How do you report income from discounted cash flows ?

[Abdenour Achab]

Let's take an example. Let's say a trust deed backed note was issued in August 2005 in the amount of $44,500, with interest rate of 6%, and payments of $266.80 amortized over 30 years. Let's say you bought it in September 2006 for $16,500, when the balance was $43,000. In October 2006, you received a $266.80 payment, $215 of which is interest and $51.80 is principal pay down. 

How much interest income would you report on your taxes for that October 2006 payment ?

Do you report some discount element as short term capital gain, or just as interest ?

Any references to an IRS publications will be appreciated, but I prefer note investors telling me, using numbers, what they would report, and where, in the case of the above example.

Also, please don't respond if you have never bought a note at a discount. I don't want this thread turning into a generic discussion about what is and what is not taxable income, or how similar situations are handled when people buy low or no interest bonds at a discount, or how people who sell their house and take back a mortgage do it.

Thanks in advance.

[Mike Hartzog]

@Abdenour Achab

When you buy a discounted note, all of the interest portion of the payment is booked as Interest Income. In addition, a portion of the principal part of each payment is considered income as well. This is based on the percentage of discount you bought the note at. Changing your example a bit for easier math, let's say you bought a 100K balance note at 80K, so you bought it at 80% of UPB. So in this case you can only count 80% of the principal portion of each payment as return of capital, and the other 20% would go into an Discount Earned account. The two accounts, Interest Income and Discount Earned, are both considered income from your investment. No difference between the two from a taxation perspective, however, you want to maintain separate accounts for each so that what you report as interest income matches the amount reported to the IRS by your servicer.