Dividing the Debts in a California Divorce

My spouse ran up huge credit card debts during the marriage. In dividing assets and debts in the settlement agreement, who should be responsible for these debts?

In California, Family Code section 910 provides that the community is liable for all debts incurred during the marriage and prior to separation. It doesn’t matter whether the debt was incurred by one spouse for his or her own benefit or for the family. It also doesn't matter whose name appears on the bill or the credit card statements. If it was incurred during the marriage and prior to separation, it’s a community property debt and both spouses are equally liable. This means that when the parties are negotiating a settlement and tallying the marital balance sheet such debts should be divided equally. A better option might be that one spouse agrees to pay off the joint debts in return for a greater share of the community property. The spouse paying off the debts can at least make sure that joint debts are paid, because as long as debts are jointly owed both spouses are financially responsible to the creditors.

What if a married couple pays off one party’s pre-marital debts?

Consider this example. Bob and Jackie get married. Bob has huge credit card debts that he incurred before the marriage. Bob and Jackie want to improve their credit rating so they can buy a house. They agree to pay off Bob’s debts. However, once they are debt free, Bob files for dissolution. In this case, Bob and Jackie have used community property earnings to pay off Bob’s separate property debt. California case law states that the community is entitled to a reimbursement for the amount it paid to discharge one party’s separate property debts.¹ So, in the above example, the community is entitled to a reimbursement for paying Bob’s debts.

What if one party uses his or her separate property to pay off community property debts?
 
In this example, after they get married Bob and Jackie go on vacation and rack up huge debts. Jackie dips into her brokerage account which she built up prior to the marriage to pay off the vacation debts. In this case, Jackie has used her separate property to pay off community debts. California case law states that a spouse who, during marriage and before separation, uses separate property to satisfy a community debt is presumed to make a gift to the community.² So, in the above example, Jackie is not entitled to a reimbursement for paying the community vacation debts.

There is one important exception to this rule. Family Code section 2640 provides that where one party uses their separate property for the acquisition of community property, the paying spouse has a statutory tracing right of reimbursement if the right has not been waived in writing. Contributions to the acquisition of property include down payments, payments for improvements, and payments that reduce the principal of a loan used to finance the purchase or improvement of property. They do not include payments of interest on a loan to purchase property, or payments for maintenance, insurance, or taxation of the property. So, in the above example, if Jackie had used her separate property brokerage account to pay off the principal on a joint mortgage or for a downpayment she would be entitled to a reimbursement of that amount.

After separation one spouse uses separate property earnings or property to pay off community debts.

In this example, after Bob and Jackie separate, Jackie continues to drive the BMW which was purchased with a loan during the marriage. Bob continues making the loan payments on the car. Can Bob claim a reimbursement credit for all the payments he makes from the date of separation to the date of trial?

California case law has developed the general rule that a spouse who, after separation, uses earnings or other separate property to pay pre-existing community obligations should be reimbursed out of community property upon dissolution.³ These are traditionally called “Epstein credits” after the California Supreme Court case that established the rule. 
 
Under the general rule, Bob could, in theory, claim credits for all the payments he makes on the car loan after separation. But what if Bob was driving the car and making the payments? Wouldn’t it be unfair for Bob to have the use of the car and also claim reimbursement credits? That’s what the Court said in Epstein.  It laid out an exception to the general rule where the paying spouse also uses the asset and the “amount paid was not substantially in excess of the value of the use.” So this means that Bob could not claim credits for the monthly payments if he drives the car, but probably could claim a credit if he paid off the entire loan. 
 
There are two other important exceptions to the Epstein general rule that a spouse who uses separate earnings or property to pay off pre-existing community obligations is entitled to a reimbursement: (a) where there is an agreement between the parties that the payments will not be reimbursed, and (b) where the payments were intended as a gift or as child or spousal support.

After separation one spouse uses community property funds to pay off his or her living expenses. What are the consequences?

In this example, Bob and Jackie separate and Bob agrees to pay $1,000 per month in support and “whatever else you need out of savings.” Jackie takes out $1,000 of community property from the joint bank account to pay various living expenses. California case law provides that the community is entitled to reimbursement where one spouse uses community property to pay separate obligations after separation to the extent that exceeds a reasonable amount for child and spousal support.⁴ A reasonable amount would probably be the amount of guideline support that a court would order in an application for temporary child and spousal support. If that amount were $1,500 in the above example, Jackie would have to reimburse the community $500 ($2,000 she received minus $1,500). In the division of community property she would receive $250 less in community property. Since this rule flows from Epstein, the parties can waive the rule in writing and agree that such payments shall not reduce the community estate.

After separation one spouse stays in the family home while the other spouse pays the mortgage. What are the consequences?

