What You Need To Know About Unexpected Phantom Income Gains

What You Need To Know About Unexpected Phantom Income Gains

Phantom income refers to an allotment of money that one does not necessarily see, but which is taxable. It is reported as part of a person’s income though one may not see the cash flow connected with the reported income. There are several examples of phantom income, one of which is income received from zero coupon bonds. These are bonds sold at a very low discount compared to the bond’s face value. Over time, this bond appreciates in value and finally reaches its face value.

Phantom income also commonly results from foreclosure. Foreclosure rates have risen dramatically over the past few years. Many foreclosed owners are dealt a second blow when they realize that they owe a significant gains tax as a result of foreclosure. People who walk away from homes with adjustable mortgages reset to higher rates find themselves owing more than their home is worth. How the gain will be handled will depend on whether the mortgage is perceived as a recourse or non-recourse debt.

If the lender forecloses on a non-recourse mortgage, the homeowner is considered to have sold the home for the exact amount of the outstanding mortgage. The difference between the homeowner’s adjusted base in the house and the outstanding debt is considered a loss or gain on the sale of the home. If the debt is recourse, such as a refinanced mortgage or a non-purchase money mortgage, foreclosure may result in cancellation of debt income and/or a gain in the sale of the home. The difference between the homeowner’s adjusted basis and the home’s fair market value will result in a loss or gain on the sale of the home. If the outstanding debt surpasses the fair market value of the property, the amount is considered cancellation of debt income. When the loan is canceled or forgiven, it becomes income because the buyer will not repay it. Homeowners with forgiven or canceled debts will be required to pay state and federal tax on the canceled amounts, at ordinary income tax rates.

Tax on phantom income is due whether the lender forecloses on the debt, or allows a short sale (where the defaulter is allowed to sell the house below cost). A short sale is better than a foreclosure in the sense that it is less damaging to the homeowner’s credit rating. However, debt relief is considered income since the bank gave the owner cash to buy the home when the mortgage was issued. This income will be taxed at normal rates.

There are various options available for people caught in such situations. The homeowner could file bankruptcy. Debts discharged through bankruptcies are usually not regarded as debt cancellation income. The other option is claiming insolvency. Tax will not be levied on the phantom debt cancellation income if you can prove insolvency existed at the time of discharging the debt. You must prove that the total of assets was less than the total of debts.