Tax Implications of Discounted Notes

[Linda Hastings]

I'm trying to understand the tax implications of investing in discounted real estate notes. I've heard a couple of differing opinions about how to calculate what is taxable income, but I'm curious to hear from some CPAs. 

I know you can use an amortization schedule to break out a payment into principal and interest portions, and, I believe, the interest received would be considered income taxed at your ordinary tax rate. But what about the principal portion? If I buy a note at a discount off the unpaid principal balance, at some point the total principal I have received will surpass the purchase price of the note. Is it at that point that all the principal portion is also taxed as ordinary income? Or is some portion of the principal received from each payment considered income as you go (and if so, is it proportional to the discount you bought the note for)? Or perhaps there's a different way altogether to determine what is considered taxable income...