As an investor, you should be consistently on the lookout for issues that might cut into your wealth, as well as those that could increase your tax burden. One such issue that could have an affect on both of these things is known as phantom income.
The good news about phantom income is that it can be relatively rare. The not-so-good news is that you’re being taxed for something you might never receive. This can put a burden on investors.
Income That Isn’t There
Phantom income is “phantom” because it doesn’t materialize as cash in your portfolio. Despite this, phantom income can be taxed by the Internal Revenue Service (IRS).
Phantom income most often becomes a problem for shareholders in “pass through” entities such as partnerships, LLCs, and S corporations. When an entity doesn’t distribute its profits to each individual partner, and the profits are instead rolled over into the company’s retained earnings, those profits could be deemed taxable at the individual taxpayer level.
For example, imagine you own 20% of a partnership that reports $500,000 of income for a given year. Instead of receiving your rightful share of the proceeds, the partners agree to reinvest the funds into the business to grow its balance sheet. Although no funds were constructively received on your part, you will still be liable for taxes on the income allocated to you on the partnerships Schedule K-1, which would be $100,000 in this scenario.
The moral of this story is to find out what a company is planning to do with its profits, before you invest in it.
Horror Stories in Real Estate
Perhaps you aren’t a shareholder. Maybe your investment sweet spot is real estate. You like the potential cash flow, as well as being able to deduct interest expense off your annual tax returns, given that there is debt financing on the property. But, phantom income could haunt you here, as well, putting a burden on income tax owed.
Debt Amortization and Depreciation. Consider two cash flow metrics when assessing rental property:
- Net Cash Flow: Net cash flow is the difference between the rental income received less total cash outflows which include operating expenses, debt service (interest + principal), property taxes, insurance and repairs.
- Taxable Income: Taxable income is the difference between the rental income received less operating expenses, mortgage interest, property taxes, insurance and repairs. One may also deduct depreciation from rental income to lower taxable income when available.
Note that the main difference between these two calculations is that taxable income only deducts mortgage interest, while also writing off depreciation. So what happens towards the end of an amortizing loan’s term when principal payments have ramped up in comparison to interest payments, and there’s little to no depreciation left to claim?
In the scenario that principal payments exceed interest and depreciation deductions, net cash flow will actually be less than what the IRS considers to be taxable. In other words, the taxpayer is getting taxed disproportionately to what he or she constructively received. This is where phantom income reveals itself.
Opportunistic Debt. During the recent economic downturn, you might have acquired a distressed real estate note from a lender. With this note, your plan is to foreclose on the borrower in order to obtain a fee interest/ownership in the asset. That foreclosed property could, however, generate phantom income, thanks to the asset’s fair-market value. For example, you acquire a distressed property note for $5 million from a lender. If the asset to which that note is attached has a fair-market value of $5.5 million, the IRS treats that extra $500,000 as taxable income. Assuming a marginal tax rate of 35%, you now owe $175,000 on “income” you don’t have.
Forgiveness or Cancellation of Debt. On the other side of the coin, maybe you, a borrower, fell on some hard times, and you owe the lender $5 million. The lender, being nice, agrees to forgive, or cancel, $500,000 of that debt. Though you’re only on the hook to the lender for $4.5 million, the IRS will treat that $500,000 as taxable income.
Ghost-Busting Phantom Income
As mentioned above, phantom income is a rare, but very real, occurrence. As a real estate investor, you might want to alter or reconsider your strategies to reduce your taxable income, and to ensure phantom income doesn’t mean a huge shock when seeing your income tax return.
At Realized 1031, we understand the tax implications of phantom income, and will work with you to solve issues that might arise from this concept. Although we do not provide tax or legal advice, call us today at 877-797-1031 for help in making the right choices when it comes to your real estate investments.