Commerce City, CO · Member since 2018 · 40 posts · 6 votes
Good afternoon everyone!
So in my self-education on notes, of course learning about that the interest portion of payments are taxes as normal income (assuming no self-directed IRA situation).
Is there any strategy to buying notes that are later in their amortization schedule than new notes because of that fact? Since we are taxed on the interest portion of the repayment, the further towards the end, the lower the % of the P+I payment that is interest.
When we get data back from our servicer, I assume (haven't bought any notes yet), that it will show how much of each payment (or total payments annually) are principle vs interest.
Where does the "kicker" weigh in here. The discounted price difference, does that come into play, i.e. come across as a taxable income? Or will we only look at the Interest portion of the payments based on the amort schedule, (even if we paid less for it?)
Lender · Redmond, WA · Member since 2014 · 553 posts · 490 votes
8y
Good questions @David Hite. To answer your first question, there is no tax benefit to buying a late stage note vs early stage. At the end of the day, you are investing to make a profit, and you will be taxed on that profit regardless of whether or not the profit comes as normal interest or return of discounted portion of principal balance.
If you do the math on a loan which is amortized to return both principal and interest with each payment (normal mortgage loan amortization) you will find that each payment has the exact same investment yield with regard to the current principal balance. Later stage notes return principal faster, thus reducing the amount of your invested capital faster, but your yield remains constant. It could be argued that an early stage note is preferable if you are looking for passive income because more of your capital remains invested longer, and it will therefor be a longer period of time before you will need to go find a new investment.
With regard to accounting for the "kicker", essentially you are tracking a thing called "Discount Earned", which is the amount of the principal returned with each payment that is not your invested capital. For example, if you buy a loan at 80% of UPB, 80% of the principal portion of a given payment will be a return of invested capital, and 20% will be Discount Earned, which is income in the same way as interest is. There are two methods of accounting for this. You can track it on a payment by payment basis, or you can run your capital account down to zero (call all principal payments return of capital), then beyond that all principal payments will be discount earned.
Investor · Kingston, WA · Member since 2008 · 1k+ posts · 1k+ votes
8y
I I use a future value calculator to determine my offer price based on my annualized yield requirements. So even with a late-stage note where most of the payment is principal if I buy it at a steep enough discount I can still earn my yield Target.