Tax implications on buying/selling defaulted paper?

2 Replies

I know nothing about notes. I have the opportunity to buy a non-performing note at a discount. The note was in a pool sold by a portfolio lender to a "loan workout" group at a substantial discount. I know the property owner and am interested in stepping in as the lender. The "loan workout" group has made a verbal commitment to sell the note to me at a discount so it is time for papers to start flying. I understand that I will pay taxes on the interest and spread between what I buy the note for and my final payoff when the property owner sells. Who pays the taxes on the difference between the original value of the note and my final net payoff?

TYIA!

I am working with a real estate attorney who is quite familiar with the legal side so I may not know all of the terminology and play-by-play but I'm not worried about the transaction going smoothly. Just trying to understand the tax implications.

Originally posted by @John C.:

Who pays the taxes on the difference between the original value of the note and my final net payoff?

I think when you say "Original Value" you mean the Unpaid Principal Balance of the loan at the time of your purchase.  You are purchasing that entire debt at a discount.  

So when you receive a payoff from the borrower, amounts above your cost basis is a gain.  If the loan balance is $100 and you buy it for $70 and the Borrower pays you $100, then you have a $30 gain.  That is your gain, not the Borrowers.  

If the Borrower owes $100 and you buy it for $70 and you accept less than than what is due, say $90, then you have a $20 gain and the Borrower has a $10 gain.  You both would have tax consequences.  

If the Borrower owes $100 and you buy it for $70 and you accept less than what is due, say $60, then you have a $10 loss and the Borrower has a $40 gain.  You both have tax consequences.  

A Borrower will have tax liability for the amounts of the principal that is not paid back.  Those generally need to be disclosed to the borrower due to the tax consequences.  Some properties provide tax exemption limits like on a residential primary residence.  Investment property and commercial property do not have those exemptions so the Borrower will have to deal with those accordingly.  

An investor pays taxes on the interest income, which can include portions of the loan principal due to purchasing at discount, and the gain at the time of payoff which is the difference between the cost basis and the balance due at the time.  

I think that is what you were looking to understand.  Hope it helps.

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