Opinion
Supreme Court No. S-15997 No. 1597
10-12-2016
THOMAS BERRY, Appellant, v. SHARON STOCKARD, Appellee.
Appearances: Justin R. Eschbacher, Law Offices of G.R. Eschbacher, Anchorage, for Appellant. Michael D. Shaffer, Anchorage, for Appellee.
NOTICE Memorandum decisions of this court do not create legal precedent. A party wishing to cite such a decision in a brief or at oral argument should review Alaska Appellate Rule 214(d). Superior Court No. 3AN-98-09845 CI MEMORANDUM OPINION AND JUDGMENT Appeal from the Superior Court of the State of Alaska, Third Judicial District, Anchorage, Frank A. Pfiffner, Judge. Appearances: Justin R. Eschbacher, Law Offices of G.R. Eschbacher, Anchorage, for Appellant. Michael D. Shaffer, Anchorage, for Appellee. Before: Stowers, Chief Justice, Winfree, Maassen, and Bolger, Justices.
Entered under Alaska Appellate Rule 214.
I. INTRODUCTION
A father who has shared physical custody appeals an order modifying his child support obligation. Shortly before modification, the father sold one of his rental real estate properties and earned a capital gain on the sale.
The father argues that the superior court erred by including this capital gain in his income for child support purposes. We agree; the commentary to the child support rule instructs that capital gains should be included in income only "to the extent that they represent a regular source of income," and our case law has consistently applied the rule this way.
The father further argues that the superior court, which also considered the mother's income in order to more precisely modify the child support obligation, erred in deducting the mother's federal income tax liability from her rental income. We disagree; the rule provides for the deduction of tax liability, rather than actual tax paid, and accordingly was properly applied here.
II. FACTS AND PROCEEDINGS
Thomas Berry and Sharon Stockard were married in 1996 and had one child together in 1997. Stockard filed for divorce in 1998, and a decree of divorce was issued in 1999. The superior court entered a child custody order and a child support order at that time, awarding Berry and Stockard joint legal custody, granting Stockard primary physical custody, and requiring Berry to pay monthly child support.
Between 2001 and 2003 Berry bought three rental real estate properties in Anchorage, but they repeatedly failed to produce any positive, taxable income. Berry claimed losses from these properties on his tax returns nearly every year. In 2007 upon Berry's motion to modify child support, an evidentiary hearing was held on whether these losses should be deducted from his adjusted annual income, the basis for calculating his child support obligation. The court concluded that the rental losses should not be deducted, and Berry did not appeal that order. Per the parties' agreement, the order also reflected the fact that Berry and Stockard now shared physical custody.
According to Berry's tax returns, the rental properties produced taxable income in one year only: $4,445 in 2011.
When calculating a parent's adjusted annual income under Alaska Civil Rule 90.3, the superior court may allow deductions for some business losses, including those associated with rental properties. See Alaska R. Civ. P. 90.3 cmt. III.B; Faulkner v. Goldfuss, 46 P.3d 993, 996-97 (Alaska 2002); Eagley v. Eagley, 849 P.2d 777, 779-80 (Alaska 1993).
In July 2013 Berry sold one of his rental properties intending to conduct a Section 1031 exchange, which would allow him to avoid recognizing a capital gain on his federal taxes that year by using the proceeds to purchase another property. But the purchase of the new property fell through, forcing Berry to recognize a gain of $148,577 and to pay an associated capital gains tax.
Under the Internal Revenue Code, a seller of certain types of business or investment property can defer recognition of a gain from the sale for federal income tax purposes by reinvesting the proceeds in the purchase of a qualified property within a certain time period. 26 U.S.C. § 1031(a) (2012).
According to Berry his post-tax gain was about $102,000 and, as of May 2014, he still had about $84,000 in cash from the sale.
In November 2013 Child Support Services Division (CSSD) initiated a review of the child support order at Stockard's request. Based on this review, CSSD found a material and substantial change in circumstances that justified modifying Berry's monthly child support obligation and moved to decrease Berry's monthly child support obligation from $257 to $89. Stockard opposed and filed a cross-motion to increase Berry's monthly child support obligation to $1,435, contending that Berry was underreporting income and that income should be imputed to him because he was voluntarily and unreasonably underemployed. She also moved to modify custody by reducing Berry's summer visitation — a change that would give her primary physical custody. Berry initially opposed, but based on the 16-year-old child's preference and the parties' later agreement, the court granted the custody change. Berry and Stockard, however, continued to dispute child support.
