Tax Treatment of Real Estate Notes: How Mortgage Note Income Is Taxed

How Are Real Estate Notes Taxed?

Interest you collect on a real estate note is ordinary income: interest is gross income under IRC §61(a)(4), and the IRS lists "loans you make to others" among the sources of taxable interest in Publication 550. If you bought the note for less than its balance, the gap is market discount, and under IRC §1276(a) both principal payments and the gain on a sale or payoff are ordinary income up to the discount that has accrued while you held it. Only gain beyond that accrued discount can be capital gain.

This guide follows a note through its life (payments, a sale, a payoff or DPO, a modification, a foreclosure) and links the statute, regulation or IRS page behind each rule.

Disclaimer: This article is educational and is not tax, legal or financial advice. How the rules apply depends on your facts. Work through your situation with a CPA or tax attorney.

How Is the Interest on a Note Taxed?

The interest portion of each payment is taxable in the year you receive it, form or no form: the IRS says to report all taxable interest "even if you don't receive a Form 1099-INT or Form 1099-OID" (Topic 403). You also file Schedule B if you "had over $1,500 of taxable interest or ordinary dividends" (Schedule B instructions).

The principal portion is a plain return of your cost basis when you bought at or above the balance. On a discounted note, Publication 550 says you "must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount."

Is Note Interest Subject to Self-Employment Tax?

Self-employment tax reaches earnings from "any trade or business carried on" by you (IRC §1402(a)), so interest earned purely as an investment would generally fall outside it. If buying notes is itself your business, the regulation says "other interest received in the course of any trade or business (such as interest received by a pawnbroker on his loans...)" is not excluded (Treas. Reg. §1.1402(a)-5(b)).

A single-member LLC doesn't change the income's character by itself: unless it elects corporate treatment, its "activities should be reflected on its owner's federal tax return" (IRS). For liability and state costs, see choosing the right entity for note investing.

How Do Market Discount Rules Tax a Note Bought Below Face Value?

Market discount is the excess of a note's stated redemption price at maturity over your basis immediately after you buy it (IRC §1278(a)(2)). It reaches mortgage notes because the same section defines a bond as "any bond, debenture, note, certificate, or other evidence of indebtedness."

Hypothetical: you pay $70,000 for a performing note with a $100,000 unpaid principal balance, so the $30,000 gap is market discount. Without an election, three rules follow:

• Principal payments are ordinary income up to the market discount accrued so far (§1276(a)(3)).
• A sale or payoff produces ordinary income up to the accrued discount not already taxed (§1276(a)(1)).
• Gain above that is generally capital gain, because amounts received when a debt is retired "shall be considered as amounts received in exchange therefor" (§1271(a)(1)). An old exception for obligations issued by a natural person before June 9, 1997 does not apply to any obligation purchased after June 8, 1997 (§1271(b)).

A small discount counts as zero: Publication 550 treats market discount as zero "if it is less than one-fourth of 1% (0.0025) of the stated redemption price of the bond multiplied by the number of full years to maturity." With 10 years left, the hypothetical's threshold would be $2,500.

How Fast Does the Discount Accrue?

By default, the accrued discount is the market discount times the days you have held the note, divided by the days from purchase through maturity (§1276(b)(1)). You can elect a constant interest rate instead, irrevocably, note by note (§1276(b)(2)). For a loan whose principal is paid in two or more payments, like an amortizing mortgage, the statute leaves the method to Treasury regulations (§1276(b)(3)); Publication 550 lists three methods for partial principal payments: constant yield, in proportion to OID, or, with no OID, in proportion to the stated interest paid in the period.

Under the ratable method, the discount accrued at a payoff depends on how long you held the note relative to its remaining term, so the same purchase discount would likely split differently between ordinary income and capital gain on a loan that resolves in months and one that pays for years.

Two Elections to Discuss with Your CPA

Under §1278(b), you can report market discount as it accrues instead of waiting for payments or a sale. The election covers every market discount bond you acquire that year and after, switches off §§1276 and 1277, and per Publication 550 cannot be revoked without IRS consent. It also matters if you borrow to buy notes, because §1277(a) otherwise limits the deduction for net interest expense on a market discount bond. The other choice is the constant-yield method above. Either way, you "increase the basis of your bonds by the amount of market discount you include in your income" (Publication 550).

