How do you report income from discounted cash flows ?

Question

Let's take an example. Let's say a trust deed backed note was issued in August 2005 in the amount of $44,500, with interest rate of 6%, and payments of $266.80 amortized over 30 years. Let's say you bought it in September 2006 for $16,500, when the balance was $43,000. In October 2006, you received a $266.80 payment, $215 of which is interest and $51.80 is principal pay down.

How much interest income would you report on your taxes for that October 2006 payment ?

Do you report some discount element as short term capital gain, or just as interest ?

Any references to an IRS publications will be appreciated, but I prefer note investors telling me, using numbers, what they would report, and where, in the case of the above example.

Also, please don't respond if you have never bought a note at a discount. I don't want this thread turning into a generic discussion about what is and what is not taxable income, or how similar situations are handled when people buy low or no interest bonds at a discount, or how people who sell their house and take back a mortgage do it.

Thanks in advance.

Mike Hartzog · Answer

@Abdenour Achab

When you buy a discounted note, all of the interest portion of the payment is booked as Interest Income.  In addition, a portion of the principal part of each payment is considered income as well.  This is based on the percentage of discount you bought the note at.  Changing your example a bit for easier math, let's say you bought a 100K balance note at 80K, so you bought it at 80% of UPB.  So in this case you can only count 80% of the principal portion of each payment as return of capital, and the other 20% would go into an Discount Earned account.  The two accounts, Interest Income and Discount Earned, are both considered income from your investment.  No difference between the two from a taxation perspective, however, you want to maintain separate accounts for each so that what you report as interest income matches the amount reported to the IRS by your servicer.

Mike Hartzog · Answer

I am no expert in tax law.  I do my own bookkeeping but I use a CPA at tax time.  I can tell you that capital gains and losses can happen when an asset is sold, so they don't apply in the example we have been discussing.  Here's an IRS Tax Topic article on it.

https://www.irs.gov/taxtopics/tc409.html

Abdenour Achab · Answer

Thank you very much @Mike Hartzog for that explanation. So, the Discount Earn account is an income, but it's neither interest, nor short term capital gains, nor short long term capital gain ? By the way, I buy note in my own name. Any idea where in my tax returns I should report it ? So far, I have just been reporting it as interest (along with the real interest income), both bundled in interest earned line of my 1040.