Taxation of NPN (Non Performing Notes)

I recently had a question from someone who has been buying non-performing notes from a hedge fund.  He buys notes at a huge discount and, as he puts it, “slides into the bank’s position”.  He then negotiates with the borrower to figure out something that will work for both parties.  Usually that includes reducing the principal in return for the borrower paying off the note or agreeing to some modified payment schedule.  He wants to know what the tax consequences are of buying, modifying, selling and/or getting payments on these notes.

The general answer to his question was the same that is often true with sophisticated situations: “It depends”….  Here’s what I wrote back to him:

First of all, if you are in the “business” of buying and selling notes, then gain is always ordinary income.  It’s just like an auto dealership; if a car sits on the lot for a year before selling, the gain on the sale is still dealer (ordinary) income.  Self employment taxes also apply if the entity is a proprietorship.

On the other hand, when dealing with an “investor” in cars, then selling it after a year can get you long term capital gains, less than a year short term capital gains, and in neither case do self employment taxes apply.

The issue of whether someone is in the “business” or merely an “investor” is a question of fact based on the totality of the circumstances, including whether the income is used to live on, whether the taxpayer has another job, how the business/investment is marketed, level of activity, etc., etc., etc.

When buying and holding a note, the payments that come in have three aspects: one is interest (based on the terms of the note), second is discount earned, and the third is basis recovery.  The first two are normally treated as interest income by the note owner, although the 1099 sent to the payer at the end of the year will show the interest based on the original terms of the note.

That original allocation no longer applies once there is a modification; the interest calculation then, if payments are received, is now based on the new terms of the note, at least as far as the year-end 1099 to the payer is concerned.  The basis in the hands of the buyer stays the same, so there will also be a different calculation for discount earned.

Often there are no payments, or only a few payments received before the re-negotiated note is sold or paid off.  In that case there is (usually) gain on the sale.  The face amount of the note does not matter as far as the accounting is concerned for the owner of the note; all that matters is what was paid for it.  That is the basis.  Period.  Gain is recognized on the difference between the basis and whatever was received on sale.  In a normal investor scenario, that gain can be long or short term depending on how long the note was held.

The caveat is that at a certain level of activity, the IRS can rule that the person buying and selling is in the business, i.e., a dealer, just like with dealer houses, where a house flip that happens to not close for a year is still ordinary income, meaning no installment sales, no 1031’s, possibly self employment taxes, etc.  But depending on the situation, that can work to your advantage.  Think about the notes you buy that end up having zero value.  If you are an investor and hold some notes for a year before giving up on them, you might run into the capital loss limitation rules, where you can only offset $3,000 of the losses against your ordinary income.  But if you are a dealer, all losses can be used to offset all your income.  Again, it depends on the situation.

Re-negotiating the note never changes the basis on the books of the note owner unless that owner puts more into the deal one way or the other.  There are some ways of doing that, used by people who are very familiar with present value concepts as they pertain to notes, but they involve several steps, generally at least one other person or entity not controlled by the taxpayer, and sophisticated bookkeeping procedures and controls to keep the processes from spinning out of control.

Hope this helps.  This is a subject that often takes people years to “internalize” enough to keep all the different size plates spinning without getting dizzy.  But well understood, the profits can be substantial.