After 28 years of marriage, Josh and Eileen are in the process of negotiating their separation. They both lead successful careers, Josh heads-up business development for a growing tech company and Eileen manages a rental property in addition to her demanding role as a gallery owner. As part of the negotiation process at separation, Eileen and Josh’s lawyers are working to identify where equalization may be required financially.
The divorce lawyers have asked for a detailed reporting of income and expenses from each spouse. In preparing this, the first points of reference may be their tax returns. However, these documents may not include “invisible” cash flows that should be accounted for.
Here are some scenarios where tax deductions have been used to offset income. It’s important to look beyond the tax return for these “invisible” cash flows to determine fair equalization.
Rental income
Eileen expended her gallery six years ago by purchasing a commercial building, it allowed her gallery to grow with room for Eileen’s business to diversify with a real estate holding. The gallery resides on the main floor, and Eileen leases the space on the two floors above it.
The income from Eileen’s rental property is reduced by tax-deductible expenses which include mortgage interest and annual capital cost allowance. Capital cost allowance is not a cash outflow but instead a notional amount that reflects the expected depreciation of the capital property over time. The mortgage principal payments Eileen makes are actual cash outflows that are not included in the taxable rental income shown on the tax return, so should be factored into the overall calculation to determine equalization.
Commission income
A large portion of Josh’s income is derived from the commission he earns. He deducts certain expenses for the purpose of calculating his taxable income. These expenses are required to make the commissioned income and include office expenses, frequent travel expenses, and car lease payments. Josh works out of his home two days a week, so he also deducts some housing expenses from his income for tax purposes, i.e., a percentage of the heat, hydro, and internet expenses based on the use of the den as the office. These expenses may overlap needed lifestyle expenses.
As we see from Eileen and Josh’s situation, looking at tax returns alone to identify income and expenses may significantly understate the amount of cash flow that is entering the home and may hide some shared expenses. An experienced Investment Advisor at Richardson Wealth can help to determine fair equalization payments as part of the separation agreement.
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