What Is a Discounted Note? Types, Risks, and Tax Treatment

A discounted note is an existing promissory note or mortgage note that its holder sells for less than the total remaining payments owed, taking a lump sum today in exchange for the future income stream. The buyer collects the scheduled payments from the borrower going forward, and the gap between what they paid and what they eventually collect is their return. On privately held notes, that return typically runs from about 12% for well-secured paper to 25% or higher for unsecured obligations.¹

How the Discount Is Calculated

The math rests on a single idea: a dollar arriving years from now is worth less than a dollar in hand today. To figure out what a note is worth right now, an investor takes each future payment, divides it by one plus the required annual rate raised to the number of periods until it arrives, and adds up the results.²

A simple case makes it concrete. Say a note owes a single $10,000 balloon payment one year from now, and the buyer wants a 10% return. The present value is $10,000 ÷ 1.10, or $9,090.91. The buyer pays $9,090.91 today, collects $10,000 in a year, and keeps the $909.09 difference.

Real notes are usually longer and more complex. A seller-financed real estate note might have 20 years of monthly payments still to run. The same present value logic applies to each individual payment, and payments further out get discounted more heavily. That’s why long-dated notes trade at deeper discounts than notes close to payoff.

What Drives the Required Yield

The discount rate isn’t arbitrary. Anything that raises the chance the buyer won’t collect in full pushes the required yield up, which pushes the purchase price down.

Borrower creditworthiness. A clean payment history and strong credit lower the rate; missed payments or heavy debt raise it.
Collateral quality. A note backed by real estate with meaningful equity gives the buyer a fallback. Unsecured notes, or notes where the property has slid underwater, command steeper discounts.
Interest rate environment. A note carrying a 5% stated rate when market yields sit at 7% has to be discounted more to make the numbers work. Above-market rates sell tighter.
Remaining term. Longer notes carry more uncertainty about the borrower, the property, and the economy, so they trade at deeper discounts.
Servicing costs. Collecting payments, managing escrow, and handling borrower issues cost money, and that cost gets built into the yield the buyer demands.

In practice, yields on privately held notes cluster between 12% and 20% for reasonably secured paper and climb to 25% or more when the security is weak or absent.¹

Why Sellers Take Less Than Face Value

Holding a note ties up capital for years. The seller trades that long wait for cash today because the money has better uses now: paying down other debt, funding a new venture, covering the tax bill from an underlying sale, or simply reducing exposure to a single borrower.

For owner-financed real estate, the trigger is often that the seller wants out of the lending business. Tracking payments, chasing late borrowers, monitoring insurance and taxes, and potentially foreclosing all take time and expertise the original seller may not want. Selling the note hands that work to someone who does it professionally, and the discount is what that convenience costs.

Common Types of Discounted Notes

Real Estate Notes

The largest market involves owner-financed real estate. When a property seller finances the buyer, the note is secured by a deed of trust or mortgage, and that security interest gives the holder the right to foreclose if the borrower defaults. Real estate notes attract more buyers and trade at tighter discounts than unsecured paper because that collateral is there.

The original holder can sell months or years after closing, provided the borrower has paid on time and the property has held its value. The investor steps into the seller’s shoes with the same security interest and the same enforcement rights.

Business Promissory Notes

When a business changes hands and the seller carries part of the price, that note can also be sold at a discount. The collateral is usually equipment, inventory, or receivables rather than real estate. The buyer typically protects their position by filing a UCC-1 financing statement with the debtor’s home-state secretary of state, which establishes priority against those business assets.³

Business notes tend to trade at deeper discounts than real estate paper because the collateral depreciates faster and is harder to liquidate. Diligence goes beyond the physical assets to the borrower’s financial statements, cash flow, and the competitive health of the business.

Structured Settlement Payments

People receiving periodic payments from lawsuit settlements or insurance annuities sometimes sell those future payments to a factoring company for a lump sum, but these transactions face heavy legal oversight. Federal law imposes a 40% excise tax on any company that buys structured settlement payment rights without court approval, which effectively forces every legitimate deal through a judge.⁴

Forty-eight states have their own structured settlement protection acts requiring the court to find the transfer is in the seller’s best interest before approving it.⁵ New Hampshire and Wisconsin are the only states without their own statutes, though federal approval requirements still apply. Courts weigh whether the seller has dependents relying on the payments, whether they understand the consequences, and whether the discount is reasonable.

