Hi ,

What is it about April 15?  Lincoln died on that day...the Titanic sank...the first Arab-Israeli war...Fidel Castro came to power...the US national debt hit a new record (although that happens every day now)...and of course US income taxes are due.  Did you know the average American worker doesn't start making any money until April 24?  Meaning, that's how long he or she has to work -- 114 days from Jan.1 to April 14 -- just to make enough to pay federal, state and local income taxes.

If you own notes, you'll want to read the article below on how to figure any income tax that is due.  It might save you a bundle!

Speaking of notes, we've just signed up two legendary names in the note and real estate world:  JOHN SCHAUB and DEAN ENGLE will be teaching at The Paper Source Note Symposium in Las Vegas April 28-30.  John will teach a special 3-hour seminar on how note investing and real estate investing is intertwined.  Dean -- one of the founders of defaulted bank note investing -- will teach "Manipulating Risk."  You can't afford to miss either, nor can you afford to miss over a dozen other experts who will teach you everything from real estate note investing and brokering to cell tower leases!  See  www.PaperSourceSeminars.com for all the details (or call 800-542-2270).   Sign up using the coupon code march and save $50.00.

Cheers,

W. J. Mencarow
President, The Paper Source, Inc.
www.PaperSourceOnline.com
www.PaperSourceUniversity.com

Suppose I buy a note for $5,000 that has a balance of $10,000. The interest rate is 12%. I collect interest for the year of $1,200 and principal of $1,000 in the first year. How do I report the $1,000 principal collected on the tax return? — Bruce Moeller

At first glance, this might seem to be a complicated tax question, but fortunately for note investors there are two simple solutions. I'll show the commonly used method first.

In your example, the note, which is an asset, was purchased at a 50% discount. As the payor makes the contractual payments, half of each principal dollar paid is your investment coming back and half is profit. So on your income tax return, with $1,000 of annual principal paid, you would show $500 of "discount earned" and $1,200 of "interest," both of which are taxable as income. The other $500 of the cash flow is your investment coming back, termed "return of capital," and is not taxable.

If you look at a typical two column amortization schedule for your example, principal and interest, imagine the principal column being split into two more columns, 50% of which is "discount earned" with the other 50% being "return of capital."

To clarify with a slightly different example, assume you bought the $10,000 note at a $3000 discount, for a purchase price of $7000. As each principal dollar was collected, 30% would be taxable "discount earned" and the remaining 70% is your untaxed "return of capital." Interest is still interest.

There is another method referenced by the IRS which is less frequently used. You did not quote a yield or a length of term in your example, so let's just say it was priced to yield 18%. You can print an amortization schedule showing your $5000 investment at 18%. The principal column, although it won't match the payor's schedule, is your money coming back and the "interest" column, which also does not match the payor's, is really your total taxable yield. The reason this is not selected often by investors — although the IRS unsurprisingly is happy for you to use it — is that more taxable income appears in the early years with more untaxable "return of capital" in the later years.

John Moren is the author of the NoteSmith family of loan servicing software that tracks mortgage notes, discounted notes, leases, rent, and other cash flows. www.NoteSmith.com

Meet John Moren at The Paper Source Note Symposium April 28-30 in Las Vegas:  www.PaperSourceSeminars.com