Tax planning and management are already complex enough. Then comes the unexpected — phantom tax. This concept is something that not many companies and inventors anticipate, but it’s still a tax liability that you must address. Otherwise, you can suffer penalties and other unwanted consequences.
What is phantom tax? It’s the tax you pay for income that does not exist yet as cash. In most cases, this phantom income comes from investment gains, so those investing in real estate assets are most likely to encounter phantom tax.
Understanding the implications of phantom income and taxes is essential in areas like real estate investment and alternative investment strategies, such as 1031 Exchanges. That way, you can take on more proactive measures that may prevent you from dealing with tax issues. Realized 1031 has shared a guide that will help solidify your ideas on what may seem like a spectral concept. Let’s dive in.
What Is Phantom Tax?
Phantom tax is a general term for tax liability generated by phantom income. The latter term refers to any income that a taxpayer receives that hasn’t materialized into cash yet, hence the term phantom. For investors, this idea can be frustrating because you have earned income on paper but not in real life. As such, you’re getting taxed over money that isn’t in your pocket yet. It may be hard to find an additional resource just to address this tax liability, adding to the hassle.
How does phantom income occur anyway? Here are a few example scenarios where investors somehow earn extra money.
Debt Restructuring or Cancellation
One common scenario where phantom income tax occurs is when debt is canceled, forgiven, or restructured by lenders. When this happens, the forgiven amount becomes taxable income — even though you didn’t actually receive any money. You will need to pay this liability on your tax return during the year the cancellation occurred.
Non-Distributed Profits
Similarly, in partnerships and certain investment vehicles like limited liability companies (LLCs), income can be allocated to partners based on profits that are retained by the business rather than distributed. Again, this practice leads to income that the partners never actually received. Even so, they are liable to pay the phantom income. Given how these earnings are non-liquid, paying the taxes becomes a tricky situation.
Deferred Compensation
Deferred compensation is any type of compensation delayed until a specific date. This situation commonly occurs between employers and employees. In such cases, your income is recognized for tax purposes before you actually receive any cash — phantom tax, in other words.
Given these situations, it’s easy to deduce that phantom income can be unpredictable. Thus, it takes a lot of effort to plan for an expense that doesn’t actually improve your cash position.
Phantom Tax vs Other Types of Taxes
Here are the ways phantom taxes affect your cash position and other areas of investing compared to regular income tax.
Impact on Cash Flow
- Regular Income Tax: Regular income tax refers to the salary, wages, and business income that a taxpayer receives. You pay taxes based on the cash you receive, so there’s little interruption to your cash flow.
- Phantom Tax: Given how phantom income is profits you have not received, you can experience a significant cash flow crunch.
Timing of Income Recognition
- Regular Income Tax: The IRS recognizes the tax liability at the time of earning and receipt of income, which usually occurs on a current basis.
- Phantom Tax: Tax liability is more unpredictable, more dependent on the differences in the timing of expenses and revenues.
Complexity
- Regular Income Tax: More concrete and predictable. It’s easier to plan around regular income tax because things are relatively straightforward.
- Phantom Tax: Hidden tax issues are harder to find and require proper analysis and in-depth knowledge of business transactions or real estate investments.
Non-Cash Transactions
- Regular Income Tax: Regular income tax doesn’t usually apply to non-cash transactions. Your tax liability remains closely tied to the actual cash you received.
- Phantom Tax: Phantom tax comes from income that’s usually non-cash, such as the aforementioned debt forgiveness and deferred compensation. As such, the disconnect between the income and actual cash flow complicates tax planning.
How Does Phantom Tax Work
Here are the mechanics that result in a shadow or phantom income, which then results in phantom tax.
1. Income Recognition
This is the first stage where tax laws require specific forms of income to be accounted for. It won’t matter whether the taxpayer received the income in cash. The main determining factor that determines phantom income is if the taxpayer earned the income or was vested in it.
2. Tax Liability
Once the income is recognized, it becomes part of the taxpayer’s gross income during that tax year. As such, their taxable income increases and by extension, the tax amount they have to pay to the IRS.
3. Payment Without Extra Cash
Now that a taxpayer has a tax liability, they must file within the tax year and pay their dues. Things get tricky because even though there’s recognized income, the taxpayer doesn’t get any cash. As such, financial management becomes necessary to reduce the strain on cash flow.
