How to report taxable gains on NPNs

[Carlos Little]

Hello everyone,

I am about to begin investing in notes myself, but I have a conflicting question posed by a client of mine who also invests in non-performing notes.

How do you report any gain from these notes on your tax return?

As a simple scenario, let's say I purchase a note with a original face value of $100K for $20K. I understand my basis is now $20K. If I work out an agreement with the homeowner to modify the note to receive payments over 30yrs or $80K (principle), how much do I report as income this year?

My experience tells me that I must compute the gain (%) and report that percentage of the principle as a taxable gain + the interest received AS I RECEIVE IT IN PAYMENTS each year.

I keep hearing from other sources that we must include the entire projected gain as income (all at once) in the year we made the modification to the note. Thereby reporting approximately $60K income + interest immediately thus creating a "phantom income" issue.

It seems crazy to think that I would be taxed and accordingly penalized for picking up well over $60K in income when I haven't received a fraction of it. I wouldn't be able to pay the taxes on cash that I haven't received.

What has been your experiences with this?

Am I missing something or are they?

Thanks for the information or insight. I'm sure this affects everyone here on this forum.

Carlos

[Bill Gulley]

Originally posted by Carlos Little:
Hello everyone,

I am about to begin investing in notes myself, but I have a conflicting question posed by a client of mine who also invests in non-performing notes.

How do you report any gain from these notes on your tax return?

As a simple scenario, let's say I purchase a note with a original face value of $100K for $20K. I understand my basis is now $20K. If I work out an agreement with the homeowner to modify the note to receive payments over 30yrs or $80K (principle), how much do I report as income this year?

My experience tells me that I must compute the gain (%) and report that percentage of the principle as a taxable gain + the interest received AS I RECEIVE IT IN PAYMENTS each year.

I keep hearing from other sources that we must include the entire projected gain as income (all at once) in the year we made the modification to the note. Thereby reporting approximately $60K income + interest immediately thus creating a "phantom income" issue.......................

Carlos

You report the basis as you receive it, interest on all of it as you receive and your 60K gain in the year you modified the note for the earned asset you received. Earned income does not need to be in cash paid to you, you pay taxes on income and benefits received in a taxable period.

If you're in the business, making most of your money in buying and modifying notes, don't forget self employment taxes on that amount as well.

And, if you're in the business, you'll need a license. Nest month, you'll need a license to collect the payments as well, best to use a mortgage servicer.

Need to read the IRS Code pertaining to business income, "being in the business of" as opposed to investment income. You're not passive if you're modifying notes. If the majority or a significant amount of your income comes from any active venture, you're in the business. You'll also be in the business as to license requirements, doing this individually. :)

[Ellis San Jose]

I'm not a CPA. So be sure you speak to a knowledgable CPA in Real Estate & note investing.

It may be important in what entity you hold the note in & the purpose of that entity. If you are considered a "dealer" you may very well have to report the entire gain.

Steven Hamilton II is a great person to ask this.

[Carlos Little]

Originally posted by Ellis San Jose:
I'm not a CPA. So be sure you speak to a knowledgable CPA in Real Estate & note investing.

It may be important in what entity you hold the note in & the purpose of that entity. If you are considered a "dealer" you may very well have to report the entire gain.

Steven Hamilton II is a great person to ask this.

Thank you Ellis. This link you provided is exactly what I was looking at along with similar info that caused me to rethink my previous thoughts on how/if I would incur a immediately taxable event. Thanks again.

I guess I'm trying to see how to limit my exposure to something like this.

[Carlos Little]

Originally posted by Bill Gulley:

You report the basis as you receive it, interest on all of it as you receive and your 60K gain in the year you modified the note for the earned asset you received. Earned income does not need to be in cash paid to you, you pay taxes on income and benefits received in a taxable period.

If you're in the business, making most of your money in buying and modifying notes, don't forget self employment taxes on that amount as well.

And, if you're in the business, you'll need a license. Nest month, you'll need a license to collect the payments as well, best to use a mortgage servicer.

Need to read the IRS Code pertaining to business income, "being in the business of" as opposed to investment income. You're not passive if you're modifying notes. If the majority or a significant amount of your income comes from any active venture, you're in the business. You'll also be in the business as to license requirements, doing this individually. :)

Thank you Bill for the information and example.

I'm guessing the actual modification creates an event which effectively is a sale of an asset (previous note) in to a new one. This is what requires the immediate posting of the actual gain. Does that sound right?

I also appreciate the advice about licensing, etc. That makes good sense.

[Bill Gulley]

Yes, basically, as a security type instrument or a cash asset it doesn't get the tax considerations that inventory or other property receives, the gain is recognized as it is made, the type of entity is irrelevant, it's income recognition individually or in any business entity with respect to notes. If you're an investor not a dealer, the income recognition is still the same, but if it's owned by your 401K for example, that increase may be deferred, not because of the note or what you accomplished but by the nature of your tax deferred plan.

I see Steven Hamilton (our resident tax guy) was here, guess he felt no comment was necessary. I usually don't get into taxes, I leave that to Steve or the CPA types, but this is also an issue with income recognition dealing in notes.

It's always good to have a tax liability, it means you're making money, you're making more than Uncle Sam gets so be happy! :)

[Carlos Little]

Bill I agree, it's good to have a tax liability. My client and I just are trying to limit having to pay a large amount of taxes on something that we have not "constructively received".

I really appreciate your help. I may hit Steve up separately as well once I get more specific facts.

[Steven Hamilton II]

Originally posted by Carlos Little:
Hello everyone,
I am about to begin investing in notes myself, but I have a conflicting question posed by a client of mine who also invests in non-performing notes.