Stockard's allegation of voluntary and unreasonable underemployment was based on the fact Berry was employed part-time with the Alaska Air National Guard and earned substantially less than he did at his prior full-time job.
After three evidentiary hearings the superior court resolved the child support dispute in June 2015. The court concluded that Berry's one-time capital gain from the sale of the rental property should be included in his income because it was "a regular source of income." The commentary to Alaska Civil Rule 90.3, the court explained, provides that "capital gains in real and personal property transactions" should be included as income for child support purposes "to the extent . . . they represent a regular source of income." The court reasoned that Berry had accrued equity in the property each month through his monthly mortgage payments, which he had made for more than a decade. Concluding that the increased equity qualified as a regular source of income, the court held that the income from the property's sale "should be recognized as a mere component of the income producing process rather than an irregular event that has no child support consequences."
Alaska R. Civ. P. 90.3 cmt. III.A.16.
The superior court further explained that even if that capital gain is not a regular source of income, it should still be treated as income for child support purposes. The court acknowledged that the commentary to Rule 90.3 stated otherwise, but it noted that this court has never officially adopted nor approved the commentary and that "the law is not as clear on the capital gains issue as the Rule 90.3 commentators would have one believe." The court identified several inconsistences in how the commentary treats non-recurring sources of income and in how this court treats one-time capital gains for child support purposes. Because the court could discern no "bright-line rule," it considered the equities and concluded that they favored including the capital gain as income.
Next the superior court addressed which years should include the capital gain. Typically funds count toward child support income only in the years in which they are earned, but Rule 90.3 permits a court to vary a child support award "for good cause." In the court's view, clear and convincing evidence established "that manifest injustice would result if the value of Berry's capital gain were not spread out beyond the 2013 calendar year, and those unusual circumstances require[d] variation of the child support award to spread the capital gain out over two years and one month." Based on this good cause finding, the court apportioned the capital gain to Berry's income over 25 months, from December 1, 2013, to December 31, 2015.
See Alaska R. Civ. P. 90.3 cmt. III.E ("Child support is calculated as a certain percentage of the income which will be earned when the support is to be paid.").
See Alaska R. Civ. P. 90.3(c)(1) ("The court may vary the child support award as calculated under the other provisions of [Rule 90.3] for good cause upon proof by clear and convincing evidence that manifest injustice would result if the award were not varied.").
The superior court then addressed Stockard's finances. It noted that her income must be considered in determining child support before October 21, 2014, because Berry and Stockard shared physical custody until that time. The court explained that in addition to her salary, Stockard revealed during testimony that she had additional unreported rental income from a roommate amounting to $250 to $400 per month, an average of about $325. Citing Shepherd v. Haralovich, the court then deducted federal taxes from this rental income and added that adjusted amount to her salary. The court used this total — Stockard's annual salary plus the tax-adjusted rental income — to calculate her support obligation for 2013 and 2014.
See Alaska R. Civ. P. 90.3(b)(1) (providing that when parents share physical custody of the child, the court must consider the income of both parents).
170 P.3d 643, 650 (Alaska 2007) (observing that federal income tax liability should be deducted from imputed income).
Based on these calculations, the superior court issued four child support orders: (1) December 2013; (2) January 1, 2014 to October 20, 2014, when Berry and Stockard shared physical custody; (3) October 21, 2014 to December 31, 2014, when Stockard had primary physical custody; and (4) January 1, 2015, until their child graduated from high school in 2016.
Berry appeals, claiming that the superior court erred in (1) including the one-time capital gain from the sale of his rental property as income, (2) apportioning that one-time gain over 25 months, and (3) imputing federal taxes to Stockard's rental income.
III. STANDARD OF REVIEW
The proper method of calculating child support, including "whether an item qualifies as income for the purposes of Rule 90.3," is a question of law that we review using our independent judgment, adopting the rule of law "most persuasive in light of precedent, reason, and policy."
