subject: More On Unexpected Phantom Income Tax Gains [print this page] This can crop up in the form of theoretical mark to market capital gains, forgiveness on a bank or credit card loan, or gains related to deductions decreasing over time. This situation can cause "taxable income" to increase even though your net income remains the same.
An example of mark to market gains is a gain on an investment, such as a property or financial asset in which there is an unrealized gain. The IRS requires that an investor pay taxes on unrealized gains in certain investment vehicles, regardless if the investor actually received cash on that specific asset. This occurs within many types of futures and over the counter financial markets, where there is a perceived value of the instrument on the last day of the year, which requires a ordinary income or capital gains tax payment, if the position associated with the financial instrument that is in the money.
An example of a real-estate "Phantom Income Gain" can come on a short sale if you are underwater on a property.
For example, say you decided that you can no long continue to make mortgage payments on a home or business that cost 1 million dollars, where you still owe the back 500 thousand dollars and the agreed upon sales price is 900 thousand dollars. If the bank agrees to forgive 100 thousand dollars of the loan, this amount can be considered phantom income. In this case, the IRS could potentially ask you for a tax payment on the 100 thousand dollars that was forgiven. This could also occur for debt associated with a credit card loan or a car loan.
A third way phantom income could arise is within gains on real-estate, that are associated with diminishing deductions and depreciation. If a mortgage on a home or a condo that is used to generate rental income is a 30 year note, the interest expense in the first year will be a lot higher than the interest expense in year 20 and 30. As interest on a note moves lower and the principal payments move higher, the amount that can be deducted to determine the taxable amount, will diminish. If the revenue received on a rental property is a fixed amount, then as the years go by, you will reach a point where the revenue will not exceed the combined liabilities as your taxable income rises, and the outcome will be a cash flow loss.
There are a number of solution to work around these issues. One could be to incur a unrealized loss in the year that you have a phantom income gain. Another would be to re-finance a real-estate investment, which will allow you to use a new interest rate on a longer term loan to recreate a new interest expense. If the property is an investment property, you could sell at the time when the investment begins to create a negative cash flow situation.
by: Trail Potter
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