Phantom Tax in Real Estate Investment
In real estate where tax deferrals and debt forgiveness are not uncommon, phantom tax becomes a looming presence that haunts investors. Knowing the scenarios where such liability can occur helps you manage your cash flow and potentially avoid situations where you’re short on funding to fulfill tax obligations.
One common example of phantom income is during debt forgiveness, as we outlined above. In the real estate industry, this may happen when an investor’s property is underwater and the lender agrees to forgive a portion of the debt. The forgiven amount is taxable according to the IRS.
Any form of debt forgiveness will result in phantom income, such as the following:
- Short Sales
- Loan Modifications
- Deeds in Lieu of Foreclosure
- Bankruptcy Discharge
Another area where phantom tax affects real estate investors is in the allocation of rental income and expenses in partnerships. These include real estate investment partnerships (REIPs) or limited liability companies (LLCs). Even if the partnership does not distribute all its profits to investors, the income is still taxable to the individual partners based on their share of the profits. Each investor may need to pay taxes on the income retained within the partnership for reinvestment.
Does Phantom Tax Occur in a 1031 Exchange?
A 1031 Exchange is the swap of a like-kind property for another, allowing the property owner to defer taxes. While 1031 exchanges are a powerful tool for tax deferral, they can also inadvertently trigger phantom tax issues if not managed carefully. Here are certain scenarios where you may earn phantom income liable to taxation.
- Property Value Shortfall: When investors do not acquire equal or greater property value in their exchange, the shortfall could be considered taxable boot. In particular, this boot will be taxable as capital gains. We still consider this as a phantom tax because it’s a tax liability that arises from a transaction that hasn’t generated any cash flow yet.
- Depreciation Recapture: The depreciation recapture amount — which is the amount the IRS taxes when you sell a depreciated property at a profit — is considered phantom tax. Although a 1031 exchange defers capital gains tax, it does not eliminate the depreciation recapture tax. This liability can come up when you sell the property outside of a 1031 Exchange. In this situation, you’re essentially getting taxed on previously deducted depreciation. We can consider this phantom income tax since it represents tax liabilities on income that was never actually realized as cash.
- Zero-Coupon Investments: When investors need to acquire highly leveraged property to meet the requirements of their 1031 exchange, they often use zero-coupon investments as a way to acquire maximum property value for minimum equity. Although these investments are an effective tool for an exchange, they do not generate a current distribution for investors since all of the property-level income is used to pay debt service. Phantom income tax in this scenario is driven by the loan principal paydown that occurs despite not receiving income to pay that tax.
Impact of Phantom Tax on Cash Flow and Investment Returns
Given how you need to pay income taxes on money you don’t have, phantom tax can affect key financial areas.
Cash Flow Crunch
Investors must pay taxes on income they haven’t received, leading to a cash crunch. If you don’t have enough when income from partnerships or forgiven debts trigger tax liabilities, you may need to find another source, such a loan or another asset that’s more liquid. You may even have to tap into your personal funds to take care of the liability.
Reduced Investment Returns
One area where you could find additional funding to pay phantom tax is other investment property income. If you choose this route, you will end up eating into your profits. The investment may look good on paper, but you’re receiving an amount that’s significantly lower than what was projected.
Unpredictable Finances
Phantom tax is often unpredictable, making it difficult to plan cash flow and returns accurately. As we showed in our comparison above, regular income tax is perfectly predictable since you pay the tax for the cash you received. Phantom tax — on the other hand — complicates financial planning since it can arise from timing differences in recognizing income and expenses.
Creates a Need for Reserve
One strategy that some investors use is to maintain cash reserves to cover phantom tax liabilities. While this proactive approach does help mitigate the possibility of a cash crunch, creating a reserve still requires setting aside funds that could have been used for new investments and other expenses.
Strategies To Mitigate Phantom Tax
Given the impact of phantom tax on your cash flow and revenue, it’s important to have ways to manage it. Here are several strategies you can take to minimize the impact of phantom tax on your finances.
