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From November 2006
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Phantom Income
When I first heard the esoteric term phantom income, images of a ghost in a French opera house crying, “Christine, Christine!” ran through my head. But I was in a business meeting in Sacramento, not a Broadway theater in New York. For those who experience phantom income, the concept and its implications are very real.
Defining phantom income is simple enough: It is reportable or taxable income that does not generate cash flow. Understanding how phantom income occurs takes a little more effort. But the effort is worthwhile, since the concept can affect several types of people, including investors, business owners and real estate owners.
Investments
The simplest example of phantom income is that of zero-coupon bonds. Backed by the full faith and credit of the issuer, these securities are offered at a deep discount to the investor, and they mature at face value. Also known as “STRIPS,” these bonds are ideal for investors who are not in need of present income but instead want their money to grow and accumulate until a particular date.
For instance, let’s say you buy a zero coupon bond for $50 with a face value of $100, with a maturity date 10 years from now. The bond is worth more than you paid for it every year because of accrued interest, but you have to pay tax on this interest just as if you received a check — even though you don’t actually receive the interest until the bond matures.
Business Owners
It is not uncommon for business owners to tap into cash reserves or explore other sources of funding just to pay Uncle Sam, and the reason why is phantom income.
Owners and members of “pass-through” entities such as partnerships and limited liability companies especially may feel the effects of phantom income, since they are often personally responsible for paying the tax on their portion of the business’ income.
So how does a business end up with high taxable income but little cash to pay tax estimates? A simple reason may be the method of accounting the business is using.
If companies are on the accrual method of accounting, income is recorded when it is earned, rather than when payment is actually received. This leads to the business looking great on financial statements, but not so great on the bank statements.
Another reason may be a buildup of cash reserves. It is a good thing when business owners put cash aside for a “rainy day” fund, or for a possible expansion or equipment purchases. The downside is that the cash is not available for use, but it is still taxed as income, since it was set aside from business operations. Phantom income can also crop up or worsen when tax deductions are reduced and taxable income is high. This is the situation when a company has a lot of nondeductible expenses, such as payments for officers’ life insurance policies or meals and entertainment expenses (only 50 percent of business entertainment expenses are now deductible).
Real Estate
That new, impressive retail center with plum tenants you pass on your way to work every day may indeed be profitable, but the real estate owner may still be experiencing a money crunch. How? If a large part of the cash flow from tenants is being used to pay down principal debt, there may not be enough cash left over to cover other real estate expenses, since only the interest portion of debt payments is deductible.
Another way phantom income can surprise a real estate owner is when a lender puts a “lockbox” stipulation on a property. This is a typical provision in nonrecourse loan documents that is triggered when a major tenant vacates a property unexpectedly, allowing the lender to sweep all rent payments into the lockbox until a new tenant is secured for the property.
Linda Bak, co-founder of Private Equity Group in El Dorado Hills, cautions her clients to read all loan provisions before investing in a tenants-in-common property, because if a lockbox clause is triggered, “owners will still have to show the rental income from the property on their tax return, even though the income from the property is in the lender lockbox and not their own pocket.”
Concludes Bak, “Whether it’s real estate, investments or running a business, phantom income is not a term that should scare you; it’s just something you need to be aware of and be prepared for when tax season arrives.”
Nicole M. De Santis is exchange counsel for First American Exchange Company, a 1031-qualified intermediary in downtown Sacramento.
Serious Spectar at Tax Time
By Nicole De SantisWhen I first heard the esoteric term phantom income, images of a ghost in a French opera house crying, “Christine, Christine!” ran through my head. But I was in a business meeting in Sacramento, not a Broadway theater in New York. For those who experience phantom income, the concept and its implications are very real.
Defining phantom income is simple enough: It is reportable or taxable income that does not generate cash flow. Understanding how phantom income occurs takes a little more effort. But the effort is worthwhile, since the concept can affect several types of people, including investors, business owners and real estate owners.
Investments
The simplest example of phantom income is that of zero-coupon bonds. Backed by the full faith and credit of the issuer, these securities are offered at a deep discount to the investor, and they mature at face value. Also known as “STRIPS,” these bonds are ideal for investors who are not in need of present income but instead want their money to grow and accumulate until a particular date.
For instance, let’s say you buy a zero coupon bond for $50 with a face value of $100, with a maturity date 10 years from now. The bond is worth more than you paid for it every year because of accrued interest, but you have to pay tax on this interest just as if you received a check — even though you don’t actually receive the interest until the bond matures.
Business Owners
It is not uncommon for business owners to tap into cash reserves or explore other sources of funding just to pay Uncle Sam, and the reason why is phantom income.
Owners and members of “pass-through” entities such as partnerships and limited liability companies especially may feel the effects of phantom income, since they are often personally responsible for paying the tax on their portion of the business’ income.
So how does a business end up with high taxable income but little cash to pay tax estimates? A simple reason may be the method of accounting the business is using.
If companies are on the accrual method of accounting, income is recorded when it is earned, rather than when payment is actually received. This leads to the business looking great on financial statements, but not so great on the bank statements.
Another reason may be a buildup of cash reserves. It is a good thing when business owners put cash aside for a “rainy day” fund, or for a possible expansion or equipment purchases. The downside is that the cash is not available for use, but it is still taxed as income, since it was set aside from business operations. Phantom income can also crop up or worsen when tax deductions are reduced and taxable income is high. This is the situation when a company has a lot of nondeductible expenses, such as payments for officers’ life insurance policies or meals and entertainment expenses (only 50 percent of business entertainment expenses are now deductible).
Real Estate
That new, impressive retail center with plum tenants you pass on your way to work every day may indeed be profitable, but the real estate owner may still be experiencing a money crunch. How? If a large part of the cash flow from tenants is being used to pay down principal debt, there may not be enough cash left over to cover other real estate expenses, since only the interest portion of debt payments is deductible.
Another way phantom income can surprise a real estate owner is when a lender puts a “lockbox” stipulation on a property. This is a typical provision in nonrecourse loan documents that is triggered when a major tenant vacates a property unexpectedly, allowing the lender to sweep all rent payments into the lockbox until a new tenant is secured for the property.
Linda Bak, co-founder of Private Equity Group in El Dorado Hills, cautions her clients to read all loan provisions before investing in a tenants-in-common property, because if a lockbox clause is triggered, “owners will still have to show the rental income from the property on their tax return, even though the income from the property is in the lender lockbox and not their own pocket.”
Concludes Bak, “Whether it’s real estate, investments or running a business, phantom income is not a term that should scare you; it’s just something you need to be aware of and be prepared for when tax season arrives.”
Nicole M. De Santis is exchange counsel for First American Exchange Company, a 1031-qualified intermediary in downtown Sacramento.
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