” The Illinois statute does not say what, exactly, is a “just proportion.”
The duty of a divorce lawyer is to argue that the greatest proportion of value to their client is also the most just proportion for the court to award.
Once that value is determined, the party not keeping the property can be awarded their share of the property from other marital property or the party keeping the property can get a home equity loan in order to “buy out” the other party.
Additionally, the rent from the rental property is also marital property to be divided. The party collecting the rent must account for the rental proceeds or have the rental proceeds be deemed as a dissipation against them.
“[R]ental proceeds [a]re marital property…Failure to explain specifically how money in exclusive control is spent requires a finding of dissipation.” In re Marriage of Schuster, 224 Ill. App. 3d 958, 979-80 (Ill. App. Ct. 1992)
| Type of Property | Description |
|---|---|
| Non-Marital Property | Property acquired by gift, legacy, or descent, or property acquired in exchange for such property. Non-marital property and its income remain with the original owner unless commingled. |
| Marital Property | Any property acquired during the marriage, except for inheritances or gifts received by one spouse. Marital property is divisible in a divorce and includes rental income. If non-marital property is placed in both spouses’ names, it becomes marital property. Division of marital property is done in just proportions, considering each party’s contribution. |
Valuing A Second Home Or Rental Property
If a rental property or second home is deemed to be marital, then it must be divided in some capacity. Real estate cannot be physical divided (you keep the east wing and I’ll keep the west wing) so the value of the property must be divided.
In order to divide the value of a real estate property, the value must first be determined.
The easiest way to determine the value of a property is simply to sell it. The parties can put the property on the open market and whatever the highest bidder pays for the property…that’s what it’s worth.
People have an unusual attachment to real estate and don’t typically treat it as a fungible asset that can be bought and sold like a stock.
The physical permanence of real estate, the sweat equity that was put into the building and the reliability of cash rents can cause one party to insist on keeping the property.
In this case, the property must be appraised. A licensed appraiser will assess the value of a property for a few hundred dollars. If the other party disagrees with said appraisal, they can hire their own appraiser. The two appraisers can then explain why their appraisal method was superior in a court of law…but usually the parties just sell the property in such a scenario.
Income From Real Estate In An Illinois Divorce
An advantage of real estate as an investment is that it has a practical use which can generate money. Real estate can be rented out.
This income from the rents will be calculated into the income of the party who is awarded the real estate from where the rents are generated.
Income has a big impact on divorced parties because child support and maintenance are determined by the parties’ net incomes.
Maintenance, formerly known as alimony, has the exact formula for determining income as child support does.
“Net income. As used in this Section, “net income” has the meaning provided in Section 505 of this Act [the child support section]” 750 ILCS 5/504(b-3.5)
So, in determining net income for both maintenance and child support, we simply look to the Illinois child support statute’s definition of income.
“Computation of basic child support obligation. The court shall compute the basic child support obligation by taking the following steps:
(A) determine each parent’s monthly net income;” 750 ILCS 5050(a)(1.5)
Net income is determined by the Illinois statute NOT what your accountant says is your net income.
““[N]et income” means gross income minus either the standardized tax amount or the individualized tax amount calculated pursuant to subparagraph (D) of this paragraph (3), and minus any adjustments pursuant to subparagraph (F) of this paragraph (3)” 750 ILCS 505(a)(3)(B)
We have some options to determine income. First, we need the definition of both “Gross income” and “Standardized Tax Amount”
“[G}ross income” means the total of all income from all sources” 750 ILCS 505(a)(3)(A)
“[S]tandardized tax amount” means the total of federal and state income taxes for a single person claiming the standard tax deduction, one personal exemption, and the applicable number of dependency exemptions for the minor child or children of the parties, and Social Security and Medicare tax calculated at the Federal Insurance Contributions Act rate.” 750 ILCS 505(a)(2)(C)
Our other option is “Gross Income” minus “the individualized tax amount calculated pursuant to subparagraph D”
Let’s see what paragraph D says.