Market discount is not original issue discount. OID is the excess of an instrument's stated redemption price at maturity over its issue price (§1273(a)(1)), set when the debt is issued, while market discount "arises when the value of a debt obligation decreases after its issue date" (Publication 550). A significantly modified loan is treated as a new instrument (below), so ask whether the new one carries OID.

What Happens When You Sell a Note?

Your gain or loss is what you receive minus your adjusted basis in the note, and its character is decided in layers:

1. Accrued market discount not yet taxed is ordinary income (§1276(a)(1)).
2. Remaining gain on a note you hold as a capital asset is capital gain, long-term if you held it more than one year and short-term if one year or less (§1222). The IRS taxes net short-term capital gains "as ordinary income at graduated tax rates" and applies 0%, 15% or 20% to net capital gain depending on taxable income (Topic 409).
3. If you hold notes primarily for sale to customers, they are not capital assets, and the gain is ordinary income.

Are You a Dealer or an Investor?

The test is in §1221(a)(1): a capital asset excludes "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." In Malat v. Riddell, 383 U.S. 569, the Supreme Court held that "primarily" there "means 'of first importance' or 'principally.'"

There is no bright-line number of sales. In Biedenharn Realty Co. v. United States, 526 F.2d 409, the Fifth Circuit weighed the purpose of the acquisition and the holding period, sales efforts, the number and continuity of sales, advertising, a business office and time devoted to selling, and placed "greatest emphasis on the frequency and substantiality of sales over an extended time period." Both were real estate cases decided under the same statutory language that governs notes.

If you hold some notes for income and resell others, your purchase records are where the purpose of each note shows. Agree with your CPA on how to document it before the first sale.

How Are Payoffs, DPOs, Modifications and Foreclosures Taxed?

Payoffs and Discounted Payoffs

A payoff or discounted payoff retires the debt, so what you receive is treated as received in exchange for the note (§1271(a)(1)). Hypothetical: you bought a note for $50,000, its balance is $90,000, and you accept $65,000. Your $15,000 gain is ordinary income up to the accrued market discount, and any remainder is capital gain if the note is a capital asset in your hands. The $25,000 forgiven matters to the borrower, because gross income includes "income from discharge of indebtedness" (§61(a)(11)); whether you must report it is covered under forms below.

Loan Modifications

Under Treas. Reg. §1.1001-3(b), a "significant modification" is treated as an exchange of the old debt instrument for a new one; a modification that isn't significant is not an exchange. Because an exchange is a realization event under §1.1001-1(a), a significant loan modification can produce gain or loss with no cash changing hands. Three of its tests cover a rate change, a payment deferral and a forbearance:

• Yield. A change is significant if it moves the annual yield by more than the greater of 25 basis points or 5% of the unmodified yield (§1.1001-3(e)(2)(ii)).
• Timing. A material deferral of scheduled payments is significant. Deferrals within a safe-harbor period, the lesser of five years or 50% of the original term, are not material if the deferred payments are unconditionally payable by its end (§1.1001-3(e)(3)).
• Forbearance. Absent an agreement changing other terms, a holder's agreement to stay collection or temporarily waive acceleration is not a modification unless it lasts more than two years after the borrower's initial failure to perform, plus any period of good-faith negotiation or bankruptcy (§1.1001-3(c)(4)(ii)).

Foreclosure and REO

Treas. Reg. §1.166-6 splits a foreclosure into two pieces. If the property sells for less than the debt and the remainder is wholly or partly uncollectible, you may deduct it as a bad debt under §166. If you buy the property in, you realize gain or loss measured against its fair market value, which is "presumed to be the amount for which it is bid in by the taxpayer" absent clear and convincing proof otherwise, and that value becomes your basis in the REO. Under that presumption, the amount you bid is likely to set both your gain or loss and your REO basis unless you can prove a different value.

What 1098 and 1099 Forms Apply to Note Investors?

