I am going to go off on a limb and guess that you do not want to pay any more tax than you are required to. You don’t enjoy paying taxes on the income you earn, so you certainly do not want to pay taxes on “phantom income”. Phantom income is income that is reported to the IRS for tax purposes but that you did not actually receive.
One of the most common instances of phantom income that occurs is when an individual purchases an ownership interest in a partnership (or an LLC that is taxed as a partnership) that owns appreciated assets. Lets look at an example to understand what I mean:
Years ago, Tom and Ed formed an LLC. They each contributed $75,000 to the business, and used those funds as a down payment to purchase a rental property for $600,000. They borrowed the remaining $450,000. Over the years, the property appreciated in value and is now worth $750,000. Sam is interested in joining the LLC and agrees to purchase a one-third ownership interest for $250,000. As part of that purchase, he acquired one-third of the “original basis” in the rental property ($200,000).
If the LLC sold the property the next day, it would recognize a gain of $150,000. Each owner’s K-1 would show capital gains of $50,000 which they would be required to report on their individual tax return. However, this is not fair to Sam. He already paid for the appreciation on the property when he purchased his ownership interest, so he should not be taxed on it now. This is phantom income.
To avoid this issue, partnerships and LLCs can make an election under Internal Revenue Code Section 754. If this election is made, for tax purposes the business would step up the basis of the rental property to reflect the additional contribution made by Sam. Therefore, after this election is made the business would show a basis in the rental property of $650,000.
Upon the sale of the rental property, this basis would be specially allocated among the owners. Tom and Ed would each still have a basis of $200,000, and Sam would have a basis of $250,000. Therefore, if the rental property was sold for $750,000, Tom and Ed would show capital gains of $50,000 each and Sam would not show any capital gains.
Another element of this election is that if the Section 754 basis is allocated to depreciable property, the Section 754 basis can be depreciated. In Sam’s case, residential rental property can be depreciated over 27.5 years so Sam is able to depreciate his $50,000 over 27.5 years for an annual tax deduction of $1,818.