Utilize Tax-Deferred Investment Vehicles
Investing in tax-deferred investment vehicles like 1031 Exchanges and Delaware Statutory Trusts (DSTs) can serve as an effective strategy for phantom tax. Through these approaches, you can defer taxes on capital gains and reinvest them on another asset. Although 1031 Exchanges and DSTs don’t eliminate phantom tax entirely, they do push the tax liability further down the line. This added time helps you plan and manage your finances. If done right, this strategy potentially gives you enough funding for phantom taxes like depreciation recapture.
Maintain Cash Reserves
The age-old advice of saving for rainy days becomes even more relevant for investors who are facing the possibility of phantom tax. Maintaining cash reserves is one of the most straightforward strategies to handle phantom tax liabilities. Having dedicated funds for the potential tax bills provides an added shield from the cash crunch.
At first, the cash reserve may feel like an opportunity cost. However, having this cushion helps you avoid scrambling for cash during unexpected moments. You won’t also have to liquidate investments during ill-timed moments.
Use of Losses To Offset Phantom Income
Tax-loss harvesting is the use of losses to offset capital gains taxes and other forms of phantom income tax. This strategy can also work on phantom income. For example, investors can use passive activity losses to offset the taxable income from phantom income. Not only does tax-loss harvesting help reduce your overall tax burden, but it also allows you to align tax liabilities closer to your actual cash flow. Even so, you need to carefully balance the losses and tax liabilities to ensure that your overall investment strategy remains sound.
Using Installment Sales for Large Transactions
Installment sales are another management strategy that provides some cushion against considerable phantom tax liabilities. While this approach doesn’t take away phantom tax entirely, installment sales can help spread the recognition of income over several years. This advantage helps reduce the immediate impact of phantom tax, so you won’t have to pay a huge lump sum in a single tax year.
Working With Tax Professionals and Financial Advisors
It’s always a practical idea to engage with finance and tax experts to navigate your way around phantom tax planning. These professionals can spot potential phantom tax triggers and prepare strategies that can help you minimize liabilities. For new investors, these experts help with techniques like optimizing depreciation schedules or restructuring partnership agreements. Finally, regular consultations with financial advisors and tax experts can help you stay informed on the latest news and changes in tax laws, allowing you to make more confident decisions in the future.
Legal and Tax Implications of Phantom Tax
Phantom tax may create a cascade of complex scenarios that even seasoned investors may not know how to handle. Here’s a closer look at some legal and tax considerations you’ll want to keep in mind.
IRS Compliance
Given how phantom tax is a tax liability, failure to file and pay to the IRS can result in fines, interest on unpaid taxes, and other legal consequences. You may find it hard to keep track of phantom tax, so it’s crucial to have your accountant or other tax professional help you navigate the intricate rules and ensure you’re able to report non-cash income.
Estate Planning Impact
Phantom tax may also affect estate planning. One example is when an estate has an asset that generates phantom income. In such a case, the estate may be liable for taxes on income that the beneficiaries haven’t actually received. This can complicate estate settlements, especially if the estate lacks liquid assets to cover the tax bill.
As a workaround, you can consider strategies like setting aside reserves or restructuring assets to reduce the impact of phantom income on your estate. Proper planning can help minimize the tax burden on your heirs and preserve more of the estate’s value.
Investment Strategy Impact
The need to find additional cash to pay the tax liability can disrupt your overall strategy. You may need to liquidate some assets during an inopportune time just to have enough funding to pay for the phantom tax.
If you do opt for the aforementioned strategies like DSTs and 1031 Exchanges, these approaches have their own set of legal requirements and complexities that you must adhere to. Failing to structure these transactions correctly can result in losing the tax benefits and facing immediate phantom tax liabilities.
Wrapping Up: All You Need To Know About Phantom Tax
Phantom tax is the ghostly tax liability that emerges where you least expect it, turning into an obligation that you have to address even if you don’t have cash to pay for it. As such, it’s important to stay aware of the situations where phantom income can emerge. You should also work with tax and finance professionals to design and execute strategies that mitigate the effects of phantom tax. That way, you can remain confident with your investment decisions and never be spooked by what may be lurking in the future.
For more details about phantom tax, 1031 Exchanges, and related topics, contact Realized 1031 today.
Sources
https://www.investopedia.com/terms/p/phantom-income.asp
https://www.irs.gov/taxtopics/tc431
https://www.investopedia.com/terms/d/deferred-compensation.asp
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
https://www.investopedia.com/terms/t/taxgainlossharvesting.asp
