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...

[Diane E.]

I'm a CPA, and these are my observations.

My take is that note investors have a couple of different payment pieces.  The first is borrowers' payments treated as interest income and principal paydown on the original note.  Unless you modify the note, the borrower's interest expense is based on the original amortization schedule.   So, the note buyer will recognize interest income based on the borrower's paydown of the original note balance.  

However, the note buyer investor bought the note at a discount to the face value.  This brings in a second payment piece:  the discount element.  For investors, it would seem that any amounts received in excess of the cost basis would be treated as capital gain (long-term or short-term depending on holding period).  However, debt acquired at a discount from the face value may be considered subject to rules known as the "market discount" rules (Internal Revenue Code Section 1278(a)(2)).  

A May 2010 bulletin from the real estate restructuring group of Syracuse & Hirschtritt LLP discusses market discount income. See http://www.thsh.com/documents/NYDOCS1918310-v3-Rev... .  In general, the market discount income is considered ordinary income accrued ratably over the remaining term of the mortgage.  Per the Bulletin: "For example, if the purchaser acquires a $10 million mortgage debt with three years remaining until maturity for a purchase price of $7 million, and one year later sells the indebtedness for $10 million, the purchaser will recognize $1 million in ordinary income (the accrued market discount portion of the gain) and $2 million as a capital gain."  

Some argue that when a default has already occurred, the market discount rules don't apply and gain should be treated as capital gain.  The most conservative position would be to ratably amortize the market discount and include the market discount amortization amount in ordinary income.