To that end, I wonder if its better to treat my friend, instead, as a private investor receiving a percentage return; or to structure the partnership as a short-term loan.

Until the SBA comes out with official guidance specific to REI investors and how exactly we are to treat these funds, everything else we guess here is like reading tea-leaves to predict the future. 

Do I treat this as a prepayment or escrow type account, crediting cash and debiting the prepay? 

Treat it 100% like a business and don't make it personal and have agreed upon goals and plan with the partner.

The piece I am trying to figure out is how to navigate the discount portion of the note which for me as the payor would be treated as cancellation of debt income (which is taxable).That's why I am investigating the "price reduction after purchase" method as a means to achieve the win-win without me getting hosed on taxes.Any particular reason you personally wouldn't pursue the price reduction path? 

Our system treats these people worse than people who have had multiple credit failures.

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I legitimately try to do everything right - I treat renters with dignity and respect, over-remodel my units, I tend to be lenient most of the time but at the end of the day, maybe I'm just wondering at what point it's time to intentionally plateau instead of continuing this arch?  

However, I want the original investors cash to be treated differently than new cash.

As they reiterate in the BP Podcasts time and again, real estate is a business and the best ( … the only) way to excel is to treat it like a business.Keep that mind working.