“Suppose I buy a note for $5,000 that has a balance of $10,000. The note interest rate is 12%.
I collect interest for the year of $1,200 and principal of $1,000 in the first year.
How do I report the $1,000 principal collected on the tax return?”
Answered by John Moren, the author of the NoteSmith family of loan servicing software that tracks
mortgage notes, discounted notes, leases, rent, and other cash flows. www.NoteSmith.com
At first glance, this might seem to be a complicated tax question, but fortunately for note
investors there are two simple solutions. I’ll show the commonly used method first.
In the example you gave, the note, which is an asset, was purchased at a 50% discount. As
the payor makes the contractual payments, half of each principal dollar paid is your investment
coming back and half is profit. So on your income tax return, with $1,000 of annual principal
paid, you would show $500 of “discount earned” and $1,200 of “interest,” both of which are
taxable as income. The other $500 of the cash flow is your investment coming back, termed
“return of capital,” and is not taxable.
If you look at a typical two column amortization schedule for your example, principal and
interest, imagine the principal column being split into two more columns, 50% of which is
“discount earned” with the other 50% being “return of capital.”
To clarify with a slightly different example, assume you bought the $10,000 note at a
$3000 discount, for a purchase price of $7000. As each principal dollar was collected, 30%
would be taxable “discount earned” and the remaining 70% is your untaxed “return of capital.”
Interest is still interest.
There is another method referenced by the IRS which is less frequently used. You did not
quote a yield or a length of term in your example, so let’s just say it was priced to yield 18%. You
can print an amortization schedule showing your $5000 investment at 18%.
The principal column, although it won’t match the payor’s schedule, is your money
coming back and the “interest” column, which also does not match the payor’s, is really your
total taxable yield. The reason this is not selected often by investors — although the IRS
unsurprisingly is happy for you to use it — is that more taxable income appears in the early years
with more untaxable “return of capital” in the later years.
I hope that helped.
Happy investing!
This article appears in the April, 2015 issue of THE PAPER SOURCE JOURNAL, along with
much other information about note investing and brokering. For information:
https://papersourceonline.com/paper-source-journal/infosubscribe/
What about depositing the benefit in a self-directed Roth IRA which is tax-free?
Thanks for an excellent and simple answer to the question of how to account for discount and interest as it is receive in payments from a whole note purchase.
A further question – How do you do your interest and discount recognition for partial purchases?
Our servicer reports entire interest amount paid by borrower as interest income on 1099 to us. However, it does not match the investor amortization and interest at face rate of the partial purchase we made. Too much is attributed to interest income – leaving too little for the discount realized in each payment.
How do you advise?
Thanks for the insightful explanation; can we have an explanation on the other side of the transaction, the seller?
Using your example of a $10,000 note purchased with a $3000 discount obviously the seller can deduct the $3000 discount as a “cost of sale” can he not? But then how does the seller deal with the interest he should have earned that he sold at a discount? And let’s assume that he’s at a 50% cost basis for long-term capital gains, obviously he would pay 15% long-term capital gains on a portion of the principal and ordinary income on the interest… What else am I missing?
Great information, John. I see investors use both methods, and the ones who use an amortization schedule showing their actual yield almost never realize that they are paying higher taxes by “front loading” how they report the discount (profit) they made on the deal. For investors earning 18%+ yields on their notes, the tax differences can be significant.
Nice to hear from you, John, and thank you for the comment. It means quite a bit to me coming from someone with your knowledge and experience.
In the example you quoted, the note seller will show a receipt of $7000 and now is done. There is no “unearned interest.” It is exactly like selling any other asset; you simply do not collect any further benefit, whether it is a car, a rental house, or a note. The seller collects only a payment for the asset sold.
The way the $7000 appears on the next year’s income tax form depends on how the $10,000 note was treated the year it was created. If the tax payer showed a $10,000 capital gain when creating the note, for instance, now there is a $3000 loss against it for an overall $7000 net profit across two tax years.
Hopefully I did not misunderstand your question. Mr Groom who posted below probably would be a better person to answer this, anyway, since I am not a tax professional.
The partial purchase can be handled almost exactly the same. Let’s assume that in the example the note was really $100,000 and the note seller agreed to sell a $10,000 piece of the note for $7000. The borrower still is paying based on the original amortization schedule (aka an A Schedule or Am Schedule).
Here is the only difference:
The buyer can print an amortization schedule (a B Schedule) showing the $10,000 amortizing at 10% with each payment. Again, some of the “principal” will be discount earned (30% of it) and some will be return of capital (70% of it). The note seller already knows he received $7000 and the B Schedule shows that the buyer controls $10,000 of the note. The difference between them will be the profit.
The B Schedule is quite important because the borrower is unlikely to pay every payment over a long term exactly on the due date and exactly in the right amount. The borrower even may want to pay off early. There needs to be a record of when the note buyer is finished so the original note can go back to the note seller.
This issue illustrates why it is so difficult to service a note, especially a partial note purchase, using amortization schedules. They are predictive but income tax forms are reactive, as is loan servicing software. Good quality loan servicing software will maintain A and B Schedules, plus the actual payment history, all at the same time.
Your servicer is collecting principal and interest, then simply passes it along to you with IRS 1099-INT. The servicer shows the same interest out as in, making it easy on the servicer, and has no tax liability on that money. The 1099-INT is not reflecting your tax situation because it is not a tax form, remember, but an information return. It would be wise to document the discrepancy when you file because it appears when when you attach a 1099-INT to your return that you had loaned money to the servicer, which is not correct. I cannot advise you on your situation further, not being a tax professional, but someone else in this forum, like Mr. Groom, would be qualified to share some thoughts.