Full Purchase Versus Partial Purchase

Not every sale is all-or-nothing. In a partial purchase, the investor buys only a set number of the remaining payments. If a note has 240 monthly payments left, the buyer might take just the next 60. Once those are collected, the note reverts to the original seller, who resumes collecting the remaining 180.

Partials suit sellers who need some cash but don’t want to give up the entire income stream at a steep discount. They give up a smaller lump sum and keep a valuable back-end position. Buyers get shorter exposure and less capital at risk, though yields on partials tend to be lower than on full purchases because the shorter window carries less uncertainty.

There’s a legal wrinkle worth knowing. Under the Uniform Commercial Code, transferring less than the entire instrument doesn’t count as a negotiation, so the buyer doesn’t acquire holder-in-due-course status and is treated as a partial assignee.⁶ That distinction matters if a dispute ever arises, because the partial buyer’s enforcement rights are weaker than those of someone who bought the whole note.

Risks Buyers Need to Price

The discount exists because the risk exists. Investors who mispricce that risk lose money in predictable ways.

Borrower default. If payments stop, the buyer has to work out a modification or foreclose, which costs money, takes months or years, and doesn’t guarantee full recovery. Unsecured notes offer no foreclosure remedy at all.
Collateral depreciation. A property worth $200,000 at purchase might be worth $150,000 in three years. If the buyer counted on that equity cushion to absorb losses, a market drop can erase it.
Prepayment risk. If the borrower refinances or sells and pays the note off early, the buyer gets principal back sooner than modeled. That sounds fine until you remember the yield calculation assumed years of interest payments that will never arrive. On a deeply discounted note, an early payoff can compress the actual return well below the target.
Document defects. Missing signatures, unrecorded assignments, or bad legal descriptions can make a security interest unenforceable. Careful diligence catches most of these, but not all.
Servicing burden. Payment collection, escrow, insurance monitoring, and borrower communication take infrastructure. Outsourcing to a loan servicer adds cost, and picking a bad one creates compliance problems.

Experienced buyers demand larger discounts on weaker paper, insist on real equity in the collateral, and diversify across enough notes that one bad deal doesn’t take the portfolio down.

Tax Treatment

The tax rules run in opposite directions depending on which side of the deal you’re on, and neither side is as intuitive as most people expect.

If You’re Selling the Note

Selling a note you originally took back as seller financing counts as a disposition of an installment obligation. The gain or loss equals the difference between your basis in the note and what the buyer pays you.⁷ The character follows the original transaction: if the underlying sale produced capital gain, the note sale does too; if it produced ordinary income, so does the disposition.

Basis is computed by multiplying the unpaid balance by your gross profit percentage and subtracting that from the unpaid balance.⁷ Sellers who don’t run this calculation before agreeing on a price sometimes find the tax hit takes a bigger bite than they planned for.

If You’re Buying the Note

The discount a buyer captures is generally income that gets reported over the life of the note rather than in one shot at payoff. Under the original issue discount rules, the holder of a debt instrument must include a portion of the discount in gross income each year on a constant-yield basis.⁸ That can mean owing tax on income you haven’t actually collected, sometimes called phantom income.

Exceptions exist. Loans between individuals made outside a business context and not exceeding $10,000 are exempt from OID inclusion, and short-term obligations maturing within a year of issuance are also excluded.⁸ For notes bought on the secondary market rather than at original issuance, the market discount rules under Sections 1276 and 1278 may apply instead, and those can allow the buyer to defer recognition until payoff or resale. The line between OID and market discount is technical enough that working through it with a tax professional before closing is usually worth the fee. State tax rules don’t always mirror the federal treatment either, so both sides should account for that in the same planning.

1
Texas Society of CPAs. How to Value Privately Held Promissory Notes
2
Wall Street Prep. Present Value (PV) – Formula + Calculator
3
Wolters Kluwer. What Is a UCC Filing – Learn the Basics
4
Office of the Law Revision Counsel. 26 USC 5891 – Structured Settlement Factoring Transactions
5
National Structured Settlements Trade Association. Frequently Asked Questions
6
Legal Information Institute. UCC 3-203 – Transfer of Instrument; Rights Acquired by Transfer
7
Internal Revenue Service. Publication 537 (2025) – Installment Sales
8
Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount