Income is good. So more income must be better, right? That’s usually true, but not always. The issue is in recognizing and appreciating the difference between “income” and “cash flow.”
Those of you who have taken my online video course will remember this graphic from Lesson 10:
Remember that when we analyze an income property we start off by taking all of its revenue and subtracting out all of its operating expenses. That’s gives us its Net Operating Income. NOI is useful for a number of reasons, not the least of which is that it gives us a nice level playing field – one that is independent of financing and taxes – where we can compare the performance of different investment properties.
But then our analysis branches off into two directions. One branch will tell us how much taxable income we’re likely to generate, while the other will project our cash flow before taxes. It is here, in the differences between these two branches, that the dreaded Phantom Income may rise from the crypt.
Before we get too deep into the weeds, generally speaking what is phantom income and why do we care?
In short, our phantom represents income on which we’re going to have to pay taxes but where we didn’t actually get cash in hand with which to pay those taxes.
How can that happen?
There are several ways, but perhaps the most common as it relates to an income-property investment is revealed by the graphic above. Our cash flow is reduced by the full amount of our debt service, i.e. our mortgage payments, but our taxable income is reduced by just the interest portion of those payments. Early in the life of a mortgage, our payments are mostly interest, so the difference may not be all that great. And besides, we also have a non-cash deduction for depreciation* that will usually more than offset the non-deductible principle portion of our debt service.
As time goes on, however, and the mortgage becomes “seasoned,” we find ourselves with less and less deductible interest and more and more non-deductible principle. Eventually, we can’t hide behind our depreciation deduction any longer to make up the growing difference. Our taxable income – and therefore the amount of money we need to pay our taxes – grows faster than our cash flow, and we may find ourselves with more tax liability than cash flow needed to pay it. The Phantom strikes.
There is another common situation where we might find ourselves haunted by phantom income, and that is as a partner in a pass-though entity. Imagine that we have a 10% interest in a real estate partnership. We receive our end-of-year form K-1 showing that we must report 10% of the partnership’s income on our tax return; but the managing partner or sponsor has decided to keep some or all of the cash in the partnership this year rather than distribute it to the partners. As in the previous scenario, we have taxes to pay, but they exceed the amount of cash we received.
What can we do about the specter of taxable income in excess of cash flow? In the first example, maintain timely and accurate tracking of your property’s financials so you know where you stand and won’t be taken by surprise at tax time. Another strategy might be to refinance, and put the proceeds toward acquisition of another property. In the partnership case, understand the managing partner’s plans for distributions, and perhaps be cautious about entering into deals where distribution plans are not articulated clearly.
Remember, there is nothing supernatural about phantom income; it’s a fact of investment life.
— Frank Gallinelli
* If you’re unfamiliar with depreciation, this is it in a nut shell: You can generally deduct the cost basis of your investment property over time — over 27.5 years for residential property and 39 years for non-residential, according to current rules. The cost basis includes the buildings but not the land. When you sell, the depreciation taken may be recaptured. These are the highlights; there are more details, as your CPA will be happy to explain.
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