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Beware of Phantom Income

Updated: Dec 8, 2023

What is phantom income? It's income, but you might not feel like you gained anything, even though your tax bill says otherwise. It can come in different forms. Perhaps you sold an appreciated stock towards the end of a tax year, only to buy another which rapidly declined in value the next year. You owe tax currently, even though your current overall economic position potentially worse. It's basically a timing difference, but it can have dramatic effects in certain situations. Provisions in the tax code allow for accelerated depreciation deductions, but it is also important to plan for when it is time to sell.

Bonus depreciation sounds great, right? You get to deduct the full amount of business asset the year it is placed into service. Perhaps you even borrowed money to purchase this asset. This seems like a great deal. Oftentimes, it is. You purchase something, deduct it and get huge tax savings right away. But what happens when it is time to sell the item?

For example, take a business vehicle. You purchase it from the dealer, finance it, and deduct it the year you place it into service. Effectively, the bank is financing this deduction. A couple years go by and you decide to sell the vehicle. You use the proceeds to pay off the loan, perhaps you still have some cash left over. You sold the asset for way less than what you originally paid. But, since the vehicle is fully depreciated, you need to recognize gain. This is §1245 recapture of depreciation and it can sneak up on business owners who don't plan for it.

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