How to report taxable gains on NPNs

[Carlos Little]

Hello everyone,

I am about to begin investing in notes myself, but I have a conflicting question posed by a client of mine who also invests in non-performing notes.

How do you report any gain from these notes on your tax return?

As a simple scenario, let's say I purchase a note with a original face value of $100K for $20K. I understand my basis is now $20K. If I work out an agreement with the homeowner to modify the note to receive payments over 30yrs or $80K (principle), how much do I report as income this year?

My experience tells me that I must compute the gain (%) and report that percentage of the principle as a taxable gain + the interest received AS I RECEIVE IT IN PAYMENTS each year.

I keep hearing from other sources that we must include the entire projected gain as income (all at once) in the year we made the modification to the note. Thereby reporting approximately $60K income + interest immediately thus creating a "phantom income" issue.

It seems crazy to think that I would be taxed and accordingly penalized for picking up well over $60K in income when I haven't received a fraction of it. I wouldn't be able to pay the taxes on cash that I haven't received.

What has been your experiences with this?

Am I missing something or are they?

Thanks for the information or insight. I'm sure this affects everyone here on this forum.

Carlos