How do you report any gain from these notes on your tax return?

As a simple scenario, let's say I purchase a note with a original face value of $100K for $20K. I understand my basis is now $20K. If I work out an agreement with the homeowner to modify the note to receive payments over 30yrs or $80K (principle), how much do I report as income this year?

My experience tells me that I must compute the gain (%) and report that percentage of the principle as a taxable gain + the interest received AS I RECEIVE IT IN PAYMENTS each year.

I keep hearing from other sources that we must include the entire projected gain as income (all at once) in the year we made the modification to the note. Thereby reporting approximately $60K income + interest immediately thus creating a "phantom income" issue.

It seems crazy to think that I would be taxed and accordingly penalized for picking up well over $60K in income when I haven't received a fraction of it. I wouldn't be able to pay the taxes on cash that I haven't received.

What has been your experiences with this?

Am I missing something or are they?

Thanks for the information or insight. I'm sure this affects everyone here on this forum.

Carlos

@Carlos Little ,

One important thing to take into account is how long was left on the note before you modified it.

[Steven Hamilton II]

Sorry @Bill Gulley

[Carlos Little]

Thanks for your input @Steven Hamilton II . I will get more information from the client as to the time left on the note prior to modification.

It looks like my thinking was not too far off the mark. I just had not considered the fact that the modification itself is considered a sale and therefore recognized at that point.

Also, I have to check into the fact that we are picking up the note at a substantial discount from it's initial face value. In your experience has this issue (OID) been a reason for recognizing the full discount amount as income upon acquisition of the note?

Please let me know if I'm off the mark on anything.

Thanks again everyone.

[Steven Hamilton II]

Originally posted by Carlos Little:
Thanks for your input @Steven Hamilton II . I will get more information from the client as to the time left on the note prior to modification.
It looks like my thinking was not too far off the mark. I just had not considered the fact that the modification itself is considered a sale and therefore recognized at that point.

Also, I have to check into the fact that we are picking up the note at a substantial discount from it's initial face value. In your experience has this issue (OID) been a reason for recognizing the full discount amount as income upon acquisition of the note?

Please let me know if I'm off the mark on anything.

Thanks again everyone.

@Carlos Little ,

It would be considered a "deemed exchange". debt due to the different being greater than 5% (4,000). Other things that can trigger a deemed exchange such as a change in the term, interest rate.

So unless it is paid off this year they are paying tax on phantom income. If there were smart, they would have negotiated an annual change based upon consecutive payments. That could gave given you room. IT would allow you to avoid a major modification it would have simply been principal forgiveness annually. Now you must also 1099 the mortgagor for the cancelled debt.

[Carlos Little]

Originally posted by Steven Hamilton II:

It would be considered a "deemed exchange". debt due to the different being greater than 5% (4,000). Other things that can trigger a deemed exchange such as a change in the term, interest rate.

So unless it is paid off this year they are paying tax on phantom income. If there were smart, they would have negotiated an annual change based upon consecutive payments. That could gave given you room. IT would allow you to avoid a major modification it would have simply been principal forgiveness annually. Now you must also 1099 the mortgagor for the cancelled debt.

Ahhhhh! Now we're getting somewhere. This may be the strategy I was looking for.

So you're saying as long as the client does not fully modify the note at once, but simply "rewards" the homeowner with principal forgiveness for paying regularly and consistently, we could possibly avoid the full inclusion as long as we don't make a substantial change to the originally issued note.

In your opinion would you think they could repeatedly inch the principal down just under the 5% threshold each year to avoid it being "substantial", or is the 5% the maximum total changes to the original note. I know there are other changes that cannot be over a certain amount either (interest, term, etc.). I can research this if you don't know off the top of your head.

Thanks Steve, this is getting good.

[Steven Hamilton II]

@Carlos Little ,

I couldn't tell you off the top of my head; although I would strongly encourage the slow foregiveness of principal.

[Dion DePaoli]

I am not inclined to dive too far into this but you should go seek a local experienced tax professional who is familiar with Troubled Debt Restructuring (TDR) and the guidance that has been issued by FASB over the last couple years.

Many publications from 2009 and prior fail to include the guidance and clarification from FASB on the treatment of troubled debt. After the crash, the conversation around TDR came to the forefront and most of what you see on the internet is simply the echo of the conversation and may not include the rules that have been reviewed and commented on for clarity. Impairment losses can be used to offset gains, provided it qualifies. Guidance is given in FASB 15 and a couple other publications.

Moral of the story, this is not so straight forward and is a complexity that, in my experience, only a few accounting firms have had to dig in and sort out. Simply stated, the tidal wave of investors entering into distressed debt investments and the subsequent actions and consequences of such actions, while not overly new, grew exponentially in volume since the crash and cause much discussion, for the greater good. Further, in my experience, and certainly not taking anything away from Steve or Bill, whom I have much respect for, not many smaller accounting firms have had to actually deal with. I can't tell you over the last couple of years the amount of time and energy that has been spent going round and round with accountants and auditors about taxation's applicable rules. Needless to say, a lot.

I will also agree, Bill said it well, if you are being taxed, you are making money and that sort of is the point. That said, nobody wants an excessive or unrealistic tax burden and there are things that you can do to complement that idea. There is no real way through this thread to go over all of the finite details. Many details will apply.

I also note a dangerous idea mentioned in one of the OP follow ups, "...my client and I...", be careful that sounds like you might be giving accounting advise and presumably without a license. If your client suffers harm from your "advice", you may have some issues.