Beware of Phantom Income
Real Expenses vs. Phantom Expenses
As a real estate investor, it is essential to know the difference between a real expense and a phantom expense. An investor might think a $1,000 roof repair is a good thing since he or she can deduct it as an expense. What if you never had to make that repair in the first place? You would have $1,000 of taxable income in your pocket. Being taxed isn’t automatically a bad thing, since that means you are making money on the property.
What is a Phantom Expense?
Depreciation is the perfect example of a phantom expense since it allows an owner of real estate to recover the value of the building against rental income. The IRS allows a deduction for the decrease in value of your property over time, irrespective of the fact that most properties never really wear out. Simply put, depreciation allows you to write off the buildings and improvements over a prescribed period of time, providing a “phantom expense” that is used to offset rental income.
Residential real estate and improvements are depreciated over a 27.5 year period. Commercial real estate and improvements are depreciated over 39 years.
In addition to a depreciation deduction, the Internal Revenue Code allows for the interest portion of a mortgage payment to be deducted for income tax purposes. The principal portion of a mortgage payment is treated as taxable income or “phantom income“.
During the initial years of a typical mortgage loan, the principal reduction (debt amortization) is normally offset by depreciation deductions and interest expense, decreasing taxable income. In the later years of a typical loan amortization, principal reduction will exceed interest expense and depreciation, thereby increasing taxable income and generating a seemingly disproportionate tax liability (the dreaded phantom income).
Disposition of a Property
A taxpayer may incur phantom income upon disposition of a property. Phantom income is triggered when taxable income exceeds sales proceeds upon the disposition of real estate. Usually, this results from prior deductions based on indebtedness. You may have deducted losses and/or received cash distributions in prior years that were greater than your actual investment made in the property. If you are planning to dispose of a property and believe you are in this situation, there are strategies to minimize the tax impact including IRC 1031 exchanges, which are discussed in my blog Understanding IRC Code Section 1031 and why you should care.