In broad terms, what a note buyer collects falls into interest, which is generally ordinary income, the return of what the buyer paid, which is generally not income at all, and the discount, which is taxed as it is recovered. How each is reported depends on how you hold the note and on your own circumstances, which makes this a question to work through with a CPA.
This page is an outline written by note brokers. It gives you the vocabulary for a conversation with a CPA and cannot stand in for one, because tax rules change and apply differently from one person to the next.
What is inside each payment
| Part of the payment | What it is | General idea |
|---|---|---|
| Interest | What the payer pays for the use of the money, at the rate on the note | Generally treated as ordinary income |
| Return of your cost | The part of the principal that gives you back what you paid | Generally your own money coming back, so no income arises |
| Discount | The principal you collect beyond what you paid | Taxable, with the timing and the character depending on the rules that apply to you |
The discount is the part that needs care
Notes change hands for less than the balance owed whenever the buyer needs a higher return than the rate written on the note. As an example with round figures, say you pay $81,000 for a note with $90,000 owed. If the payer makes every payment, you collect $9,000 of principal that you never paid for, which is 10% of the balance.
Example only, with round figures chosen to keep the arithmetic simple.
That $9,000 is profit and it is taxable. What your CPA needs to settle is when it is counted and what kind of income it is. Debt bought at a discount has its own set of rules, and under them the timing and the character of the discount can differ from what you would guess by looking at the payments alone.
The price and the balance are the two figures that conversation starts from. Notes we send to people who join the buyer list show both on the pricing worksheet, so you can take a real pair to your CPA in place of a made-up one.
If the note ends before its term
A payer who refinances or sells the property pays you the whole remaining balance in one sum. Whatever discount you had not yet recovered arrives with it, so more of the profit can land in a single year than you had planned for.
If you sell the note yourself, the difference between the price you receive and the cost you still have in it is a gain or a loss. Its treatment can turn on how long you held the note and on whether note buying is an investment or a business for you.
A note that goes bad has no single tax result. Taking the property back, settling for less and writing the note off each lead somewhere different, so once you know what happens if the borrower stops paying, ask your CPA about each route separately.
Who holds the note
A note in your own name puts the income on your personal return. Held through an LLC or another entity, the income may pass through to you or be taxed at the entity, depending on how the entity is set up, and a person who buys and sells notes regularly may be treated as running a business.
A self-directed IRA is different again. Income earned inside the account generally stays there under the rules for that account type, with exceptions that include an account borrowing to buy. Because buying notes in a self-directed IRA runs through a custodian, ask both the custodian and your CPA before the account buys anything.
State taxes may apply as well, and which state has a claim on the income is another point to raise with the CPA.
Records to keep from day one
- The closing statement showing what you paid, including costs.
- The payment history, with each payment divided into interest and principal.
- The year-end statement from whoever services the note.
- Invoices for servicing, legal and recording costs.
A third-party loan servicer produces most of these as a matter of course, which is a practical reason to arrange servicing for a note you own from the first payment.
One conversation to have before you buy
Find a CPA who already has clients holding private notes, take along the figures for one sample deal, and ask how the interest, the discount and an early payoff would each be reported in your case. Have that conversation while you are still working through the investor guide and before you bid. The answers may change how you choose to hold the note, and that is far easier to arrange before closing than after.
Related questions
Is all of each note payment taxable?
Generally not. Part of each payment is interest and part is principal. The principal that returns what you paid for the note is generally your own money coming back. Your CPA can tell you how the split is reported for a note bought at a discount.
Do I pay tax on note income inside an IRA?
Income earned inside a self-directed IRA generally stays in the account under that account's rules. There are exceptions, for example where the account uses borrowed money. Ask your custodian and a CPA before the account buys a note.
Will my servicer send me tax paperwork?
A third-party servicer can give you a year-end statement showing the interest and principal collected. What is filed, and with whom, depends on the servicer and the loan, so ask when you set the account up.