Note bought at a discount

[jskouberdis]

I have a situation where a client bought a discounted note from the bank 4 years ago at $240,000 and this and he has been collecting interest on the note for 4 years.  Now the note becomes due and he will get $290,000.  Is this a capital gain item or an ordinary income item for the difference in the basis and sale price.  They are in the business of financing and investing.  I would like to know what the community thinks about this.

[itonewbie]

Is $290k the par value?  If it's discounted, your client was probably not "collecting" but "accruing" interest.  That'd be my first impression based on the limited info you provided.

[jskouberdis]

No they were collecting interest at 7% for the last four years.  And will receive $40,000 more upon redemption next year.  My question is that a long term capital gain or ordinary income.  And if ordinary income is it interest income or financing income

[itonewbie]

That's an original issue or bought from the open market?  $240k sounds too clean for it to have been bought from the market.  Is there any reason why the note was sold at a discount but still paid interest periodically?

[jskouberdis]

They bought the note from the bank.  And they have been receiving interest for the last 3 or 4 years from the original borrower

[jskouberdis]

Also the borrower was a related person the my client knew.

[jskouberdis]

The borrower went to the bank and originally borrowed $290,000 about 5 years ago.  Then the bank sold the note to my client for $240,000.  And the borrower will pay my client $290,000 next year.

[itonewbie]

I assume there's a good commercial reason for the bank that originated the loan at commercial terms to dispose of the note at a discount of $40k.  But a related party stepping in to acquire the loan could trigger unintended tax consequences that may not have been taken into account to date.  You may like to refer to §108(e)(4) and the related regulations.

[jskouberdis]

I read that the borrower could possibly have to pickup cancellation of debt income on based on that internal revenue code section.  But let's not go there for now.  My main question is when they pay it off in full with the original loan amount will the holder of the loan realize capital gain or ordinary income.  That is my main concern.

[itonewbie]

You have probably read the headline in the Code but not the regs because the answer you're looking for is right there.

Spoiler

OID

[jskouberdis]

I read that it may COD income.  I did not see OID

[itonewbie]

Did you read the regs?

[jskouberdis]

I read a little bit in the regs. and it talked about OID.  Probably I should have been picking up OID pro rata as I was going along but I didn't.  What would be the best way to fix outside of amending returns.  Should I just pick up ordinary income upon the debtor paying off the debt.

[itonewbie · Accepted solution]

If you decide that these provisions should apply to your client, no one here will be able to tell you what you should do other than amending those prior year returns.  There may be a position to be taken, perhaps depending on the NTE, but that would be your call.