Robinson v. Robinson, 961 P.2d 1000, 1002 (Alaska 1998).
Swaney v. Granger, 297 P.3d 132, 136 (Alaska 2013).
IV. DISCUSSION
A. Berry's One-Time Capital Gain From The Sale Of His Rental Property Should Not Have Been Treated As Income Under Civil Rule 90.3.
In Alaska child support is awarded based on the formulas provided in Rule 90.3. Child support for both primary and shared physical custody is based on the obligor parent's adjusted annual income — "the parent's total income from all sources," less certain deductions. The commentary to Rule 90.3, which we have found "instructive," identifies a number of specific sources of funds that should be counted as income for child support purposes. Included in this list is "capital gains in real and personal property transactions to the extent that they represent a regular source of income."
Alaska R. Civ. P. 90.3(a), (b)(1)(A).
Neilson v. Neilson, 914 P.2d 1268, 1272 (Alaska 1996). However we have not officially adopted the commentary. See State, Child Support Enf't Div. v. Bromley, 987 P.2d 183, 194 (Alaska 1999).
Alaska R. Civ. P. 90.3 cmt. III.A.
Alaska R. Civ. P. 90.3 cmt. III.A.16 (emphases added).
Berry argues that the superior court should not have treated the one-time capital gain from the sale of his rental property as income. The superior court concluded: (1) Berry's one-time capital gain is a regular source of income and accordingly is income for child support purposes; and (2) even if the gain were not a regular source of income, it still qualifies as income because the commentary is not binding, this court's case law is unclear, and the equities favor this result. We address these two conclusions separately.
1. The accrual of equity in the property does not convert Berry's one-time capital gain into a regular source of income.
The superior court concluded that Berry's one-time capital gain from the sale of the property is a regular source of income because he accrued equity in the property for more than a decade by making regular mortgage payments.
Equity is "[t]he amount by which the value of . . . property exceeds secured claims or liens." But there are several problems with using accrual of equity as the basis for concluding that an asset is a regular source of income. First, as Berry notes, whether monthly mortgage payments increase equity in real estate does not depend only on whether the payments reduce the loan principal; "it also depends on the real estate market, the condition of the property[,] and many other factors." In a poor real estate market, an owner could make regular mortgage payments without any change in equity; equity could even decrease. Market uncertainty means that increasing equity through monthly mortgage payments does not guarantee that increases in equity will continue. Thus accrual of equity is a weak justification for treating a one-time capital gain from the sale of property as regular income. Regardless of whether an owner is paying down a mortgage, the accrual of equity is not guaranteed.
Equity, BLACK'S LAW DICTIONARY (10th ed. 2014).
This equity accrual rationale also suffers from a lack of limitation: If the capital gain from Berry's sale of one property counts toward Berry's income because he accrued equity in it, there is no apparent reason not to include the equity accrued in his two other rental properties in his income. Berry has substantial equity in those properties even though it has not been converted to a liquid asset via a sale. Yet during closing argument, the superior court agreed that if Berry had completed the planned Section 1031 exchange, the capital gain from the sale could not be included in his income. If the court were concerned with equity, it should not matter whether the asset is liquid or non-liquid.
See supra, note 3.
Using accrual of equity as a basis for income is also problematic because it could apply to the sale of any item that the obligor paid for over time. If accrual of equity were sufficient to convert a capital gain into a regular source of income, this would undermine the commentary's limitation that a capital gain must be a regular source of income to qualify as income for child support purposes. As Berry notes, under the superior court's equity accrual rationale, the capital gain from the sale of any item purchased with a loan and paid for via regular loan payments could be considered income for child support purposes because these regular payments convert the one-time gain into a regular source of income.
Using regular payments as the the basis for transforming a capital gain into regular income also unjustifiably distinguishes between a person who purchases property outright and a person who takes on debt. Under the equity accrual rationale, the capital gain from the sale of property bought outright would not be income for child support purposes because there would be no regular loan payments; by contrast the capital gain from the sale of property bought using a mortgage or loan would be income. This distinction lacks support in both Rule 90.3 and its commentary.
