Tax Treatment of Gain from Discounted Note Purchase

6 Replies

I own a First Mortgage Real Estate Note with a face value of $90K. I paid $72K for the note, which has a balloon payment in 2 years. Does anyone know the tax implications, if any, when I realize the $18K gain from the discount on the Note? I have tried to research this in the IRS code and can’t seem to find anything that describes the treatment of this. Thank you in advance for your input.

I am not an accountant, but wouldn't your basis be your cost; thus your taxable gain be the sales price minus basis? Whether it is long term/short term and capital/ordinary would depend on your holding period and whether or not you are in the business of selling notes.

When you say "face value", do you really mean the remaining balance on the note at the time of purchase? Or, is the original loan amount (the face value) $90K while the remaining balance at the time of purchase is less than $90K?

If the borrower pays off the note when the balloon comes due, the first $72K you receive is a return of capital and not taxable. The difference between the $72K you paid for the note and the remaining principal balance on the loan is not a return of principal, it is additional interest and will be taxed as such at your ordinary income tax rate.

If you sell the note for more than you paid for it but for less than the principal balance remaining on the note, then the difference between your purchase price and your sale price is a capital gain and taxed at the capital gains rate that applies to your tax bracket rate.

This is a general overview. The actual calculations are a little more complicated. Consult your CPA for more specific guidance.

This would be considered an installment sale. The 18k income will be realized income based on the principal payment every year. So if in the first year, you receive $10k of the $90k, then your income for the first year will be $10k/$90k * $18k. See IRS link for more information

Originally posted by Ebere Okoye:
This would be considered an installment sale.

I don't think installment sale applies here. David says he bought a note for $72K - he doesn't say anything about selling real estate and taking back paper. I'd agree with Dave T on this one. Even if principal payments are received during the two years before the balloon is due, Dave's reasoning would still be applicable. The principal received would reduce the $72K "basis" and increase the capital gain when the balloon payment is received.
Originally posted by Ebere Okoye:
This would be considered an installment sale.

This is not the correct interpretation of David's situation. He bought a debt instrument at a discount to the principal balance owed on the note. In effect, he bought a note at a market discount and this discount has the same tax treatment as Original Issue Discount (OID).

The OID rules treat the discount as additional interest which may be either accrued until the note is redeemed or reported as current income in the year received.

The details can be found in IRS Pub 550.

Thank you everyone for these thoughtful contributions. I will be reading the IRS rules referred to this weekend, good times! To clarify, I bought the note from the previous owner, who sold the home and took back the note. I never owned or sold the property.
We did an Assignment of the note and recorded a 1st Trust Deed. Also, the payments are interest only with the entire $90,000 principle due in two years.