It’s often the case that after separation one spouse moves out of the family home (“the out-spouse”) while the other spouse stays in the home with the children (“the in-spouse”). The out-spouse, usually the husband, may offer to maintain the status quo by continuing to pay the mortgage payments and other payments such as property taxes to maintain the property. In such a situation, the in-spouse should be warned that there may be serious consequences of such an arrangement at the time of trial.
 
We’ve already seen one consequence. The out-spouse paying the mortgage payments may be entitled to Epstein credits because he or she is paying separate property earnings towards a community property debt unless there was an agreement to waive such reimbursements or such payments were a form of child or spousal support. 
 
The other major consequence is that if the reasonable rental value of the family home is more than the mortgage payments, the in-spouse may be required to reimburse the community for the difference in these payments between the date of separation and the date of trial. These are called Watts charges after the case that established the rule.⁵ The general rule is that where one spouse has the exclusive use of community assets between the date of separation and trial, that spouse may be required to compensate the community for the reasonable value of that use. Consider this example. Bob and Jackie separate. Jackie and the kids stay in the family home after separation. Bob agrees that he’ll continue to support the family and pay the mortgage and other expenses. The mortgage payments are $1,500 per month. If Jackie had to pay the fair market rent for the property she’d pay $2,500 per month. Bob pays the mortgage for 10 months from the date of separation to the date of trial. Bob could argue that he should be reimbursed Watts charges of $10,000 ($2,500 - $1,500 x 10). In a division of community property he’d be entitled to an extra $5,000. Bob could argue that he should also be entitled to Epstein credits of a further $15,000 ($1,500 x 10) which would increase his share of community property by $7,500.

This would mean that Jackie’s entitlement to community property would be reduced by $25,000 when she thought that Bob was supporting her and maintaining the status quo. Isn’t this grossly unfair?⁶ You’d think so but that didn’t stop the Court of Appeal from awarding Epstein credits and Watts charges in similar circumstances in In re Marriage of Jeffries (1991) 228 Cal. App. 3d 548. But wait a minute. Isn’t there an exception to the rule where payments are made “in lieu of spousal support”? The answer is yes, but this has to be clearly spelled out before the Court will treat such payments as support. In Jeffries, there was even an Order of the Court that said the payments were “in lieu of spousal support.” However, the Order also said that the Court retained jurisdiction to characterize the payments and determine whether the husband should be entitled to reimbursements.

In another case the Court of Appeal reached exactly the opposite conclusion to Jeffries.⁷ In this case the husband also paid the mortgage pursuant to a temporary court order “in lieu of spousal support” and at trial claimed Epstein credits and Watts charges. The Court of Appeal held that public policy and the language of the Court order required that the Court deny the husband’s claims for Epstein credits. The Court then decided that since the wife was, in effect, paying the mortgage she would not have to pay any Watts charges because the monthly mortgage payments were the same as the fair market rental value of the home.
 
The only solution to this mess is for the parties and their attorneys to agree early in the proceedings whether a spouse’s payment of community debts (such as the mortgage) and one spouse living in the family residence should be treated as spousal support which does not generate Epstein credits or Watts charges. If it’s treated as spousal support, any agreement or order should contain explicit language that mortgage and other payments by the out-spouse and exclusive residence by the in-spouse in the family home “shall be treated” as spousal and, if applicable, child support and the paying spouse shall not receive any reimbursements such as Watts, Epstein, or Jeffries credits and charges.

Summary:

Footnotes:

1. Marriage of Walter (1976) 57 Cal. App. 3d 997.
2. See v. See (1966) 64 Cal. App. 2d 778. In In re Marriage of Nicholson (2002) 104 Cal. App. 4th 289, the Court of Appeal held that where husband had used $30,000 that his mother had given him as a gift (i.e., separate property) to pay off the credit card (community property debts) so the couple could qualify for a loan to buy a house, he was not entitled to a reimbursement.
3. In re Marriage of Epstein (1979) 24 Cal. 3d 76. See also In re Marriage of Tucker (1983) 141 Cal. App. 3d 128.
4. Epstein, above; In re Marriage of Stallworth (1987) 192 Cal. App. 3d 742.
5. In re Marriage of Watts (1985) 171 Cal. App. 3d 366.
6. This is the conclusion of one Family Law Commissioner: “It is fundamentally unfair for one spouse to move out and to allow a post-separation living arrangement to stabilize on one set of financial assumptions and then, without warning to the other spouse, introduce for the first time at trial a concept as pernicious as a Watts credit claim to set up an entirely different set of financial assumptions.” Commissioner Richard Curtis (2003)
7. In re Marriage of Garcia (1990) 224 Cal. App. 3d 885.