The superior court relied on our holding in K.F. v. S.G. to support its conclusion that Berry's one-time capital gain was regular income. In K.F. we reviewed a child support order in which the obligor-parent claimed that her financial expert had mistakenly included the capital gain from the sale of a rental property in her income. But the superior court nevertheless used the income calculation the mother originally submitted. We affirmed, reasoning that the mother's financial expert had included the capital gain from the sale as part of her net rental income for that year; the $21,025 capital gain offset the $47,703.91 in claimed rental losses. We explained, "the master properly included the proceeds from the sale of the . . . rental property as one component of [her] yearly rental activities."
Nos. S-11901, S-11971, 2007 WL 1302414, at *8 (Alaska May 2, 2007).
Id.
Id.
Id.
Id.
Relying in part on K.F., the superior court determined that the sale of Berry's rental property "was part of a significantly larger real estate rental enterprise" that encompassed Berry's two other rental properties and his intent to purchase another property with the sale's proceeds. And therefore the capital gain from the sale was a component of Berry's annual rental activities whereby he "effectively exchanged [rents] for a capital gain while other rental activity continued."
But the decision to allow the capital gain to be included in the mother's income in K.F. was based not only on the fact that the capital gain was a component of her yearly rental activities but also on the fact that rental losses were deducted from her income. The capital gain from the sale of rental property offset these deducted losses to calculate her net rental income.
Id. Though the facts provided in K.F. are sparse, an earlier decision in the same case reveals that the mother's rental property losses were deducted from her income for child support purposes. See id. at *1 (noting that mother had deducted depreciation for her rental property in previous case).
Id. at *8.
In contrast Berry's losses from his rental properties have never been deducted from his income. In 2008 the court determined that such losses were not deductible, and Berry did not appeal that decision. Though Berry's rental properties continued to generally operate at a net taxable loss following that order, those losses also were not deducted. And the 2015 order similarly did not allow such deductions.
Thus Berry's circumstances are different from those in K.F. In K.F. we allowed the mother's capital gain to be included in her income because her net rental losses were deducted from her income. The underlying rational is sound: When parents deduct rental losses from their income, they may also be required to include any gains — capital or otherwise — in calculating their net loss. Holding otherwise would undermine the rationale for the deduction.
See Neilson v. Neilson, 914 P.2d 1268, 1273-74 (Alaska 1996) ("[T]he determinative factor as to whether a claimed expense is deductible under Rule 90.3 is whether it is an 'ordinary and necessary expense[] required to produce the income' and whether the allowance of such an expense would defeat the goals of Civil Rule 90.3.").
This distinction is underscored by subsequent developments in K.F. On remand the superior court recalculated the mother's gross income; it no longer deducted her rental losses from her income. On appeal we affirmed the revision. We also affirmed the court's decision to not include a one-time capital gain in the father's income, even though we had previously affirmed the court's decision to count the mother's capital gain as income. Explaining the difference, we noted that there was "no evidence that [the father's] . . . capital gain was a regular source of income" and thus his capital gain "f[ell] into the general rule of exclusion," in contrast to the mother's gain.
Faulkner v. Goldfuss, No. S-13018, 2010 WL 1135745, at *2-3 (Alaska Mar. 24, 2010).
Id. at *4-6.
Id. at *8.
Id.
The superior court also cited Eagley v. Eagley to support its conclusion to include Berry's capital gain in his income. According to the superior court, Eagley characterized periodic mortgage payments as "an investment that generates equity over time." Based on this statement, the superior court concluded that Berry's monthly mortgage payments, which increased Berry's equity, were "a regular source of income to him." But Eagley addressed reasonable and necessary business expense deductions rather than capital gains: The superior court denied a parent's request to deduct, as a business expense, payments on a loan used to purchase a business. The superior court reasoned that allowing such a deduction would be "incorrect since [the principal payment] represents distribution of actual income of the business to the owner in increased equity in the business." We affirmed, emphasizing that "principal payments constitute an investment which increases . . . equity in the business." Because Eagley used accrual of equity to justify disallowing deductions of loan payments from income — and did not address capital gains — the case offers little support for the superior court's analysis.
849 P.2d 777, 782 (Alaska 1993).
Id.
Id.
Id.
