What You Need To Know About Unexpected Phantom Income Gains

Real estate investors are amidst the year-end scramble for a myriad of reasons. As an aforethought, it is wise to take a perfunctory look at one’s financial portfolio to be aware of what opportunities, advantages, and dangers lie ahead. For most, knowing the gains, losses, legal and tax implications of each assist in decision-making for the short and long terms. How to prepare for the unexpected phantom income gains will serve many, whether part of an LLC or Sub-Chapter S Corporation. There are more specific implications for those holding distressed commercial property or relinquished property due to short sale, foreclosure, or deed in lieu.

Phantom income arises when there is debt restructuring within a corporation which brings about tax liability void of cash flow. For property owners who purchased with leverage and face not only negative equity but an inevitable release of the building or land, the excess amount over what the lender has agreed to forgive is deemed a taxable gain, referred to as phantom income. As daunting as this scenario may seem, there is a way to circumvent the potential loss created by the “gain”.

By taking into account the current conditions and undervalued markets at large,  investors best option is to utilize the benefits inherent in a 1031 exchange by relinquishing the current distressed property and trade up to one that offers more cash flow. A lofty suggestion? The common sense is in the details. Financial forecasts and indicators show recovery in the commercial sector may not be realized for a few years. Typical advice is to buy-and-hold. By instituting this same modality, it offers a delay or removal of the phantom income gain, depending on the investment property chosen for the exchange and its ongoing performance. Let’s examine the idea from the lender’s perspective.  They are about to take back your property with nothing in return; add it to the thousands of others they have on their books. More than likely, the property needs improvements, needs tenants, and a Buyer who would be willing to pay more for it than it’s CMV. By engaging in a 1031 exchange, the lender gains an opportunity. Here’s how it works.

For example’s sake, it is recommended that you elect to purchase a property via 1031 exchange that has 5-10 percent more value than your current property’s debt. The downpayment needed to purchase this property could be derived from your other assets to be used as collateral. Information from an article posted on realpropertycheck.com entitled “Negative Equity and How You Can Avoid Tax on Phantom Income from Relinquished Property”, details the benefits of using a Qualified Intermediary in this process. “You convey the property you want to relinquish to a QI before foreclosure. The lender then forecloses on the property, now owned by the QI, or accepts the deed in lieu of foreclosure.” As long as you can make a strong case to your lender about the better value and cash flow of the property designated for acquisition through the 1031, the lender should see the upside.

Always heed the advice from tax and legal experts before acting on any investment matter. Phantom income gain is a hidden oxymoron--ignoring its consequences guarantees a loss.