Phantom Gain (Investments) - Explained
What is Phantom Gain?
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Table of ContentsWhat is Phantom Gain?How Does Phantom Gain Work?Phantom Gains and Capital Gains TaxesPhantom Gain vs. Phantom IncomeAcademic Research on Phantom Gain
What is Phantom Gain?
A phantom gain refers to a situation whereby an investor owes capital gain taxes despite the fact that the investor's general investment portfolio might have depreciated in value.
How Does Phantom Gain Work?
The most popular instance for an investor to be hit with a phantom gain is when there is a mutual fund investment. Supposing a set of investors wants to cash out of a mutual fund, it may make a mutual fund manager sell stock shares so as to raise the needed cash to payout. But selling these stocks can generate capital gain for investors in the mutual fund, even in a situation whereby the act of the investor group selling the mutual fund makes the mutual fund's overall value to decline. Phantom gains can be difficult to identify sometimes because the losses might not be obvious on the surface. For instance, let's consider a bondholder who also gets coupon payments from that same bond. Supposing the bondholder gets a coupon payment summing up to $150 during the period of one year and sells the bond within that year for a $130 loss, the bondholder might think that he or she has made a $20 during the year. However, the taxes to be paid by the investor on the coupon payment would decrease the net payment. Imagine that the investor's tax on the coupon payment is $30. This investor has $20 as his phantom gain, but in the real sense, he or she has lost $10.
Phantom Gains and Capital Gains Taxes
Income which results from the sale of an asset for more than its price of purchase is referred to as a capital gain and the federal government taxes it as income. For practicality, the government only wants taxes to be paid upon the sale of an asset, as fluctuations in asset prices happen often, making it potentially disruptive to the economy to levy taxes whenever an asset experiences a price increase. But this policy also brings about frustrating dislocations such as phantom gains, when investors owe taxes, despite the fact that they have not experienced a general increase in their investment's value.
Phantom Gain vs. Phantom Income
Phantom gains are sometimes mistaken for phantom income, which is a concept that is different and broader. On the other hand, phantom gains refer particularly to income from the value appreciation of a taxpayer's assets, phantom income is any income which the IRS recognizes, but which the taxpayer does not receive. Debt forgiveness is one instance of phantom income, which is treated by the IRS as taxable, despite the fact that the taxpayer responsible does not get any money from which he can pay the tax.