Finally we note that Alaska is among a handful of states in how it treats capital gains for child support purposes. Alaska explicitly differentiates between recurring and nonrecurring capital gains and provides that only recurring capital gains may be included in income. By contrast, courts in many other states have held that capital gains, even if they are one-time events, should be included. By explicitly distinguishing between capital gains that are "a regular source of income" and those that are not, the commentary distinguishes Alaska law on capital gains from those other states. The equity accrual rationale undermines this distinction.
LAURA W. MORGAN, CHILD SUPPORT GUIDELINES INTERPRETATION & APPLICATION § 4.07, Westlaw (database updated 2015).
See id. at n.94 (comparing decisions from various states).
Alaska R. Civ. P. 90.3 cmt. III.A.16.
We hold that the accrual of equity in the rental property via regular mortgage payments did not render Berry's capital gain from the property's sale a regular source of income.
This conclusion does not disturb our holding in Caldwell v. State that the "continued availability" of a one-time capital gain "could conceivably be treated as an exceptional factor [under Rule 90.3(c)(1)] warranting some increase in [the parent's] support obligation." 105 P.3d 570, 575 (Alaska 2005). But we emphasize, as in Caldwell, that relying on the continued availability of such funds requires the superior court to consider the totality of the circumstances analysis and to make findings conforming to Rule 90.3(c) requirements. Id.
2. Because the one-time capital gain is not a regular source of income, it should not be included in Berry's income under Civil Rule 90.3.
The superior court concluded that even if Berry's capital gain is not a regular source of income, it should still be included in his income because the commentary is inconsistent and not binding, our case law is unclear, and the equities favor its inclusion. But the commentary and our case law clearly state that a capital gain must be a regular source of income to be income for child support purposes.
The superior court identified several "inconsistent positions" in how the commentary defines income under Rule 90.3. For example funds derived from "prizes and awards"— usually a non-recurring, one-time gain — are counted as income, whereas a one-time capital gain is not. Similarly money "derived from self-employment and from business or partnerships" is counted as income, but the capital gain from Berry's rental property enterprise — a form of self-employment — is not. Because of such inconsistences, the superior court gave the commentary little weight.
Alaska R. Civ. P. 90.3 cmt. III.A.23.
Alaska R. Civ. P. 90.3 cmt. III.A.7.
The superior court also opined that this court "has not decisively determined whether, and under what circumstances, a one-time capital gain should be included as income for child support purposes." For example, we suggested in a footnote that the capital gain from the sale of non-inherited property should be counted as income:
If on remand the superior court determines that th[e] property was indeed inherited, only the interest from its sale and capital gain, if any, . . . would qualify as income under the guidelines of Rule 90.3. If the property is not inherited, only
capital gain from its sale and the interest portion of the payments should be considered income . . . .And in a memorandum opinion we approved including a one-time capital gain from the sale of rental property as income because the gain was "one component of [the parent's] yearly rental activities." In another memorandum opinion we acknowledged this prior holding but held the opposite.
Robinson v. Robinson, 961 P.2d 1000, 1003 n.3 (Alaska 1998) (emphasis added) (citations omitted).
K.F. v. S.G., Nos. S-11901, S-11971, 2007 WL 1302414, at *8 (Alaska May 2, 2007).
See Faulkner v. Goldfuss, No. S-13018, 2010 WL 1135745, at *8 (Alaska Mar. 24, 2010) ("We find no evidence that [the parent's] . . . capital gain [from the sale] was a regular source of income . . . . Therefore, it appears [that the] capital gain falls into the general rule of exclusion.").
First, regardless of how the commentary treats other types of income, the commentary clearly provides that "capital gains in real and personal property" are considered income under Rule 90.3 only "to the extent that they represent a regular source of income." While it is true that we have never adopted the commentary as binding authority, we have cited the commentary's capital gains principle several times with approval. Because the commentary treats capital gains clearly and we have consistently relied on its capital gain principle, any perceived inconsistencies in the commentary's definition of income carry little weight.
Alaska R. Civ. P. 90.3 cmt. III.A.16.
State, Child Support Enf't Div. v. Bromley, 987 P.2d 183, 194 (Alaska 1999).
