Is “phantom income” taxable if the property was homesteaded by the owner? This is shaky ground. Some people attempt to discover the answer to this question on a state-to-state basis, but in fact, it’s covered in The Mortgage Forgiveness And Debt Relief Act. Sometimes it feels like the IRS is out to get everything we own. Having a little assurance that we’re not being cheated is absolutely necessary in today’s economy.  To have a little background on this, let’s explore the actual meaning of this ambiguous question.

Broadly defined, the Homestead exemption allows homeowners to protect their principal residence from creditors or property taxes. This is, of course, the broadest definition of the term, but it will serve our purposes. How is it legal for the IRS to collect tax on homesteaded property? Additionally, How can a person legally be taxed for an amount of money that was never physically received? These are valid questions.

According to The Mortgage Forgiveness And Debt Relief Act, the money was not taxable when first issued because there was an obligation to repay the lender; it wasn’t “income”. If the loan is forgiven, it’s an amount that was received but did not have to be paid back. That’s when forgiven debt crosses the line into “taxable income” territory. The money was never received, regardless of the value of the property. Since the margin between the value of the property and the price paid got wider, it could be viewed as equity.

It might feel like we’re being cheated every time we turn around, but if you take a closer look, you’ll see that the advantages greatly outweigh the disadvantages. Let’s say, hypothetically, that the IRS is attempting to collect taxes on forgiven debt in the amount of $14,000. If the outcome is unsatisfactory, there’s always the option of selling the property for its retail price and putting that $14,000 in your pocket. The transaction might not yield any cash, but it certainly improved your net worth.
This post was written by Stephen Hachey. Follow Stephen on Google, Facebook, Twitter & Linkedin.