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Imputing Income to Assets in Divorce
The courts have been imputing earned income to an unemployed or underemployed person for years, regardless of whether that spouse is the supporting or the supported spouse and in the context of both spousal and child support. By the same token, a party is not expected nor permitted to underutilize financial capital. In other words, the same can be said for asset based capital as human capital. The Miller case in New Jersey, 160 N.J. 480 (1999) cemented the concept and established that a reasonable rate of return can be imputed to a payor's (or payee's) investment assets, different from the actual rate of return and "the income available to either party through investment of any assets held by that party is to be considered in the alimony calculus".
In Aronson V Aronson, 245 N.J. Super. 354 the court made it clear that interest income from an inheritance could also be considered in the alimony calculation. In Stifler v. Stifler, 304 N.J. Super 96 went further and held that income could be imputed to an asset inherited by the supporting spouse, which had been converted into a non-income bearing asset, to reflect interest that could have been realized had the funds been invested differently.
Both marital and nonmarital assets are part of the support equation. In assessing both the need and ability to pay alimony, the court is required to consider all relevant economic factors, including the financial resources of each party, the assets and liabilities distributed to each, the nomarital holdings and all sources of income available to either party. That's a fairly broad dictate. Is a vacation home treated the same as a stock portfolio? What about the house? The answer is YES..all assets represent the potential for income, regardless if income is being realized. Regarding the house, if a spouse uses property settlement assets (or inheritance for that matter) to purchase a home post- divorce, the value of the home that exceeds the previous marital home should be considered available for income imputation, under the concept of maintenance of lifestyle. In other words, a spouse cannot buy an expensive home and say they have no assets to produce income. Other planning options are discussed below regarding the home and income imputation. In general, all assets can potentially produce income, the next question is how much?
Some states have established what is considered a reasonable rate of return for the imputation of income to assets by statute. Ohio Rev. Code Ann. 3119.01 C(11)(b) states that "Interest rate determined from local passbook savings rate, not to exceed statutory rate". West Virginia Code 48-1-205(d) states that "assets considered underperforming if they do not produce income at a rate equivalent to current six-month certificate of deposit rate or such other rate the court determines is reasonable". Vermont Stat. Tit. 15 653(5)(A)(i) states "current rate for long term US Treasury Bills".
Historically, an interest rate assumption has been used to determine the prudent investment standard. Since the Great Recession and the deliberate reduction in interest rates, it does not make sense to project future returns based on objectively manipulated historically low interest rates. As a testifying financial expert, I've presented testimony utilizing a total return assumption over a dozen times in the Arizona Superior Court with the majority of judges accepting my analysis. In other words, the prudent investment standard should be the total return of a diversified portfolio of Stocks, Bonds and Cash.
Also, the assumption in imputation of income to assets is that the spouse would not have to invade principal, but rather a return calculation that imputes the income that is potentially available from an asset while maintaining the asset value. Accordingly, the use of Monte Carlo simulation software can determine what a specific portfolio of stocks, bonds and cash can produce over a long period of time by determining the historic returns of this hypothetical portfolio and calculating a probability that the hypothetical portfolio can maintain portfolio value and distribute a projected amount (Monte Carlo simulations are used to show how variations in rates of return each year can affect portfolio survival results. A Monte Carlo simulation calculates the results of the plan by running it many times, each time using a different sequence of possible returns, based on actual historic ranges of returns of the proposed asset allocation. These multiple trials provide a range of possible results). By using this approach, we can with a high probability (above 95%), project the stream of payments an asset has the potential to earn, while maintaining portfolio value. The distribution rate may or may not be the actual historical total return. In one notable case recently, the judge reviewed my analysis, which showed a portfolio of approximately $4 million dollars could provide a distribution of $264,000 or a distribution rate of 6.6%. The historic rate of return used to determine that distribution rate, utilizing Monte Carlo simulation, was 6.9%. The judge accepted the historical rate of return, or 6.9% to impute income to the assets. In other cases, the judge has accepted the distribution rate, or 6.6%, in this example.
Taxes and Inflation
Currently, child support calculations in Arizona are based on Gross Earned income, not income net of taxation, or take home pay. Therefore, I conclude, taxation should not be considered in determining the potential imputed income to assets for support purposes, both child and spousal. In addition, tax rates are both manipulative and speculative. For instance, a person may be able to use municipal bonds, which are currently tax free for federal income tax purposes, and state free if issued by an Arizona entity. Also, many investment options generate tax sheltered income or possibly taxable losses that can offset other taxable incomes within a portfolio, such as real estate, oil and gas, equipment leasing, and others.
Personal spending habits could also affect tax rates on investment income, such as charitable contributions and charitable planning trusts, which provide tax deductions that could be used to offset taxable income. Most investors take advantage of tax planning strategies to reduce and manage taxes incurred on all income. It is impossible to project what rate someone will pay in the future given all the tax issues currently being discussed in congress and anticipated in the future, some of which include a flat tax, national sales tax and other deviations from our current income tax system.
With regards to Inflation, I do not assume that the income stream imputed to an asset should be annually adjusted for inflation, as I have seen from other financial experts, because it is speculative and cannot be projected based on past economic environments or future expectations. For instance, we've had periods of deflation (negative inflation is deflation) as well as inflation: 1818-21 when prices declined by almost 50%, 1830s to 1843, following the Panic of 1837, when the currency in the United States contracted by about 33%, Between 1875 and 1896, according to Milton Friedman, prices fell in the United States by 1.7% a year, The most recent period of major deflation was between 1930–1933 when the rate of deflation was approximately 10 percent/year. The current effects of the Great Recession cause more uncertainty in the global economic future and financial markets, increasing the possibility for deflation, inflation or stagflation, and each is impossible to project.
Imputing income to assets is relevant to both the supporting and supported spouse. The theory is there is potential income from every asset, even use assets such as a home. Generally, the home is not included in income imputation, but possibly should. It's a choice to purchase a home for cash vs. financing vs. renting. If a spouse rented or financed a home, those funds would be available for income. Of course, if a spouse rented or financed, their cash flow needs would increase and be included in the calculus for support from a "needs" perspective, but they would also have assets available for income to offset that need. The two issues may net out, but analysis could prove otherwise.
For instance, renting/financing a $200,000 home might cost $1,400 per month to rent/finance, or 8.4% of the value. Assuming the imputed income rate is 6%, the attorney for the supporting spouse should not assume the entire property settlement is available for imputation, but rather allocating $200,000 from the property settlement to the home (assuming that was a similar value as the previous marital home) and imputing income on the balance. In this situation, the net spousal support would be less (established support need minus imputed income from assets).
On the other hand, renting a $550,000 home might cost $2,400 per month, or 5.2% of the value, or below the imputed income rate. In this case, the attorney for the supporting spouse should assume the entire settlement is available for income imputation and the rent/mortgage payment would increase the spousal support need, allowing more assets to impute income to offset, which would result in less spousal support from the supporting spouse.
Irretrievable breakdown of the marriage, or one spouse wanting to live separate and apart, are both grounds for a legal separation.
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