Two details catch note investors. For the 1099-C test, the regulations say "lending money includes acquiring an indebtedness not only from the debtor at origination but also from a prior holder" (Treas. Reg. §1.6050P-2(e)), and the instructions' safe harbor for newly formed organizations "does not apply to an entity formed or availed of for the principal purpose of holding loans acquired or originated by another entity," a description that could fit an LLC formed to buy notes. And if you cancel $600 or more in connection with a foreclosure in the same calendar year, Form 1099-C alone can satisfy both, with boxes 4, 5 and 7 completed.

How Does a Self-Directed IRA Change the Tax Picture?

An individual retirement account "is exempt from taxation" under §408(e)(1), apart from the tax on unrelated business income, so interest, discount and gains inside a self-directed IRA don't create an annual tax bill. A Traditional IRA is taxed on distributions; a qualified Roth distribution "shall not be includible in gross income" (§408A(d)(1)). Setup is covered in how to buy mortgage notes with a self-directed IRA.

§4975(c)(1) prohibits any direct or indirect sale or exchange of property, lending of money, or furnishing of goods, services or facilities between the IRA and a disqualified person, and any use of the IRA's assets for that person's benefit. Disqualified persons include your fiduciary and your "spouse, ancestor, lineal descendant, and any spouse of a lineal descendant" (Publication 590-A). If you engage in one, the account "stops being an IRA as of the first day of that year" and is treated as distributing all its assets to you at fair market value (Publication 590-A; §408(e)(2)).

Interest is excluded from unrelated business taxable income (§512(b)(1)), but not for debt-financed property (§512(b)(4)), so an IRA that borrows to buy notes can owe tax on part of the income. The trustee of an IRA with $1,000 or more of gross unrelated business income files Form 990-T (Form 990-T instructions).

Does Installment Sale Treatment Apply to Notes?

When you sell on terms. An installment sale is "a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs" (§453(b)(1)), and gain is recognized as payments arrive. Dealer dispositions and inventory are excluded, and you can elect out by the return's due date, including extensions (§453(b)(2), (d)). That covers selling a note to a buyer who pays over time, or selling REO with owner financing.

When you buy a seller-carried note. A seller who reported a property sale on the installment method recognizes the deferred gain when they sell you the note. Gain is the amount realized minus the note's basis, which is face value less the income that "would be returnable were the obligation satisfied in full" (§453B). Hypothetical, ignoring depreciation recapture: a seller sold a property for $200,000 with $40,000 down and a $160,000 note, and their gain was $100,000, half the contract price. The note's basis is $160,000 minus $80,000, or $80,000, so selling it to you for $130,000 triggers $50,000 of gain, treated as coming from the sale of the property. That is part of what the seller weighs when you negotiate. If you sold a home on seller financing to a buyer who lives in it, Publication 550 says to report the interest on Schedule B with the buyer's name, address and SSN, or you "may have to pay a $50 penalty."

What State Tax Issues Should You Watch For?

Each state sets its own rules; California's guide shows the questions to ask. California taxes residents on all income regardless of source. For nonresidents, "interest and dividends generally have a source where you are a resident," unless the account or security is used in a trade or business or pledged as security for a loan whose proceeds are used in a trade or business in California, and "real property is sourced and taxed based upon where the property is located" (FTB Publication 1031), which matters once a foreclosure turns a note into REO. Entities carry state costs too: "every LLC that is doing business or organized in California must pay an annual tax of $800" (California FTB).

What Records Should You Keep?

Keep a file per note, because every rule above runs on per-note facts: the purchase agreement, settlement statement and recorded assignment that set your basis; any market discount election statement and the accrual method you used; the servicer's principal-and-interest history; modification, DPO and forbearance documents with their dates; foreclosure bids with any valuation behind them; and every 1098 and 1099 filed or received.

Questions to Bring to Your CPA

Ask these before the year's first purchase, not at filing time:

1. Which accrual method fits my notes, and should I elect current inclusion under §1278(b)?
2. Are my notes capital assets, or do I hold any primarily for sale to customers?
3. Is my note activity a trade or business for self-employment tax, Form 1098 and Form 1099-A?
4. Is my entity an applicable entity that must file Form 1099-C?
5. Is this proposed modification significant under §1.1001-3?
6. Which states can tax this income, given where I live, where my entity is and where the properties sit?

If the answers to the first two aren't written down, write them down before the next bid. Every later answer depends on them.