See Shepherd v. Haralovich, 170 P.3d 643, 649 (Alaska 2007); Caldwell v. State, 105 P.3d 570, 573 (Alaska 2005); Faulkner v. Goldfuss, No. S-13018, 2010 WL 1135745, at *8 (Alaska Mar. 24, 2010); K.F. v. S.G., Nos. S-11901, S-11971, 2007 WL 1302414, at *8 (Alaska May 2, 2007).
Second, our case law on capital gains also favors following the commentary. Three of our holdings are based on it: Caldwell v. State reversed the superior court's decision to include proceeds from the sale of stock in a parent's income because "[t]he sale proceeds amounted to one-time capital gains." Shepherd approved including the capital gain from the sale of rental property as income because the superior court "only considered the net sale proceeds insofar as they could have been reinvested to provide a source of regular income." And Faulkner v. Goldfuss approved not including a one-time capital gain in a parent's income because there was no evidence that the capital gain was a regular source of income.
105 P.3d at 573-75 (emphasis added).
170 P.3d at 649 (emphasis added).
No. S-13018, 2010 WL 1135745, at *8.
While we have made some statements in tension with the commentary's capital gain principle, none of those statements was crucial to a holding. The majority of our case law follows the commentary's principle, and we adhere to that principle here. Capital gains should only be considered as income for child support purposes to the extent they represent a regular source of income.
In particular, we disavow the contrary implication in footnote 3 of Robinson v. Robinson, 961 P.2d 1000, 1003 n.3 (Alaska 1998).
Because we conclude that the commentary and our case law are clear that capital gains must be a regular source of income to be included as income for child support purposes, we do not address Berry's arguments regarding the equities or his challenge to the 25-month apportionment of the gains.
B. The Superior Court Did Not Err In Deducting Federal Income Tax Liability From Stockard's Rental Income.
Stockard revealed during testimony that she received an additional source of income from a part-time renter that she had not reported. That part-time renter paid her about $250 to $400 per month, so the superior court found that these payments averaged $325 per month or about $3,900 per year. Next the court deducted Stockard's federal income tax liability from the $3,900 in rental income and added this adjusted rental income to Stockard's annual salary for 2013 and 2014. It then used these final amounts to calculate the amount of child support Stockard owed in each of those years. Berry argues that the superior court erred in deducting the federal tax liability because she did not actually pay federal income tax on this rental income.
Under Rule 90.3(a)(1)(A)(I), federal income tax must first be deducted from a parent's gross income to arrive at the parent's adjusted income, which is used for calculating the amount of child support owed. A parent's federal income tax liability, not the amount of tax that the parent actually paid, is the amount that should be deducted under Rule 90.3. Accordingly in Heustess v. Kelley-Heustess we remanded a child support order that did not deduct federal income tax liability from the parent's income even though the parent could not show that he paid federal income taxes. Similarly in Bergstrom v. Lindback we held that the superior court erred in reducing a parent's adjusted annual income by the tax amount withheld rather than his actual tax liability: A parent's "actual tax liability under existing Internal Revenue Service regulations, rather than the [actual] amount withheld [from the parent's salary], is the proper basis for determining the amount to be deducted from his income" under Rule 90.3(a)(1)(A).
Heustess v. Kelley-Heustess, 259 P.3d 462, 470 (Alaska 2011) ("[T]he mandatory deductions set forth in Rule 90.3(a)(1)(A) [which includes federal income tax liability] are based on liability, not the amount actually paid.").
Id.
779 P.2d 1235, 1236-37 (Alaska 1989). --------
The superior court's order is consistent with Heustess and Bergstrom. The superior court deducted Stockard's federal income tax liability from her rental income before adding it to her annual income. A parent need not have actually paid federal income tax to be afforded this deduction; the deduction allowed under Rule 90.3 is based on liability, not the amount of tax paid. Therefore the superior court did not err in deducting Stockard's federal income tax liability from her rental income.
V. CONCLUSION
We REVERSE the superior court's inclusion of capital gain in Berry's income and the accompanying child support orders. We AFFIRM the superior court's deduction of federal income tax liability from Stockard's rental income. We REMAND for further proceedings consistent with this opinion.