Any prudent commercial real estate investor will take into consideration the tax implications as an important part of his or her investment analysis. The majority of commercial real estate investments come with some favorable tax benefits in the form of depreciation and interest expense, both of which are tax deductible. However, for many investments, the tax implications can be far more complicated and may be extremely unfavorable to an investor. The culprit is often known as Phantom Income and occurs when the IRS determines that the taxable income exceeds the “actual” income to the investor.
Generally speaking, Phantom Income can occur in three scenarios:
- Debt Amortization – In addition to depreciation, the IRS allows for the interest portion of the mortgage payment to be deducted for tax purposes; however, principal reduction is treated as taxable income. In the initial years of a typical mortgage loan, the principal reduction is typically more than offset by depreciation and interest expense, thereby greatly reducing the taxable income and often creating a taxable loss.
In the later years of a typical amortization schedule, principal reduction will exceed interest expense and depreciation, thereby increasing a borrower’s taxable income and generating a seemingly disproportionate tax liability. In cases of investments that generate minimal Cash Flow After Debt Service, such as Credit Tenant Lease (“CTL”) Financing, typically the cash flow will eventually become insufficient to pay the borrower’s tax liability.
- Opportunistic Debt Acquisitions – Often, especially during down economic cycles, investors will seek to opportunistically acquire loans (typically distressed loans) from lenders who need to get the loans off their books. Typically these investors’ objective is to foreclose on the borrower and obtain the fee interest in the property. However, this strategy can create significant taxable income without the benefit of the associated cash flow.
If an investor were to acquire a note for $3mm and subsequently foreclose on a property with a Fair Market Value (“FMV”) of $3.5mm, the investor would be subject to $500,000 of taxable income or a $175,000 tax liability ($500,000 gain x 35% marginal tax).
- Forgiveness/Cancellation of Debt –Rather than selling a distressed borrower’s note, a lender will often choose to work with the borrower and forgive or cancel a portion of the debt. Similar to the example above, a decrease in indebtedness is treated as taxable income. For example, if a borrower owes $3.5mm and a lender reduces the principal balance to $3mm, the borrower would be subject to the same $500,000 as above and incur a tax liability.
As illustrated in the examples above, Phantom Income can be particularly precarious in that the taxable income does not come with “actual” income in the form of cash flow to cover the tax liability. Often, investors have taxable losses from other investments to offset the effects of Phantom Income. Our team at Metropolitan Capital Advisors is experienced in working with a wide range of commercial real estate loans and in identifying potential risks. Please contact any of our seasoned professionals to help you identify such potential risks in your investments.
The author, Brandon Wilhite, is a Senior Director in the Dallas office of Metropolitan Capital Advisors. Brandon can be contacted at firstname.lastname@example.org