The Trail of Tracing and Transmutation

By Kristen Sherwood

Have you ever had a client ask, “What happens to my inheritance if I decide to separate from my spouse?”

“Is this my separate property?”

“What if I used this for [insert marital purpose here]?”

Clients come in with the often-googled buzzwords “comingling” and “conversion” and think that since these funds were used for a marital purpose or placed in a joint account, then surely, they have been converted to marital funds[1]. However, the buzzword you should introduce your clients to is “tracing.”

What to Ask

• Where did the funds come from?
• How were the funds used?
• Do they have documentation of the use of funds from the original source?
• How is the property titled?

What if your client used these funds to pay down the mortgage on the marital residence?

Your client walks in and tells you she’s previously received an inheritance and then paid $50,000.00 toward the mortgage on her marital home. Now, she is separating from her spouse, and she wants to know what this means. Can she get credit for these funds? Sort of, but first – is the marital residence titled as tenants by the entirety? If so, this payment is presumed a gift to the marriage.[2] But there is still hope! If she can successfully trace, she can use her separate contributions to a marital asset as a distributional factor in the final determination of equitable distribution.

If the presumption is successfully rebutted (or is not applicable), then the “source of funds” analysis would apply.[3] This is all possible because by paying down the mortgage, you can make an argument that by using separate property, your client increased the value of a marital asset, and, as such, the same should be considered as a distributional factor for an unequal distribution of the marital estate in your client’s favor. The courts have held that real property is acquired at the time it is paid.[4] In using the source of funds analysis, you can provide evidence to support your position that your client should receive an unequal division of the marital estate in her favor. Since, in this scenario, we are discussing real property that is held by the entirety, which is presumed a gift to the marriage, the paydown of the mortgage using separate funds (i.e., an inheritance), the separate paydown is also considered a gift to the marriage. However, if tracing can be done, then once the funds have been appropriately traced back to the inheritance, your client has an opportunity to receive credit for this paydown by way of an unequal distribution of the marital estate in their favor.

A good place to start would be to ask the client if they can pull some bank statements, check images, and mortgage statements showing where that $50,000.00 came from and how much it decreased the principal balance on their mortgage.

What if your client put their inheritance into a joint bank account?

Let’s say your client walks in and says he received an inheritance and then deposited that money into his joint bank. Your client may ask, “Have these funds been converted to marital property?” You guessed it, not if you can trace it back to his inheritance! Because North Carolina is a tracing state, simply placing separate inherited funds into a joint account does not automatically “convert” or “transmute” the funds to marital property [5], but the client will need to be able to show that the amount deposited and held in the joint bank account is his inherited funds. This may be easy if this account was a pass through while opening a new account or investing, but the more these funds are comingled and used by both parties, the more difficult tracing can become.

What if your client and the client’s spouse regularly use the inherited funds?

That brings us to another scenario, what if your client says she received an inheritance several years ago, and after placing it in a separate bank account, your client started transferring funds into a joint bank account in increments of $5,000.00. As discussed above, this alone will not immediately cause transmutation to occur. Over a number of years, all while inherited funds are being slowly added to the joint account, your client and her spouse continue to use their debit cards, pay monthly bills, vacations, going out to eat, etc., from the joint account.[6] You can see how this may make it a bit more difficult to trace whether the deposits paid to the joint checking account are separate. If the funds cannot be properly traced back to the original source, then the argument is that these funds were used for a marital purpose and transmutation has occurred. Simply, if you cannot trace, transmutation is the case!

Tracing: Best Practices

When it comes to tracing, the courts have all but said “follow the money.” This can be as simple as pulling a few statements or check images to show the portion paid to create a separate interest. But as you can see, over time, with comingling and continued use of inherited funds, tracing can then become a tedious task.

With that in mind, a few tips can help make tracing a client’s separate inheritance a bit easier:

• Ask for documentation of when the client received the gift or inheritance.
• Ask for documentation of any funds used to pay off marital assets or debts.
• Know when to hire an expert.
• Know that real property has nuances.