Firm Articles

Phantom Gain

by Arthur J. McDaniel

In a recent article1 , Celia Chen, Director of Housing Economics for Economy.com, Inc. listed some of the over heated real estate markets in the United States. Her definition for over heated involved the comparison of the median housing cost to the median income for the area. That ratio is still within its traditional range in most of the country, but is much larger in certain regions, among which is the Riverside-San Bernardino-Ontario area. Ms. Chen listed several reasons, including low interest rates, alternative mortgage products, and investor demand -- the latter factor accounting for perhaps 20% of the mortgages. It is the investor demand, which makes it so difficult for developers to plan, because at the first sign of weakness in the market the investors will leave.

Several scenarios can occur when demand leaves an overheated market: real estate development or investment partnerships will have unsold projects or over-mortgaged projects, especially if funds had been distributed rather than applied to the reduction of debt; homeowners or landlords may have refinanced at the appreciated valuation and may now have to sell. In that circumstance, the possibility of “phantom gain” arises.

Let us look at an example. Suppose an investment partnership purchased a $100,000 building several years ago for 20 percent down. During the last few years, the building had appreciated so the partnership refinanced it to 80 percent of its $500,000 appreciated value and distributed the excess funds to the partners. With the decline in the market, and perhaps a lost tenant, the lender foreclosed on the building and then resold it for $450,000. The partnership receives nothing. However, the partnership has realized phantom gain to the extent that the mortgage of $400,000 exceeded its basis (ignoring depreciation) of $100,000. This gain of $300,000 is taxable to the partners. This example may already be familiar to many investors.

Take the same example as a home purchased by an individual. The rules for excluding gain on the sale of a principal residence still require the single homeowner to recognize $50,000 of long-term capital gain.
 
Another situation that can arise occurs if a partnership or individual has sold property on the installment basis. Assume the owner has sold it on the installment basis for $500,000 accepting $50,000 as a down payment and a note with adequate stated interest for $450,000. Assume the basis of the property is $350,000. After one installment, the seller has received $100,000, and the buyer deeds the property back because it has declined in value to $250,000. What happens on the reacquisition? Phantom Gain happens. According to the Internal Revenue Code, when a seller reacquires real property in satisfaction of the debt secured by that property, the seller recognizes gain to the extent the total cash received exceeds the amount of gain recognized before the reacquisition, limited to the amount of remaining gain. In this example, the seller received $100,000 before the reacquisition, and reported $30,000. The seller has to recognize an additional $70,000 in gain because of the reacquisition. The seller’s basis in the reacquired property will be its basis in the buyer’s note immediately before the reacquisition, $280,000, increased by the amount of gain recognized because of the reacquisition, $70,000. The seller is left holding the same property, now worth $250,000, with a basis of $350,000. This situation could be different if the seller reacquired their former principal residence. In that circumstance, there would be no gain recognized if the seller used the exclusion rules on the original sale and then resold the property within one year because the rules treat the resale as part of the transaction constituting the original sale.

DISCLAIMER

As provided in Treasury Department Circular 230, this article is not intended or written by Lobb Cliff & Lester, LLP to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

1. Economy.com, Inc., U.S. Housing Market: The Never-ending Party, July 28, 2005

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