Ask about a non-RE language
Recall that if a TM $M$ doesn't halt on input $x$, then $x \notin L(M)$

Your mistake is in (1), if $M$ doesn't halt on $x$, then $M'$ doesn't halt too (since the simulation of $M$ on $x$ doesn't halt). so  $M'$ doesn't accept any input, that is $L(M')=\phi$.