“As used in this Section, “individualized tax amount” means the aggregate of the following taxes:
- federal income tax (properly calculated withholding or estimated payments);
- State income tax (properly calculated withholding or estimated payments); and
- Social Security or self-employment tax, if applicable (or, if none, mandatory retirement contributions required by law or as a condition of employment) and Medicare tax calculated at the Federal Insurance Contributions Act rate.” 750 ILCS 5050(a)(3)(D)
The Illinois statute presumes that the child support payor only gets money from his or her own labor?!? That won’t work if someone owns an income generating property.
The Illinois statute tacks on an additional section that we can use for the purposes calculating child support from rental income.
“Business income. For purposes of calculating child support, net business income from the operation of a business means gross receipts minus ordinary and necessary expenses required to carry on the trade or business. As used in this paragraph, “business” includes, but is not limited to, sole proprietorships, closely held corporations, partnerships, other flow-through business entities, and self-employment.” 750 ILCS 505(a)(3.1)
As most owners of rental properties know, you don’t get a lot of income from real estate. After the mortgage, property taxes and upkeep, there’s not a lot of additional income left. Most of the value in holding real estate as an investment is in the increase of equity from paying off the mortgage and the increase in the value of the real estate year over year.
The income from the real estate, however big or small, will be included in the net income of the child support payor.
But, there’s one big exception to the expenses which reduce your net income from rental properties: you cannot include accelerated depreciation expenses (or probably any depreciation expenses).
Depreciation is a system which allows real estate owners to deduct the costs of buying and improving a rental property. Instead of taking one large deduction in the year that the property owner buys (or improves) the property, depreciation distributes the allowed deduction across the useful life of the property.
The Internal Revenue Service (IRS) has very specific rules regarding depreciation and rental properties. One of those rules allows for “accelerated depreciation.”
Accelerated depreciation allows the property owner to take more of the depreciation expenses at the beginning of the ownership. This reduces the net income for tax purposes AND, possibly, for the purposes of calculating child support and alimony.
In determining child support, Illinois law does not allow the calculation of “[t]he accelerated component of depreciation and any business expenses determined either judicially or administratively to be inappropriate or excessive shall be excluded from the total of ordinary and necessary business expenses to be deducted in the determination of net business income from gross business income” 750 ILCS 5050(a)(3.1)(A)
While “accelerated depreciation” is definitely not allowed when calculating child support and/or maintenance an argument is often made that no depreciation expenses should be allowed in calculating child support and/or maintenance. After all, depreciation is not a real expense accruing that year and therefore could be determined to be “judicially…inappropriate or excessive.”
Many expenses relating to a building could fall under “judicially…inappropriate or excessive” depending on the creativity of the building owner’s accountant and the scrutiny of the other party’s divorce attorney.
Finally, some income from a rental property may be marital property and, thus, divisible by an Illinois divorce court.
Income from real estate which was improved by a spouse will only be non-marital if the “income is from property acquired by a method [which deems property non-marital] if the income is not attributable to the personal effort of a spouse.” 750 ILCS 5/503(a)(8)
Managing The Rental Property During An Illinois Divorce
The parties are bound to the terms of the lease as is the tenant. But, divorces take a long time and sometimes a lease will expire during the pendency of an Illinois divorce. The parties can agree to keep the tenant but either party can unilaterally evict the tenant beyond the pendency of their lease.
If “some of the joint owners wish to terminate the tenancy, unanimous consent to renewing the lease does not [need to] exist.” Daugherty v. Burns, 772 N.E.2d 237 (Ill. App. Ct. 2002)
Keeping The Rental Property After An Illinois Divorce
A rental property is a business. There’s no reason that two divorcing parties cannot be in business together. A corporation or LLC could be created whereby both parties are 50% owners. The rent from the property could then flow 50/50 to each party.
An agreement to keep the rental property would probably need to be incorporated into the Marital Settlement Agreement. The parties would need a specific buy-out clause should either party decide to exercise said agreement.
If you and/or your spouse own rental property and are getting a divorce, you have a lot of hard decisions as to what will happen to this property. Contact my Chicago, Illinois family law firm to discuss your option with an experienced Chicago divorce attorney.
